2016 - Planet of The Aches

Eye on the Market Outlook 2016
J.P. MORGAN ASSET MANAGEMENT
Planet of the Aches. Some aches and pains are constraining the global economy, with more severe strains occurring in the emerging
world. We believe contagion to the US and Europe will be limited in 2016, and expect their consumer revivals to continue, courtesy
of low inflation, low commodity prices, central bank intervention and reduced fiscal austerity. However, above-average equity
valuations, peaking corporate earnings momentum and stagnant productivity growth will likely result in a year of modest single-
digit returns on diversified portfolios.
This year’s cover art transforms some well-known aches and pains: exhaustion, tinnitus,
periodontitis, bronchitis, acid reflux, hangovers, restless leg syndrome, appendicitis,
conjunctivitis, anemia, mononucleosis, E. coli infections, iron deficiency, narcolepsy,
macular degeneration and altitude sickness. These aggravating but generally not life-
threatening conditions are meant to convey a slow growth world, but not one on the
precipice of collapse or recession. Competitive devaluations are unlikely to alleviate
these aches and pains; successive rounds of currency depreciation in Europe and Asia
mostly redistribute income across countries, rather than boost aggregate demand.
Most of these conditions are homegrown: Latin American and Australian overexposure
to commodity prices, weak consumer activity in Japan, economic dissonance across
countries in the Eurozone, a surge in dollar-borrowing emerging economies and slowing
corporate profits growth in the US. However, some conditions are the result of contagion:
“ECBotulism” refers to the impact of ECB policy on countries like Sweden that are forced
to engage in destabilizing quantitative easing, or lose export market share (see page 15
for more details). As for Canada, there was no need to transform the name of an illness
for our cover: “Dutch Disease” refers to an economic condition in which one sector of the
economy (in this case, oil and gas) drives the currency to such a high level that it causes
medium-term damage to the rest of the country’s export sectors.
Cover art by Norm Bendell.
FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY –

NOT FOR RETAIL USE OR DISTRIBUTION
MARY CALLAHAN ERDOES
J.P. Morgan Asset Management
As we enter 2016, I want to thank you for the continued trust and confidence you place in
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unemployment weighed heavy on all of our minds. But at the same time, record
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To help guide you in the coming year, our Chief Investment Oﬃcer Michael
Cembalest has spent the past several months working with our investment
In his ever-insightful
leadership acrossand always-entertaining
Asset new year outlook,
Management worldwide to buildMichael Cembalest examines
a comprehensive view
of the macroeconomic
the ailments landscape.
hindering stronger In doing
growth around theso, we’veand
world, uncovered some potentially
offers a long-term prognosis
exciting investment opportunities, as well as some areas where we see reason to
for global markets. Michael and our strategy team take an in-depth look at macroeconomic
proceed with caution.
implications and detail what we can expect in the year ahead, from peaking corporate earnings
Sharingtothese
momentum perspectives
stagnant and opportunities is part of our deep commitment to
productivity.
you and what we focus on each and every day. We are grateful for your continued
trust and confidence, and look forward to working with you in 2011.
We hope you enjoy this piece, and, more importantly, we wish you good health and much
happiness in the coming year.
Most sincerely,
Most sincerely,
FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND
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M A R K E T• OUTLOOK 2016
J.P. MORG AN QUALIFIED INVESTORS ONLY – NOT FOR RETAIL USE OR DISTRIBUTION
JANUARY
J a n u a r y 1,
1 , 2016
2016
Table of Contents
Planet of the Aches: Executive Summary 1
US: rising dollar takes a bite out of growth, but consumer rebound should continue 8
Europe: cyclical improvements for another year…the bigger test will be in 2017 12
Japan: government intervention in equities overrides macroeconomic weakness 17
Why all the focus on emerging markets? 19
China: capital spending reversal now in full swing; China slowing, not melting 24
Special Topics 27
Regulatory impacts on bond market liquidity as the credit boom comes to an end
The impact from stock buybacks and share count reduction is probably peaking
The improved resilience of global banking systems
Oil: a roadmap for lower prices first, higher prices later
Credit risk of US states: broad generalizations do not apply
Private equity: an update on performance vs. public markets
Hedge funds: generally delivering lower returns in line with risk-based benchmarks
How bad is Brazil, and what is the risk of contagion through sovereign default?
Special topics in 2015: The Millennials, and high-renewable electricity grids
Sources and acronyms 40
Click on the video to hear Michael

Cembalest, Chairman of Market
and Investment Strategy, discuss
the cover illustration of “Planet of
the Aches.”
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Executive summary
INTRODUCTION
Planet of the Aches. Stars are aligning for mid-single-digit returns on diversified portfolios in 2016.
That would be a little better than 2015, when returns on many diversified portfolios ranged from 0% to
3.5% 1. The aches and pains shown on the cover are aggravating (resulting in slow growth) but
generally not life-threatening (recessionary). Growth is mostly sustained by consumer spending; global
retail sales are still growing at 3%-4% per year in real terms, as they have since 2012. However,
manufacturing, trade and capital spending are stagnant (1st chart), despite 10,000 volts of monetary
stimulus 2 from developed world central banks (2nd chart). Since mid-2014, global profits have also
stagnated (3rd chart), in part since declines in energy and mining sectors have not been offset by gains
elsewhere, resulting in diminishing returns on equities (4th chart).
Global manufacturing, exports and capex: stagnating Developed world central bank assets and policy rates
Y/Y % change Assets, US$ trillions Policy rate, GDP-weighted
$13 4.5%
15% 4.0%
Equipment $11 3.5%
10% capex 3.0%
$9 2.5%
Export volume
5% 2.0%
$7
Central bank Weighted 1.5%
assets policy rate 1.0%
0% $5
Manufacturing output 0.5%
$3 0.0%
-5%
2010 2011 2012 2013 2014 2015 2005 2007 2009 2011 2013 2015
Source: J.P. Morgan Securities LLC, CPB. Capex and manufacturing Universe: US, Eurozone, Japan, UK + Aus/Can/Den/NewZ/Nor/Swe/Swi
output exclude China. Q3 2015 an estimate for capex. October 2015. Source: National central banks, IMF. October 2015.
Slowdown in global earnings, with or without EM Despite central bank policy, diminishing returns on
Earnings per share, local currency, trailing 12-months (both axes) global equities, Rolling 1-year total return in local currency
75 30 35%
MSCI World Equity Index earnings MSCI World
70 28 30% Equity Index,
per share, excluding EM
65 26 25% excluding EM
60 20%
24
55 MSCI World Equity Index earnings 15%
22
50 per share, including EM 10% MSCI World
20
45 5% Equity Index,
40 18 0% including EM
35 16 -5%
30 14 -10%
2010 2011 2012 2013 2014 2015 2010 2011 2012 2013 2014 2015
Source: MSCI, Datastream. November 2015. Source: Bloomberg. December 17, 2015.
1
Using index returns through December 30, we develop a rough estimate for 2015 diversified portfolio returns.
• For US$ investors: A 60/40 mix of the MSCI All-Country World Equity Index and the Barclays US Aggregate Fixed
Income Index returned 0%, assuming 50% of Eurozone and Japanese equity exposure is currency hedged.
• For Euro investors: A 60/40 mix of the MSCI All-Country World Equity Index and the Barclays Global Aggregate
Fixed Income Index returned 3.5%, assuming 67% of US and Japanese equity exposure and 100% of fixed
income exposure are currency hedged.
• In both cases, portfolio returns would be ~1% higher if emerging market equity exposure were excluded, while a
10% US high yield allocation would subtract 0.5%.
• For additional context, the HFRI Fund-Weighted Composite Index and the HFRI Hedge Fund of Funds Index were
both up 0.3% through November 30.
2
Given Fed reinvestment policy that’s expected to continue despite rising rates, asset purchases of 60 billion Euros
per month by the ECB and an expected increase in asset purchases by the Bank of Japan, developed world
central bank assets shown above may increase by another $2-$3 trillion over the next 2 years.
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The emerging markets component of the global slowdown

INTRODUCTION
The more severe aches and pains are generally felt in the emerging markets, which is why they’re
inflamed on this year’s cover. The “emerging markets growth premium” has actually been shrinking
since 2010. In developed economies, economic conditions are more stable, as stronger service sector
activity offsets weak manufacturing. The key issue for 2016 is whether economic illnesses in
emerging markets will result in contagion in the developed world. Our assessment is that for
the most part, contagion will be limited.
Falling emerging markets growth premium Advanced economies stable despite EM weakness
Y/Y real GDP growth Manufacturing/services survey (PMI), 3-month average
9% 58
Emerging
7% markets 56 US, Eurozone &
5% Emerging Japan
3% 54 markets
1% China
52
-1% Expanding
Developed 50
-3% markets Contracting
-5% 48
1997 2000 2003 2006 2009 2012 2015 2010 2011 2012 2013 2014 2015
Source: J.P. Morgan Securities LLC. Q3 2015. Source: Markit, ISM, JPMAM. November 2015.
We expect bank credit growth and retail sales growth to keep falling in the emerging world
while they improve in the developed world. A key catalyst for these trends: a $550 billion annual
wealth transfer from oil producing countries to oil consuming countries, with the largest gains accruing
to countries with low gasoline taxes, such as the US 3.
A divergence in bank credit growth... ...and in real retail sales

Y/Y % change (both axes) Y/Y % change (both axes)
20% 4% 9%
4% Developed Developed
markets markets 8%
3% 18%
3%
2% 7%
16%
1% 2% 6%
0% 14%
5%
-1% Emerging Emerging
1%
markets 12% markets
4%
-2%
-3% 10% 0% 3%
2009 2010 2011 2012 2013 2014 2015 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15
Source: Central banks, IMF, J.P. Morgan Securities LLC. July 2015. Source: J.P. Morgan Securities LLC. October 2015.
3
The US consumer benefits to a greater degree from lower oil prices given lower gasoline taxes. From
June 2014 to September 2015, consumer-facing gasoline prices fell by 30%-35% in the US, by 25% in China, by
15% in the rest of the developed world ex-US, and by only 5%-10% in the EM world ex-China.
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While EM illnesses are a factor, lower US equity returns have a domestic catalyst as well
INTRODUCTION
The August correction in US equities was not just a reaction to a 2% China devaluation. I also see the
correction as a reaction to slow US revenue and earnings growth, even after stripping out large declines
in the Energy sector. The second chart shows single-digit revenue growth for “core” sectors, which
exclude Energy, Financials and Utilities. Furthermore, sectors that do generate higher revenue growth
attract a lot of interest: Healthcare was the only sector in Q2 with revenue growth over 5%, leading to
over-crowding and a Healthcare correction4 in August and September.
The RMB devaluation and its impact on US and EM Slow US core revenue and earnings growth
equities, Index level (both axes) Y/Y % change, Q1 2014 to Q3 2015
2,150 1,100 14%
2,100 1,050 12%

1,000 10%
2,050
950 8% S&P 500
2,000 Nominal
MSCI EM core revenues
S&P 500 900 6% global GDP
1,950 S&P 500
850 4%
1,900 core earnings
800 2%
1,850 750 0%
Initial RMB devaluation Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3
1,800 700
'14 '14 '15 '15 '14 '14 '15 '15 '14 '14 '15 '15
Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15
Note: Core excludes Financial, Energy, and Utility sectors.
Source: Bloomberg. December 17, 2015. Source: Empirical Research Partners. December 2015.
The “dollar altitude sickness” and “earnings anemia” shown on the cover have taken a toll on
2015 and 2016 earnings expectations. From peak levels, S&P 500 earnings expectations for 2015 have
fallen by 12% and expectations for 2016 have fallen by 15%. A proxy for small business operating
margins (“intentions to raise prices” less “intentions to raise wages”) shows downward pressure on
margins in 2016. Lower earnings growth argues for P/E multiples that are closer to “average” than
“peak”. While low inflation and low interest rates prompt some to call for higher multiples, I am
reluctant to believe that investors should reward a sub-par earnings outlook with higher valuations.
Falling earnings per share estimates for the S&P 500 Proxy for small business operating margin trends
Consensus S&P 500 earnings per share Net % planning to raise prices less net % planning to raise wages
$150
15%
$145
$140 10%
$135 2016
5%
$130
2015
$125
0%
$120
$115 -5%
Jan-14 Jul-14 Jan-15 Jul-15 1987 1991 1995 1999 2003 2007 2011 2015
Source: Thomson Reuters IBES. December 18, 2015. Source: NFIB. 3-month average. November 2015.
4
During the selloff in Healthcare, correlations across stocks spiked to 60% (~2x the average level since the mid
1970s), and forward P/E multiples fell below parity vs. the overall market, which is unusual. The last time it
happened: around 20 years ago, when the prospect of greater regulation also affected the Healthcare sector.
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Slowdown in equity and credit returns in 2015 not a surprise given elevated expectations
INTRODUCTION
We first published the “Market and Investor Optimism Barometer” in October 2014 to highlight our
concerns about the Panglossian view that prevailed at the time. Since we published the Barometer, a
proxy for risky US and European asset markets has moved sideways.
Market and Investor Optimism Percentile vs. history A simplified portfolio of risky assets
Barometer Dec-2013 Dec-2015 Cumulative total return in US$ since 1/1/2005, rebalanced quarterly
125%
Large cap median P/E ratio 84 79 Portfolio weights:
Large cap forward P/E ratio 75 78 100% 30% S&P 500
Small cap P/E ratio 89 54 30% MSCI Europe
75% 20% US high yield Oct. 2014
Europe P/E relative to US 86 54 20% Europe high yield publication of
Individual investor bull/bear 93 8 50% our Market
and Investor
Independent advisor optimism 96 52 Optimism
25%
Portfolio manager optimism 99 57 Barometer
Futures market long-short 95 95 0%
Equity market volatility 78 34 -25%
High grade bond spreads 99 24 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
High yield bond spreads 98 29 Note: 50% of European equity and high yield exposure is currency hedged.
99th percentile = most optimistic/bullish. *See box below for sources. Source: Bloomberg, Barclays Research, JPMAM. December 17, 2015.
Investors were not the only ones who were offsides. Federal Reserve expectations for US GDP growth
have consistently been too optimistic since 2010, when the Fed was projecting 4% growth for 2011 and
2012. The gaps between the dotted lines (Fed ex-ante forecasts) and the solid blue line (ex-post US GDP
growth) in the chart below are large. Hope sprang eternal.
Federal Reserve growth expectations too high Despite a painful recession, overall economy-wide debt
Real GDP Y/Y % change levels did not decline, Total non-financial debt as % of GDP
5% 275%
FOMC projections made in each year:
2010 2011 2012 2013 2014 250%
4% Developed markets
225%
200%
3%
Global
175%
2% 150%
Emerging markets
Actual
125%
1%
2010 2011 2012 2013 2014 100%
Note: FOMC projections are from meetings 12 months prior. 2000 2003 2006 2009 2012 2015
Source: Federal Reserve Board and FRB Presidents, JPMAM. 2015. Source: BIS, IMF, J.P. Morgan Securities LLC. Q2 2015.
During the global recession, in much of the developed world, debt shifted from households to
governments. From a political perspective, this may limit fiscal ammunition for spending to boost
growth, unless countries want to finance spending through central bank monetization of fiscal deficits.
While fiscal austerity in the developed world has finally subsided, we project a neutral (rather than
stimulative) fiscal impact in 2016.
*Sources for Market and Investor Optimism Barometer: J.P. Morgan Asset Management, Bloomberg, Deutsche Bank, Standard &
Poor's, American Association of Individual Investors, Investors Intelligence, National Association of Active Investment Managers,
Chicago Board Options Exchange, J.P. Morgan Securities LLC, Commodity Futures Trading Commission, Bank of America Merrill
Lynch Global Research, Barclays Capital, MSCI, Empirical Research Partners, Morgan Stanley, Datastream.
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Where do we go from here?
INTRODUCTION
US earnings are projected to rise in 2016, with gains from Consumer Discretionary, Tech and Staples;
projections also assume that 2015 is close to the bottom for Energy and Materials.
Another weak quarter for S&P 500 earnings and sales in Q3; consensus projections are higher for 2016
Earnings Y/Y growth Sales Y/Y growth
Sector Q2 2015 Q3 2015 FY 2015E FY 2016E Q2 2015 Q3 2015 FY 2015E FY 2016E
Telecom Services 11% 27% 16% 6% 3% 12% 8% 6%
Healthcare 15% 12% 13% 9% 12% 12% 12% 7%
Consumer Discretionary 9% 13% 8% 14% 2% 2% 2% 5%
Financials 5% 6% 7% 9% -11% 3% 0% 8%
S&P 500 ex-Energy 6% 6% 5% 8% -1% 2% 2% 5%
Industrials 2% 6% 4% 4% -1% 1% 0% 4%
Information Technology 6% 7% 4% 9% 1% 1% 2% 4%
Utilities 6% -1% 1% 3% -5% -3% -3% 0%
S&P 500 -1% -1% -2% 8% -5% -4% -4% 5%
Consumer Staples -3% -5% -3% 6% -2% -2% -2% 4%
Materials 3% -16% -10% 11% -14% -15% -14% 1%
Energy -57% -58% -59% -10% -32% -37% -35% 1%
Source: Morgan Stanley Research. December 17, 2015. E: consensus estimate
Do 2016 consensus projections make sense?

• I agree with projections of a Consumer Discretionary earnings bounce in 2016 vs. 2015,
given lower energy prices, an improving labor market, rising home prices and low inflation.
However, this sector has already had a great run, valuations for some stocks are elevated5 and
technicals show crowded positioning among hedge funds and other institutional investors.
• The more challenging assumption is the market’s confidence in a Tech earnings bounce.
After stripping out Apple and Google, Tech revenues are as weak as Industrials. This is not a
surprise: Tech has the highest foreign sales exposure of all S&P sectors, even more than Energy and
Materials. While it looks like the majority of the dollar’s rise is finally over, we don’t expect a major
dollar reversal. Furthermore, our outlook for Brazil, China, Europe, Japan and the rest of the Far
East for 2016 is not that different than 2015. If so, Tech earnings may not improve as much.
• An Energy rebound will probably not happen until 2017. Some companies that sold oil
forward will see hedges expire in 2016, in which case sector earnings may decline further.
• All things considered, consensus earnings growth estimates are probably 1%-2% too high; our
base case is that S&P 500 earnings and sales will rise in mid-single digits in 2016. Earnings
per share growth has been boosted by 2% per year by stock buybacks since 2012, but buybacks
and M&A activity may peak in 2015/2016 (see page 29).
5
Amazon is a good example of “improving fundamentals / rising valuations” in Consumer Discretionary stocks.
After a difficult 2014, Amazon soared in 2015 as investors responded positively to more clarity on its profitable web
services business. Amazon now has the same market cap as Wal-Mart, Costco and Target combined, while its
revenues and free cash flows are only 15%-25% as high. Amazon’s success is not without precedent; its share of
total retail sector revenues and gross profits since 1999 looks eerily just like Wal-Mart’s rise from 1971-1988. As
per Empirical Research, Amazon’s stock price now reflects expectations of 10%-20% revenue growth over the next
10 years, a feat which Amazon has already achieved but must now replicate on a larger scale.
Other signs of late-cycle behavior can be found when looking at a group of 5 growth stocks (Google,
Facebook, Amazon, Netflix and Salesforce.com). As noted by Empirical Research, their relative P/E ratios are
now 3.3x the overall market, which is roughly the same multiple as the big 4 growth stocks at the end of the 1990s
(Microsoft, Intel, Cisco and Dell). The rising correlations of today’s 5 growth stocks send a similar signal; the trailing
3-year correlation of their daily excess returns hit 45% in December 2015, which is roughly the same as the daily
return correlation of the 4 1990s growth stocks at its peak.
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Credit markets: spreads are wider, with more volatility to come in 2016
INTRODUCTION
Yields are rising on energy bonds, reflecting rising default expectations. A J.P. Morgan Securities report 6
estimated that 30% of the high yield energy market could default by 2017 assuming $45 oil and $2.75
natural gas. However, rising spreads have broadened beyond just energy/mining; in both the late 1990s
and in 2007, rising credit spreads preceded larger equity market problems.
US high yield corporate bond spreads Impact of high yield energy companies
Spread to worst over 10-year treasury US$ billions Percent
18% $70 20%
16% 18%
$60
Energy companies' 16%
14%
$50 share of total annual 14%
12%
Ex-energy $40 high yield issuance 12%
10% 10%
Energy $30
8% 8%
6% $20 6%
High yield
4% issuance by 4%
$10
energy companies 2%
2%
$0 0%
0% 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
1995 2000 2005 2010 2015
Source: J.P. Morgan Securities LLC. YTD issuance through November
Source: Barclays Research, Bloomberg. December 17, 2015. 2015 is annualized.
Rising credit spreads follow a period of large inflows into high yield, emerging markets debt, municipals
and other forms of credit. When the Fed is holding down long-term rates (financial repression) and the
frantic hunt for yield is on, it’s hard to assess the depth and health of credit markets. Some signs of
easy credit conditions: covenant-lite loans represented 70% of US loan issuance in 2015 vs. 10% in
2009, part of the continuing rise in corporate leverage (see page 29).
There’s plenty of empirical and anecdotal evidence pointing to reduced credit market liquidity (see
chart, and page 28). Many credit mutual funds hold 5%-7% in cash and securities that mature within a
year that typically trade close to par. Both categories would presumably be drawn upon first should
redemptions rise. After cash and short-term bond buffers are exhausted, price discovery on less liquid
securities can cause problems for managers7. We expect volatile credit conditions to continue in 2016.
The frantic search for yield Less liquidity in high-grade corporate bonds
Total mutual fund and ETF holdings of debt, US$ trillions Days required to trade entire market, 5-quarter average
$2.0 325
Inflation-linked less liquid
300
$1.6
Emerging market 275 more liquid

$1.2
250
$0.8 Municipal
225
$0.4 200
High Yield
$0.0 175
2005 2007 2009 2011 2013 2015 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: EPFR Global, ICI. November 2015. Source: FINRA TRACE, Barclays Capital IG Corporate Index. Nov. 2015.
6
“Energy Outlook and the Impact on US High Grade and High Yield”, J.P. Morgan Securities LLC, October 2015.
7
In early December 2015, a distressed credit mutual fund run by Third Avenue with $3.5bn in assets as of July
2014 was forced to block withdrawals (“gating”) after a wave of redemptions.
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The Planet of the Aches: a world of low returns on diversified portfolios

We expect the developed world consumer revival to "Mission accomplished": QE drives up equity valuations
INTRODUCTION
Combined forward price-to-sales ratio on MSCI US, Europe and
continue, fueled by low inflation, low commodity Japan equities, forward 12-months
prices and less fiscal austerity. However, valuations 1.6x
in developed equity markets are elevated, creating
higher hurdles for earnings. Central Bank 1.4x
intervention may provide a slightly higher boost to 1.2x

European and Japanese markets than the US in
2016, but all things considered, it looks like a single- 1.0x
digit year ahead for diversified portfolio returns.
0.8x
We expect easy monetary policy from the Fed (see
0.6x
page 10), Bank of Japan and European Central Bank '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15
in 2016, even if the Fed hikes once or twice next Source: Thomson Reuters IBES, Datastream, JPMAM. December 2015.
year; as shown below, it’s still a low inflation world.
On geopolitics, you can be forgiven for thinking that the world is a dangerous place. But as we have
written in the past, geopolitical conflict has historically not had a large, lasting impact on
financial markets; the economic, market and investment footprint of warzone countries is much smaller
than their population footprint. The business cycle has always been much more important for investors,
which is why it preoccupies our approach.
There are distressed investments out there for those willing to accept the volatility. Mining and energy
valuations are close to historic lows in relative terms 8, and emerging markets valuations are low as well.
While we may only be 50%-60% through the economic adjustment in emerging economies, markets
9
tend to bottom well before this adjustment process is through .
This year’s Outlook covers the US, Europe, Japan, China and EM, with concluding sections on credit
market liquidity, oil prices, the credit risk of US states, private equity vs. public markets, hedge fund
performance, problems in Brazil and a summary of 2 in-depth papers from 2015: The Millennials, and
our energy paper which covers the dynamics of electricity grids dominated by wind and solar power.
Michael Cembalest
J.P. Morgan Asset Management
A low inflation world

% of world GDP with core inflation below 2%
80% Market and Investor Optimism Dec-2015
70% Barometer Percentile Since
60% Emerging Markets
50%
EM P/B ratio 5 1988
EM P/B ratio relative to US 22 1988
40%
EM trailing P/E ratio 35 2004
30%
EM trailing P/E ratio relative to US 2 2004
20%
Energy and mining
10% US Energy P/B ratio relative to US large cap 1 1926
0% EU Mining P/B ratio relative to Europe 1 1980
1980 1985 1990 1995 2000 2005 2010 2015 99th percentile = most optimistic/bullish. *See box on page 4 for sources.
Source: IMF, national statistics offices. Q3 2015.
8
In addition to the data in the table above, here’s another sign of how far energy and mining have fallen: British
American Tobacco now has the same market cap as the entire UK mining sector; in 2013, UK mining was 3x larger.
9
“A History of Bottom-Feeding”, Special Edition Eye on the Market publication, April 2014.
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US: rising dollar takes a bite out of growth, but consumer rebound should continue
Any discussion of the US should start with the dollar.

Its rise explains much of the weak corporate revenue
and profit growth shown on page 5, and the export
weakness shown below. The US does not export much
to China, so we look at the real trade-weighted dollar
excluding the RMB; its rise from 2011 to March 2015
was among the fastest on record. Since then, the
UNITED
trade-weighted dollar has been range-bound, even

S TAT E S
after the Chinese devaluation in August. Looking

ahead, we believe that the majority of the dollar’s rise is
now over, at least against the Euro and the Yen.
Fast and furious: the rise of the dollar Domestic demand strong, exports weak
Real effective exchange rate, Index, July 2005 = 100 Contribution to GDP growth
140 4%
Domestic
130 vs. FX basket 3% final demand
excluding
120 Chinese RMB 2%
110 1%
100 0%
90
vs. FX basket -1%
including Net exports
80 Chinese RMB -2%
1980 1985 1990 1995 2000 2005 2010 2015 2012 2013 2014 2015
Source: Bank for International Settlements. November 2015. Source: BEA, J.P. Morgan Securities LLC. Q3 2015. Q4 is a projection.
More indications of the strong dollar’s impact: business surveys and payrolls which show large gaps
between services and manufacturing. Similarly, business capital spending is growing at 10%-15%
for domestically focused companies and falling at the same rate for globally focused companies and
energy companies. Part of the strength in services is related to commercial real estate, where office,
apartment, industrial and retail occupancy rates are improving faster than the pace of new investment.
However, commercial real estate is not cheap; hundreds of billions in Chinese capital outflows are
targeting real estate in rule-of-law countries like the US, UK, Canada and Australia, driving up prices and
lowering cap rates.
Unusually large gap between services & manufacturing Domestically oriented labor markets holding up
PMI survey level, 50+ = expansion, 3-month average Change in payrolls, thousands, 6-month avg. (both axes)
300 60
Services &
60 Services 250 50
construction
200 40
55
150 30
50 100 20
Manufacturing 50 10
45 0 0
-50 Manufacturing & -10
40
-100 mining -20
35 -150 -30
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 2010 2011 2012 2013 2014 2015
Source: Institute for Supply Management. November 2015. Source: Bureau of Labor Statistics, JPMAM. November 2015.
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The good news: improving labor markets and falling gas prices are boosting consumption and housing.
It looks like the US will grow at 2.5%-3.0% in 2016, a bit stronger than 2015. Consumer credit is
picking up and no longer just reflects rising student loans; auto loan and credit card balances are rising
as well. Federal and state/local fiscal drags have also come to an end, at least for now.
Steady employment growth Consumer credit growth

Y/Y % change Y/Y % change
20%
3%
2% 15%
UNITED
S TAT E S
1%
0% 10%
-1%
5%
-2%
-3%
0%
-4%
-5% -5%
1990 1995 2000 2005 2010 2015 1980 1985 1990 1995 2000 2005 2010 2015
Source: Bureau of Labor Statistics. November 2015. Source: Federal Reserve Bank. October 2015.
Private wages normalizing Home and auto sales trending higher

% of GDP, 6-month average Vehicle sales (% of pop.), home sales (% of households), 3-mo. avg.
40% 7.0%
6.5%
New & existing
39% home sales
6.0%
38% Light vehicle sales
5.5%
37% 5.0%
4.5%
36%
4.0%
35%
3.5%
34% 3.0%
1980 1985 1990 1995 2000 2005 2010 2015 2000 2003 2006 2009 2012 2015
Source: Bureau of Economic Analysis. November 2015. Source: BEA, National Association of Realtors, Census. November 2015.
On equity markets, profit margins declined by an amount that has at times preceded a recession, or
coincided with one. However, the driver of the 2015 margin decline was energy, as in 1985 when a
margin decline also did not signal recession. On a revenue-weighted basis, profit margins of the other 9
S&P sectors are stable. A single-digit US equity market return is our central scenario for 2016.
Bank loans to consumers and nominal consumer US profit margin decline mostly an energy story
spending, 6-month % change, annual rate Profit margin, grey bars denote recessions
8% 10% Ex-energy
7% 9%
Bank
6% loans 8%
5% 7%
4% 6%
3% Consumer 5%
2% spending Total
4%
market
1% 3% Energy
0% 2%
Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 '73 '76 '79 '82 '85 '88 '91 '94 '97 '00 '03 '06 '09 '12 '15
Source: Federal Reserve, BEA. November 2015. Source: Datastream, NBER, Barclays. Q3 2015.
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What about the Fed?
While the Fed has begun to raise interest rates, markets believe that the tightening cycle will
st
be the weakest on record. The blue line in the 1 chart shows the change in market expectations for
the effective Fed Funds rate, and implies a rate of just 1.35% two years from now. That would be the
lowest trajectory of Fed tightening since 1964 (the grey lines show prior cycles).
Current expectations vs. historical Fed tightening cycles Labor market dropouts by category since 2008
Change in policy rate Labor force participation rate
6% 66.0%
Previous tightening cycles
UNITED
S TAT E S
5% 65.5% Other
Current market expectations
4% 65.0%
Disabled
3% 64.5%
2% 64.0%
1% 63.5% Retired
0% 63.0%
-1% 62.5%
T=0 6m 12m 18m 24m 62.0%
Source: Federal Reserve Board, Bloomberg. December 16, 2015. 2008 2009 2010 2011 2012 2013 2014 2015
Note: In the cycles beginning in 1983 and 1999, the Fed reversed course
and eased within two years. Source: Federal Reserve Bank of Philadelphia, Shigeru Fujita. Nov. 2015.
I agree on a slow trajectory of Fed tightening, but I think market projections for the funds rate are too
low; the 2nd chart above is the reason why. From 2008 to 2014, 3% of the labor force “dropped out”
and stopped looking for jobs. No one knows why they haven’t returned 10 now that job openings are
rising, but eventually, tight labor supply could drive up wage inflation. It’s not happening yet, as wage
growth measures have just recovered to normal levels. However, a November 2015 NFIB survey showed
the highest reading for expected wage gains since 2007. Even in an environment of low goods
price inflation (core CPI ex-housing is growing at ~1%), wage inflation could force the Fed to
hike more quickly than what is now priced in. In my view, this is the single biggest risk for
global markets in 2016.
Three measures of wage growth Net percentage of small businesses planning to raise
Y/Y % change, 3-month average (ECI is quarterly) worker compensation, 3-month average
25%
5%
20%
Median wages
4%
15%
Average
3% hourly
earnings 10%
2%
5%
Wages and salaries (Employment Cost Index)
1%
1997 2000 2003 2006 2009 2012 2015 0%
1987 1991 1995 1999 2003 2007 2011 2015
Source: BLS, FRB Atlanta, JPMAM. Note: prior to 2010, average hourly
earnings are only for production and nonsupervisory workers. Nov. 2015. Source: National Federation of Independent Business. November 2015.
10
Federal Reserve analysts deconstructed the decline in labor force participation, and found that almost half of the
leavers had retired. Another large segment self-diagnosed as disabled; the rest departed for other reasons.
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Future challenges
Productivity growth has been weak, way below the 1980s and 1990s. Photovoltaic solar panel and
battery storage cost declines, driverless cars, 3D printing, robotics and online universities are potential
sources of increased efficiency, but they may not generate the productivity gains of prior eras. That
might be why rising R&D spending has not resulted in higher productivity growth (yet).
Why isn't R&D growth helping productivity growth? Entitlement and non-defense discretionary spending
Two-year annualized change % of GDP % of GDP, with ratio of entitlement to non-defense spending
5% 1.85% 12%
UNITED
S TAT E S
Non-farm Private R&D
Current
4% productivity 1.75%
10%
1.65%
3% Entitlement spending
1.55% 8% 4.0x
2% 3.2x
1.45% 6% 2.3x 2.3x
1% 1.0x 1.2x
1.35% 2.0x
0% 4%
1.25%
Non-defense discretionary spending
-1% 1.15% 2%
1980 1985 1990 1995 2000 2005 2010 2015 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025
Source: BLS, BEA. Q3 2015. Source: CBO. August 2015. Dotted lines are CBO projections.
Another explanation for low productivity growth might be found in the second chart, which is the
infamous exhibit I presented at my wife’s birthday party a few years ago (a.k.a. “The Shooting Party”).
While my timing was ill-advised, any discussion about entitlements is incomplete without this
picture. The Federal government spends money on entitlements, and on a laundry list of programs that
fall under the general description of “non-defense discretionary spending”. Examples of the latter:
• Transportation and infrastructure (e.g., civil and military air navigation, high-speed intercity rail
programs, highway/rail/port rehabilitation, Coast Guard, Federal Aviation Administration)
• Employment services (e.g., job retraining, dislocation and vocational apprenticeship programs)
• Natural resources and the environment (e.g., Army Corps of Engineers, EPA superfund, arsenic/lead
exposure management, pollution control and abatement)
• Energy (e.g., renewable energy integration, SmartGrid research, energy efficiency and nuclear power
demonstration projects)
• Health and education (e.g., Federally financed elementary, secondary and higher education;
consumer and occupational health and safety, NIH/CDC spending on disease control & bioterrorism)
In 1960, before the creation of entitlements, 35% of the elderly lived below the poverty line; the
creation of entitlements was a vital need. However, its creators did not link entitlements to national
income (e.g., ability to pay). The ratio between entitlement and non-defense discretionary spending was
1 to 1 in the early 1970s, is now 3 to 1, and after passage of the Budget Control Act in 2011, is headed
to 4 to 1 by 2020. Some economists refer to this phenomenon as “generational theft”, given the
degree to which programs that contribute to future growth, employment and productivity are being cut.
For more information on issues affecting US growth and productivity that might be useful
around the family dinner table (personal tax rates, corporate tax rates, the fiscal cost of the Iraq War,
government regulation, the Affordable Care Act, the impact of free trade on US manufacturing workers,
natural gas prices and hydraulic fracturing, tort reform, etc.), see our holiday piece from 2015.
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Europe: cyclical improvements for another year…the bigger test will be in 2017
Most of Europe is showing signs of improved growth. Employment, business surveys, bank lending,
consumer confidence, retail sales, car registrations, etc. are rising. Positive signals are not just in core
countries like Germany; as shown in the last 2 charts, residential mortgage, consumer and corporate
credit demand is picking up in Italy and Spain as well. The recoveries in Spain and Italy 11 are taking place
off of a very low base, but positive momentum is clear.
Eurozone employment and hours worked improving Eurozone business surveys improving, France trailing
Y/Y % change Composite manufacturing/services PMI survey, Index
2% 65
Employment
1%
60
0% Germany
55
-1%
50
EUROPE
-2% France
Total hours
45 Italy & Spain
-3% worked
average
-4% 40
2001 2003 2005 2007 2009 2011 2013 2015 2010 2011 2012 2013 2014 2015
Source: European Central Bank. Q3 2015. Source: Markit. December 2015.
Eurozone bank lending and consumer confidence Eurozone retail sales and car registrations
EUR billions, 3-mo. avg. Net balance of responses Y/Y % change, 3-month average (both axes)
25 0% 5% 20%
20 Bank -5% 4% Retail sales New car 15%
15
lending 3% registrations
-10% 10%
10 2%
-15% 5%
5 1%
-20% 0% 0%
0
-25% -1%
-5 -5%
Consumer
-10 -30% -2%
confidence -10%
-15 -35% -3%
-4% -15%
-20 -40%
2005 2007 2009 2011 2013 2015 -5% -20%
2005 2007 2009 2011 2013 2015
Note: bank lending to households and non-fin corps; consumer confidence
is net balance of positive and negative responses. Source: ECB. Dec. 2015. Source: European Central Bank, Eurostat. November 2015.
Spain credit demand Italy credit demand

Net % of banks reporting higher demand, 2-quarter avg. Net % of banks reporting higher demand, 2-quarter avg.
100% 100%
More credit demand More credit demand
75% 75%
Mortgage
Consumer
50% 50%
Corporate Consumer
25% 25%
0% 0%
-25% -25% Corporate
-50% Mortgage -50%
-75% -75%
Less credit demand Less credit demand
-100% -100%
2003 2005 2007 2009 2011 2013 2015 2003 2005 2007 2009 2011 2013 2015
Source: Banco de España. Q4 2015. Source: Banca d'Italia. Q4 2015.
11
Amazing but true: after two recessions, Italy starts growing again. Households and businesses are in
expansion mode, exports are rising, unemployment is falling and consumer spending is picking up. Italy will need
many years of easy money support from the ECB to keep this momentum going, as well as allowances from the
European Commission to postpone fiscal tightening and debt reduction. The continually rising stock of Italian
bank NPLs implies that Italian banks are not lending as much as they might, given their capital levels.
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Even with these improvements, the Eurozone appears headed

back to just 2% growth. More fundamentally, potential
growth may be low as well. In April 2015, the IMF and OECD
estimated structural Eurozone growth (i.e., the speed limit of
the economy that does not trigger inflation) at just 1%,
reflecting a decline in total factor productivity growth and
hours worked, slow growth in machinery and equipment, and
insufficient competition in protected sectors. One illustrative
statistic: from 2000-2014, total factor productivity grew by
1.4% in the Eurozone compared to 10.7% in the US 12.
The 2nd chart shows labor competitiveness gaps vs. Germany;
so far, progress in Italy and France is slow. In Italy, Renzi’s
government has passed labor market reforms, but they will
play out over years and not months, and there are still barriers
to implementation. In France, a September 2015 proposal for
EUROPE
a full Eurozone fiscal union with a centralized Treasury
by French Economy Minister Emmanuel Macron13 may reflect
the recognition that after the cyclical boost is over, France still
faces difficult problems ahead, including political obstacles to
closing its competitiveness and trade gap vs. Germany (more
on France on page 16).
Eurozone real GDP: heading back to 2% Competitiveness improvements: so far mostly in Spain
Y/Y % change, history extended from individual countries Real unit labor costs relative to Germany, index, Q1 2000 = 100
6% 140
less competitive
4%
labor market
130
2% Italy
0% 120
-2%
France Spain
-4% 110
-6%
1980 1985 1990 1995 2000 2005 2010 2015 100
2000 2003 2006 2009 2012 2015
Source: Eurostat, Bloomberg, J.P. Morgan Securities LLC. Actual data
through Q3 2015; dots represent consensus estimates for Q1 and Q4 2016. Source: Datastream, ECB, J.P. Morgan Asset Management. Q2 2015.
An exception to the low growth/stagnant competitiveness picture: Spain. It will take years for Spain to
heal (industrial production is 25% below its pre-crisis peak, unemployment is 20%, youth unemployment
is ~50%). But after a recession in which home prices and residential investment bottomed 35% and
50% below peak levels, Spain has grown at 3% for the past 2 years with contributions from both
exports and household consumption. Changes in labor market flexibility, severance and collective
bargaining are part of the reason that Spain has narrowed its unit labor cost gap with Germany. The
next test is a political one: without the benefit of currency depreciation to absorb part of the adjustment,
falling wages and prices had to account for most of it. The lingering impacts on unemployment and
household formation have altered Spain’s political landscape in ways that cannot yet be determined.
12
“Lifting potential growth in the Euro area”, Peter Praet, Executive Board of the ECB, Berlin, April 23, 2015.
13
Macron: “If we don’t move forward, we are deciding the dismantling of the Eurozone”. Full fiscal union? Good
luck with that. I cannot imagine that Germany would agree to what would amount to perpetual support.
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Equity market pricing. The P/E discount of European equities vs. the US is ~15%, which ranks in the
middle of the range seen since the 1990s. The earnings cycle is at an earlier stage in Europe and there is
plenty of operating leverage, so earnings could spike higher if GDP growth rose appreciably. But given
our 2% forecast for real GDP growth in Europe, we expect mid-single-digit earnings growth in 2016,
just as in the US. If there’s a positive surprise brewing, it could result from a recovery in European
capital spending which is still 10% below 2007 levels while US capital spending is 10% higher. All
things considered, a neutral position in Europe makes sense for 2016, particularly since the
ECB is loading up the monetary bazooka again (see box).
Relative equity market valuations: EU vs. US
P/E ratio, EU divided by US, trailing 12 months Latest ECB bazooka for weakening the Euro
30% The latest ECB announcements lengthen its
Premium to US
20% Sector neutral securities purchase program (of 60 billion Euros
10% per month) by six months. The ECB also cut its
deposit rates by another 10 basis points. This puts
0%
the rate paid by the ECB on mandatory and excess
-10% banking system reserves to -0.3%. Since deposit
EUROPE
-20% rates were set at negative levels, there have been

-30% Market-cap large capital outflows from the Euro area (and into
-40%
weighted the US), driving down the Euro. Like the Fed, the
Discount to US ECB will now reinvest principal it receives on its
-50%
1990 1995 2000 2005 2010 2015 purchased securities, prolonging its impact.
Source: MSCI, Datastream, JPMAM. December 18, 2015.
European profit margins and return on equity are ~2% below US levels; the difference is partly related
to higher US Tech margins. I view the convergence of European and US margins from 2005 to 2010 as
an anachronism resulting from the Southern European consumption/housing boom. Given the low
likelihood of a recurrence, the Eurozone may not recapture all of its underperformance vs. US equities
seen from 2010 to 2014. For US$ investors, Eurozone equities outperformed the US in 2015 only if
the Euro exposure was hedged away; otherwise, the performance gap was unchanged (last chart).
The same is true in Japan, where hedged Japanese equity returns doubled returns on unhedged equities
from 2010 to 2015. I don’t remember a time when currency hedging was more central to decisions on
regional equity allocations, and reflects the battle of central banks to debase their currencies. While the
majority of the Euro’s decline vs. the US$ may have already taken place, we believe it’s worth hedging
against another 5%-8% decline in the Euro vs. the US$ in 2016.
Net profit margin (ex-financials) In 2015, hedged Eurozone equities start to close gap
Percent vs. the S&P, Cumulative total return for a US$ investor
10% 140%
Margin convergence may have been a temporary S&P 500
anachronism of PIIGS housing/consumption boom US 120%
8% 100% MSCI Eurozone, hedged
(no FX impact)
80% MSCI Eurozone, unhedged
6%
60% (impacted by FX movements)
40%
4% Europe
20%
2% 0%
-20%
0% -40%
1980 1985 1990 1995 2000 2005 2010 2015 2010 2011 2012 2013 2014 2015
Source: Datastream. November 2015. Source: Bloomberg. December 17, 2015.
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One big question for 2017: German inflation
At some point, German inflation might render the ECB’s policy stance too easy for the Bundesbank (it is
already too easy for some non-Eurozone neighbors; see box). While German home prices are rising,
German unit labor costs, wages and goods price inflation are stable. However, given the speed with
which unemployment and idle capacity are falling, there could be a spike in German wages or prices in
2017. What will the ECB do then, since its monetary policy will be “just right” for Spain, Italy and
France? The original sin of the Eurozone was that it drove a wedge between cycles in France, Italy and
Germany that weren’t “broken” to begin with and joined economies that were very different (see charts
below). It is notable that Sabine Lautenschläger, a German member of the ECB six-person Executive
Board, came out against the idea of an enlarged ECB asset purchase program in November.
German inflation showing up in housing, but not in Death in Venice

wages or prices, Y/Y % change Industrial Production Index, 12/31/1999 = 100
6% 130
5% House prices Economic cycles more Germany
EUROPE
120 synchronous before the Euro
4% Hourly wages
3% 110
2%
GDP 100
1% France
0%
deflator
90
-1% Unit labor
cost 80 Euro exchange
-2%
rate fixed Italy
-3% 70
2010 2011 2012 2013 2014 2015 1980 1985 1990 1995 2000 2005 2010 2015
Source: Bundesbank, Statistisches Bundesamt. Q3 2015. Source: Respective national statistical agencies. October 2015.
North America vs. European Monetary Union

World Economic Forum composite competitiveness score*
100
Not in monetary union In monetary union
80
Less competitive
60
40
20
0
US Canada Mexico Germany Italy Greece
* Aggregation of institutions, infrastructure, education, goods/labor market
efficiency, business sophistication and innovation sub pillars.
Source: World Economic Forum, JPMAM. 2014.
“ECBotulism”: ECB policy and its impact on non-Eurozone countries

ECB policy is already too easy for some non-Eurozone EU neighbors. ECB policy has prompted countries like
Sweden, Denmark and Switzerland to keep pace with the ECB and engage in quantitative easing (central bank
asset purchases), driving down interest rates and currencies in order to avoid losing too much export market
share. The risk: distorting financial and asset markets and creating conditions for a crash, particularly in housing.
One notable example: Swedish home prices are up 25% since 2010 and household debt is accelerating. GDP
growth of 4% is rapidly closing its output gap, and inflationary pressures are building.
Switzerland finally gave up on its quantitative easing program and abandoned the Swiss Franc peg in January
2015 after its FX reserves ballooned by EUR 400 billion. Since January 2015, Switzerland has experienced a
decline in manufacturing, spending, wage growth, exports and confidence. In other words, the ECB is forcing
other European neighbors to choose between two equally unappealing options in the long run.
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The other big question for 2017: the French presidential election
nd
Polls suggest the National Front will make it into the 2 round of the French presidential election in
2017 against a Socialist or UMP candidate . The French system requires a 50% majority in 2nd round
14
voting. Conventional thinking is that Socialist and UMP voters will unite and support any candidate
other than the National Front. In support of this view, polls from Odoxa in May 2015 show the UMP
victorious against Le Pen in a 2nd round whether the UMP candidate is Sarkozy or Juppé. Polls show a
narrower presidential victory for the Socialist Party over Le Pen if the candidate is Manuel Valls; Le Pen
only polls higher than Hollande.
However, while business confidence is rising, the French recovery is slower than in the rest of
Europe, the number of unemployed in France is still close to its peak, and 1% growth isn’t going to
change that very much. Growth in France is mostly related to rising household debt rather than rising
disposable income or exports (France’s export market share has collapsed since the year 2000). The 2017
French election, a litmus test for Le Pen’s message of France needing to reclaim its monetary and
territorial integrity, is one of the most interesting European elections of the last 40 years.
EUROPE
Early polling for the 2017 French presidential election Unemployment improving, but not in France
Polls for hypothetical second round Harmonized unemployment rate (both axes)
70% 18% 30%
Le Pen
60% Opponent 16% Portugal
Spain 26%
50% 14%
22%
Italy
40% 12%
18%
30% 10%
France
14%
20%
Socialist
Socialist
8%
UMP
UMP
10% 6% 10%
Germany
0% 4% 6%
vs. Hollande vs. Valls vs. Sarkozy vs. Juppé 2007 2009 2011 2013 2015
Source: Odoxa. April-May 2015. Source: Eurostat. October 2015.
14
The latest results for the National Front. In May 2014 elections for the European Parliament, the National Front
emerged as the largest representative party from France with 25% of the vote. In March 2015 Departmental
elections, the National Front received 22% of the vote, and in the December Regional elections, 27%.
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Japan: government intervention in equities overrides macroeconomic weakness
Something is wrong with this picture. In the US and Japan, corporate profits sank during the global
financial crisis. In the US, the profit recovery was accompanied by a recovery in household income. In
Japan, however, corporate profits and household income moved in opposite directions, as
dynamics that helped profits recover did not help consumers.
Both the US and Japan had a profits rebound... ...but household incomes only rose in the US
Earnings per share, trailing 12-months (both axes) Real HH earnings index (both axes), Japan is 3-mo. avg.
$120 ¥60 101
116
100
$110 S&P 500 114
¥50 US 99
$100 112
98
¥40 110
$90 97
108 96
¥30
$80 MSCI 106 95
Japan ¥20 104 Japan 94
$70
102 93
$60 ¥10
100 92
$50 ¥0 98 91
2007 2009 2011 2013 2015 2007 2009 2011 2013 2015
Source: Thomson Reuters IBES, Datastream. December 2015. Source: BLS, BEA, Japanese Ministry of Health. Nov 2015.
How can we explain the outcome in Japan? The benefits of a weak Yen are mostly concentrated among
JAPAN
large corporations, given translation gains on offshore non-Yen income relative to Yen-denominated
costs. For smaller companies and households 15, a weaker Yen simply resulted in imported inflation.
While consumer spending has stabilized after a decline caused by the imposition of a Value Added Tax
in 2014, there are few signs of a rebound to pre-VAT levels. Japanese GDP growth has been volatile
and averaged 1.5% in 2015; we’re expecting a similar outcome in 2016.
Japan real GDP and components

Index, Q1 2008 = 100 The incredible, shrinking benefits of massive
110 Japanese money printing
Consumer spending
105 % change since 2012 as of:
Bank of Japan balance sheet 144% Nov
100
Real devaluation of the Yen 27% Nov
95 Real GDP
Monetary growth (annualized) 3.9% Nov
90 Bank loan growth (annualized) 2.4% Nov
Exports
Q1 '09: 63 Nominal GDP growth (annualized) 1.9% Sep
85
Core inflation (annualized) 1.3% Nov
80 Real GDP growth (annualized) 0.8% Sep
2008 2009 2010 2011 2012 2013 2014 2015
Source: Bank of Japan, Ministry of Internal Affairs and Communications,
Source: Cabinet Office of Japan. Q3 2015. Cabinet Office of Japan. 2015.
15
Another sign of how the deck is stacked against the Japanese consumer: the elevated level of Japan’s “OECD
producer protection ratio”, which measures the degree to which Japanese agricultural producers benefit from
prices that are higher than international markets. Japan’s ratio is 1.9, and only Korea’s is higher. The US ratio is
1.02, and the European Union ratio is 1.05. The Trans-Pacific Partnership is allegedly going to tackle this, but like
the other presumed benefits of the TPP for Japan, I will believe them when I see them.
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In October 2015, the Bank of Japan did not take further steps which markets were anticipating (e.g., an
increase in equity ETF purchases from ¥3tn per year, an increase in REIT purchases from ¥90bn per year
or an increase in government bond purchases from ¥80tn per year). Perhaps concerns about the
negative domestic impacts from a weaker Yen are affecting BoJ policy. Our contacts in Japan believe
that the BoJ is no longer being pre-emptive, and will wait until November 2016 to act.
Before one gets too despondent about Japan, there are some tailwinds for equity investors.
Many relate to government intervention and corporate governance reform, and explain how
Japanese equities generated positive returns in 2015:
• As described on the prior page, Japanese corporate profits have been rising; while nominal GDP
growth of 3% isn’t much, it’s better than the 0% that Japan averaged from 1991 to 2013
• Japan’s Central Bank is now the second largest equity holder, second only to the Government
Pension Investment Fund; similarly, Japan’s Government Pension Investment Fund doubled its equity
allocation from 12% to 25%
• The consequences of Japan Post Bank and Japan Post Insurance privatizations are worth watching.
The former is the largest financial conglomerate in Japan, and the latter controls the largest pool of
private savings in the world. Now privatized, they may seek more equity risk with their ¥300 trillion
in assets. Currently, 2/3 of these assets are invested in JGBs
• Corporate governance reforms are designed to push cash-rich companies to start disgorging it. As
shown, there’s plenty of room for greater shareholder distributions. Other reforms are pushing
companies to add more independent directors and protect rights of minority shareholders
JAPAN
Japanese companies have a lot more cash than US ...but do less with it
counterparts...
50% 3.5%
50%
US US 3.0% US
40% 40%
Japan Japan 2.5% Japan
30% 30% 2.0%
20% 1.5%
20%
1.0%
10% 10%
0.5%
0% 0% 0.0%
Cash (% of market cap) Cash (% of GDP) Dividend payout ratio Buybacks (% of GDP)
Source: Bloomberg, JPMAM. Q3 2015. MSCI Japan and US equity indices used in calculations.
The Japanese experiment. There are few A professor I once had told me this was impossible
Japanese velocity of money (M3) Central bank assets, % GDP
precedents for the kind of experiment Japan is 1.1 80%
conducting 16. At the current pace of BoJ purchases,
1.0 Velocity of money: 70%
private sector banks might actually run out of JGBs (GDP/money supply)
0.9 BoJ 60%
by the end of 2016, at which point the BoJ would assets
0.8 50%
have to buy them directly from the non-bank private
sector; I think it’s fair to say that no one really knows 0.7 40%
what would happen then. One thing is certain: like 0.6 30%
riding a tiger the BoJ can’t stop now, and has little 0.5 20%
choice but to continue with debt monetization as 0.4 10%
Japan’s Federal debt grows higher, and as it veers 0.3 0%
further and further into the economic unknown. 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Source: Bank of Japan, Cabinet Office of Japan, JPMAM. Q3 2015.
16
Another wacky milestone in the Japanese experiment: a Bank of Japan initiative to buy equity ETFs that
target firms raising wages and capital spending, financed by the sale of its other stock holdings.
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Why all the focus on emerging markets?
Over the course of my career, emerging markets have gone from exotic to mainstream. The table shows
rising inflows and portfolio allocations into emerging economies, EM’s share of global output and other
similar statistics. EM arguably merits more attention now than in 1998, when Russian and Asian
currency devaluations caused a sharp (but temporary) correction in developed equity markets.
The increasing importance and footprint of emerging markets
Developed world EM annual China share of EM China share of EM Asia ex-China
Inflows into EM, allocation to EM EM share of corporate bond annual corporate global fixed share of global
Year % of world GDP financial assets global output issuance (US$ Bn) bond issuance investment fixed investment
1980 1.0% <0.5% 27% - - 3% 2%
1985 2.5% <0.5% 27% - - 3% 4%
1990 1.5% <0.5% 27% $2 0% 2% 4%
1995 3.0% <0.5% 27% $14 2% 4% 5%
2000 6.5% <0.5% 29% $40 0% 5% 4%
2005 7.0% 2.75% 33% $118 12% 9% 5%
2010 11.5% 4.75% 40% $341 38% 19% 8%
2015 17.5% 5.75% 47% $931* 72%* 27% 8%
Source: Bridgewater Associates, International Monetary Fund, Economist Intelligence Unit. *2014 value.
Within emerging markets, the focus is of course on China. The charts below show China’s impact
on the world: its share of global activity and the example of copper, and its gravitational pull on the rest
of the emerging world. Many EM countries are overexposed to China through their exports of either
intermediate manufactured goods or commodities.
China's growing share of the global economy China's impact on the copper market
% of each category Copper consumption, million metric tons
Exports 2000 18
EMERGING
China
MARKETS
Oil consumption 2014 16
Output 14
12
Fixed investment
10
Growth
8
Commodity consumption 6
Steel consumption 4 Rest of
0% 10% 20% 30% 40% 50% 2 world
Source: EIU, BP, World Steel Association, OECD, USGS. 2014. 0
For commodities, average of consumption of steel, copper, aluminum, zinc, 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
tin, lead, nickel, oil, gas, coal, nuclear, cement, pork and rice. Source: USGS, World Bureau of Metal Statistics, JPMAM. 2014.
The gravitational pull of China

Correlation of Chinese GDP growth with GDP growth of all EM
countries, GDP-weighted; 10-year rolling basis
0.5
0.4
0.3
0.2
0.1
0.0
1990 1994 1998 2002 2006 2010 2014
Source: International Monetary Fund, JPMAM. 2014.
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The impact of the China slowdown on commodity prices is still underway. While most commodity
prices are down sharply vs. 2011, some are still higher than in the year 2000. Projections from Barclays’
commodities group show the copper market subject to excess supply until 2020.
Oil, coal and copper prices still above year-2000 levels Iron ore prices
Index, January 2000 = 100 Delivered to Qingdao, China, US$ per metric tonne
800 $190
Copper
700 Coal $170
Oil
600 $150
Aluminum
500 Natural gas $130
Agriculture
400 $110
300 $90
200 $70
100 $50
0 $30
2000 2003 2006 2009 2012 2015 2008 2009 2010 2011 2012 2013 2014 2015
Source: Bloomberg. December 17, 2015. Oil is an average of WTI & Brent. Source: Metal Bulletin, Bloomberg. December 17, 2015.
The next chart from J.P. Morgan Securities estimates the impact of a 1% growth decline in China on
different regions, and concludes that the impact is small on the developed world. The wild card:
where are losses from EM debt expansion going to show up? The IMF cites EM non-financial corporate
debt as having doubled from 2008 to 2014 from $9 to $18 trillion, one of the most astonishing debt
expansions on record. This includes onshore and offshore debt, and both loans and bonds. Much is
related to commodities, construction and real estate in China. The second chart shows the breakdown
of external debt measured against exports (e.g., hard-currency ability to pay). Countries like Brazil,
Turkey, Indonesia and South Africa are in the crosshairs; China looks fine on this basis.
EMERGING
MARKETS
Estimated impact of China growth shock on GDP by region External debt vulnerability by country
Cumulative impact on real growth from 1% change in China External debt as a % of exports
1.2%
200% Govt, Central Banks
1.0% Banks
150% Intercompany loans
0.8% Other sectors
0.6% 100%
0.4% 50%
0.2%
0%
TWN
PHL
IND
BRA
IDN
THA
MYS
MEX
TUR
ZAF
KOR
CHN
RUS
POL
CHL
0.0%
Developed United Euro Japan EM EM Asia Latin EM
Markets States Area ex-China ex-China America EMEA
Source: BIS, national statistics agencies, JPMAM. Note: Issuer breakdown
Source: J.P. Morgan Securities LLC. Q1 2000 to Q2 2015. not available for Taiwan. Q2 2015.
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Which countries are experiencing the greatest pain? Brazil, and Turkey
Brazil entered the commodity price decline in a weak political and economic position, and now
faces rising domestic debt, growing fiscal deficits, double-digit inflation, an unemployment
surge (from 4.6% in Q2 2014 to 8% in Q3 2015) and falling growth/wages. During the boom,
Brazil passed along benefits in the form of public sector wage indexation and increased government
spending. In retrospect, these benefits should have been temporary, or at least linked to commodity
gains while they lasted. The situation is bleak, but differs from Brazil 2002, given $350 billion of FX
reserves and less reliance on external debt. Domestic asset prices will probably be under pressure for a
while longer, but a default on Brazilian external debt is unlikely (see pages 37-38 for more details).
Turkey is one of the most capital-reliant countries in the world. The only major EM country with
a larger negative net international investment position (liabilities to foreigners net of holdings of foreign
assets) is Greece. The decline in the Turkish Lira, capital flight, falling central bank reserves, rising
inflation and domestic funding costs, asset-liability currency mismatches in Turkish banks and a weak
economy are part of its balance of payments problem, exacerbated by the risk of political instability.
EMERGING
MARKETS
Brazil: if you forgot what stagflation looks like, this is it Turkey net international investment position
Brazil real GDP growth and inflation, Y/Y % change US$ billions
12% $0
June 1994
May 2003
peak: 4,922%
9% peak: 17% Inflation
-$100
6%
-$200
3%
-$300
0% NIIP measures household,
corporate and sovereign liabilities
-3% -$400
to foreigners less domestic
GDP holdings of foreign assets
-6% -$500
1990 1995 2000 2005 2010 2015 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Source: Instituto Brasileiro de Geografia e Estatistica. November 2015. Source: Central Bank of the Republic of Turkey. October 2015.
While Russia faces the prospects of no growth in 2016

after a 4% decline in 2015, financial markets have priced
much of this in already. The Russian equity market is
trading at the lowest P/E in the EM world (even after
adjusting for its heavy weighting to energy stocks), and its
currency has already fallen by 60% from its 2011 peak.
Other than Brazil, commodity exporters like Chile and
South Africa had the worst economic momentum heading
into the end of 2015.
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Markets generally rise before economies do; are we there yet?
In other words, have EM equities corrected enough yet? Sentiment is terrible; investor positioning
appears to be very underweight; EM price-to-book ratios are ~2/3 of the way back down to 1998 levels;
and in trade-weighted terms, EM currencies (ex-China) are back at 1998 levels. The relative cheapness
in EM price-to-book ratios reflects higher weights to financial and commodity sectors than in developed
markets, but that has always been the case, so the trend shown below is a reasonable measure of
where relative value stands between the two markets.
It’s hard to pick the bottom and it typically feels awful when you get there, but I think we’ll see the
bottom in EM asset prices over the next 12-18 months. As we reviewed in our 2014 bottom-feeding
paper, the bottom in asset prices almost always occurs before peak loan defaults, unemployment, bank
failures and other distress metrics, and before exports start rising. In the past, rising surveys of
manufacturing activity have been helpful signals in timing market bottoms in emerging markets.
Balance of payments pressures in the emerging world On a P/B basis, EM getting closer to 1998 levels
Current Account: % change in: Relative price-to-book value
Country Worst Today Imports Exports Unit labor 1.6x
Currency
(% GDP) (% GDP) (US$) (US$) costs 1.4x
Malaysia 1.7% 2.2% -19% -19% -21% -17%
1.2x
Brazil -4.8% -3.2% -35% -30% -47% -29%
1.0x
Colombia -6.9% -5.9% -18% -44% -32% -31% vs. EAFE
0.8x
Turkey -10.2% -4.3% -22% -16% -38% N/A
0.6x
Indonesia -3.8% -1.8% -32% -31% -26% -15%
vs. US
South Africa -6.4% -4.1% -21% -28% -44% -18% 0.4x
Note: worst current account since 2010; change in imports, exports, currency and 0.2x
unit labor costs measured vs. peak since 2010. 1990 1995 2000 2005 2010 2015
Source: national statistics offices, EIU, J.P. Morgan Securities LLC. Q3 2015,
Source: JPMAM, MSCI. Dec. 2015. EAFE: Europe, Australasia, & Far East.
EMERGING
MARKETS
except currency which is through November 2015.
Global fund managers underweight EM vs. DM Emerging markets: real effective exchange rates
Fund manager relative positioning GDP-weighted broad REER
60% EM overweight 130
40% China
120
20%
110
0%
EM ex-China
100
-20%
-40% 90
DM overweight
-60% 80
2001 2003 2005 2007 2009 2011 2013 2015 1995 2000 2005 2010 2015
Source: BofA Merrill Lynch Global Fund Manager Survey. December 2015. Source: BIS, IMF, JPMAM. November 2015.
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There are bright spots, like India
By most accounts, India is the most under-allocated emerging market when looking at foreign holdings
of equities, bonds and FDI relative to its GDP. However, conditions are improving which may change
that. A quick summary: Indian labor is priced competitively after a decline in the Rupee (Indian unit labor
costs are 20%-30% cheaper than the rest of EM); private sector debt is low; India is a large beneficiary
from lower oil prices, given its oil deficit; inflation has finally fallen below 10% with scope for further
monetary easing; and reforms are gradually reducing barriers to growth. The government is starting to
address long-standing infrastructure problems (particularly in the power sector), and is raising limits on
foreign portfolio and direct investment. As in China, lending is gradually shifting from state-owned
banks to private sector banks. Another important initiative that’s underway: a new bankruptcy law that
recognizes bondholder rights and streamlines the collateral/collection process. While India has already
been outperforming other EM assets, we suspect this may continue.
The other point to keep in mind: not all emerging markets are the same.
Let’s use a simple measure of external debt vulnerability, such as the external debt to exports chart
shown earlier (these countries represent ~95% of the MSCI EM universe market cap). We put a dividing
line between India and Russia, and created two EM baskets: low and high external debt vulnerability. As
shown in the table, the higher vulnerability countries have seen worse equity market performance.
External debt vulnerability by country Divergent emerging market equity returns
External debt as a % of exports
Total return in US$
200% Govt, Central Banks Since 5/1/13 2015
Banks Low external debt
-3.6% -10.4%
150% Intercompany loans vulnerability
Other sectors Countries: Thailand, Taiwan, South Korea,
100% China, Philippines, Malaysia, India, Mexico
EMERGING
MARKETS
High external debt
50% -40.7% -21.8%
vulnerability
Countries: Russia, South Africa, Poland,
0%
Indonesia, Chile, Turkey, Brazil
TWN
PHL
IND
BRA
IDN
THA
MYS
MEX
TUR
ZAF
KOR
CHN
RUS
POL
CHL
Note: MSCI indices used for each country.

Source: BIS, national statistics agencies, JPMAM. Note: Issuer breakdown Source: Bloomberg, JPMAM. December 17, 2015.
not available for Taiwan. Q2 2015.
As for emerging markets dollar-denominated A modest rise in EM dollar debt yields

fixed income, yields have risen to around 7%. Yield to maturity, EMBI Global (US$ EM sovereign bonds)
18%
This might seem low in a historical context, but
the shift away from external debt to domestic 16%
debt in most countries, along with much higher 14%

FX reserves, justifies much of the yield decline. 12%
10%
8%
6%
4%
1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Source: J.P. Morgan Securities LLC. December 17, 2015.
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China: capital spending reversal now in full swing; China slowing, not melting
Let’s start with the good news:

• China is slowing, not melting down. The latest data point to growth of 5%-6%
• FX and interest rate liberalization was enacted last summer despite weak Chinese stock markets. In
rd th
the wake of the 3 and 4 plenums, there has also been some (but less) progress on state-owned
enterprises (SOEs), tax and land reform, and reform of rural-urban registration (Hukou system)
• Deregulation has boosted private company formation. Similarly, return on assets for non-state
owned enterprises is stable at ~9%; lower ROAs for SOEs is the bigger problem, as they make up
around one-third of corporate investment. The potential for productivity gains remains large
• Provincial and central government spending is rising, which will offset some of the decline in private
sector activity; the government also has room to bring down real lending rates, which are ~10%
• Sort of good news: China’s “Belt and Road” initiative, which entails the financing of roads, bridges,
pipelines, ports and rail in 67 countries across Asia, the Middle East and Eastern Europe. The plan
may help struggling Chinese steel, cement and heavy equipment companies. However, according to
Gavekal Research, $80-$100bn of project financing in a year would only be equal to one month of
domestic infrastructure spending, and take up only an estimated 20%-25% of China’s excess steel
capacity. There are also questions about productivity of investments running through Pakistan,
Yemen, Iraq, Afghanistan and Syria
• Another positive aspect of China’s exchange rate liberalization: hundreds of billions in capital
outflows despite capital controls, much of which are destined for developed countries
Private company formation rose after deregulation China real GDP and industrial production
Y/Y % change Q/Q % change, annual rate (both axes)
30% 16% 30%
25% 14% 25%
20% Private 12% Industrial 20%

companies production
15% 10% 15%
10% 8% 10%
Sole GDP
CHINA
5% 6% 5%
proprietorships
0% 4% 0%
2008 2009 2010 2011 2012 2013 2014 2015 2008 2009 2010 2011 2012 2013 2014 2015
Source: Gavekal Research. Q3 2015. Source: China National Bureau of Statistics. Q3 2015.
Government spending starting to pick up China's foreign currency reserves

Y/Y % change, 3-month average US$ trillions
45% $4.0
40%
$3.5
35%
30% $3.0
25% $2.5
Expenditure
20% $2.0
15%
$1.5
10% Revenue
$1.0
5%
0% $0.5
-5% $0.0
2010 2011 2012 2013 2014 2015 1990 1995 2000 2005 2010 2015
Source: Ministry of Finance of China, CNBS, JPMAM. November 2015. Source: People's Bank of China. November 2015.
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That’s where most of the good news ends. The charts below show contours
of the China slowdown. China’s competitive edge has diminished since the
financial crisis, and in 2016, China will likely grow at its lowest rate since 1990.
After a 50% rise in the RMB, the currency is a headwind as well. Industrial profits
have stagnated, and excess capacity and slower investment may keep them under
pressure for a while longer, driving down wages. The cracks in the China story
have been visible for some time; consider the increase in corporate debt needed
to support a unit of GDP. And as indicated by “Cirrhosis of the River” on the
cover, China has the worst environmental conditions for a country at its
level of development, an issue increasingly seen as a drag on growth.
Chinese capital formation eclipses prior Chinese service sector more stable than manufacturing
industrializations, Gross fixed capital formation, % of GDP PMI (50+ = expansion), 3-month average
50% 60
China
45% ('81-'12) 58
Services
40% 56
35% 54
Japan
30% ('60-'88)
52
Korea
25% ('78-'06) 50
Germany
20% ('54-'82) 48
Manufacturing
15% 46
2010 2011 2012 2013 2014 2015
Source: Bank of Korea, ESRI, IMF, National Bureau of Statistics of China,
Bundesbank, OECD. 2012. Source: China Federation of Logistics, Caixin/Markit. November 2015.
China fixed asset investment by sector China: electricity consumption and railway traffic
Y/Y % change, 12-month average Y/Y % change
45% 30%
40% 25%
Electricity consumption
35% 20%
(3-month avg.)
30% Other service sectors 15%
10%
25% Infrastructure
5%
20%
0%
15% Industrial -5%
10% -10%
CHINA
Real estate &
5% -15% Railway traffic
construction
0% -20%
2008 2009 2010 2011 2012 2013 2014 2015 2010 2011 2012 2013 2014 2015
Source: China National Bureau of Statistics. November 2015. Source: China National Bureau of Statistics, Bloomberg. October 2015.
Rising levels of corporate debt in China China industrial profits

Non-financial corporate debt, % of GDP Y/Y % change, 3-month average
160% 30%
150% 25%
140% 20%
130% 15%
120%
10%
110%
5%
100%
90% 0%
80% -5%
70% -10%
1994 1997 2000 2003 2006 2009 2012 2015 2011 2012 2013 2014 2015
Source: Bank for International Settlements. Q2 2015. Source: China National Bureau of Statistics. November 2015.
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While home prices have bounced, overhang of inventory will likely prevent a large increase in residential
construction. The rise and fall in onshore equity markets, which coincided almost completely with the
rise and fall in margin debt, resulted in a 90%+ decline in the open position of index futures and in
futures market trading volumes. In other words, medium-term damage was done to the inner
workings of onshore Chinese equity markets.
All things considered, China is on its way to 4% annual GDP growth by 2020. As shown in the final
chart, offshore Chinese equity market P/E multiples are beginning to reflect this reality (although after
stripping out financials, remaining sector multiples are higher).
China real consumer activity index China retail sales
Y/Y % change Y/Y % change
40% 17%
35% 16%
30% 15%
14%
25%
13% Nominal
20%
12%
15%
11%
10% 10%
5% 9%
Real
0% 8%
2004 2006 2008 2010 2012 2014 2016 2012 2013 2014 2015
Source: Cornerstone Macro Research. Q3 2015. Source: China National Bureau of Statistics. November 2015.
Housing inventories still high in smaller cities Deteriorating Chinese labor market conditions
% of 2010 housing inventory levels Index level
350% 1.5
Factors included: wage growth, labor supply-demand ratio,
300% 1.0 employment growth, manpower survey and PMI survey
250%
0.5
200%
0.0
150%
-0.5
100%
-1.0
50%
CHINA
0% -1.5
Tier 1 cities Tier 2 cities Tier 3 cities 2007 2009 2011 2013 2015
Source: Gavekal Research. October 2015. Source: Lombard Street Research. Q4 2015 is an estimate.
China: margin debt vs. onshore equity prices China price-to-earnings multiples
Price index level Outstanding margin debt, % of GDP Forward price-to-earnings ratio, equal weighted by sector
5,500 3.5% 26x
5,000 3.0%
Onshore
22x (A-shares)
4,500
2.5%
Index of onshore 18x
4,000 equity prices (CSI 300) Offshore
2.0%
3,500 (H-shares)
14x
1.5%
3,000 Margin debt
10x
2,500 1.0%
2,000 0.5% 6x
Jan-14 Jul-14 Jan-15 Jul-15 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15
Source: Chinese national statistics offices, Bloomberg. December 17, 2015. Source: MSCI, Bloomberg. December 17, 2015.
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Special topics
Regulatory impacts on bond market liquidity as the credit boom comes to an end 28
The impact from stock buybacks and share count reduction is probably peaking 29
The improved resilience of global banking systems 30
Oil: a roadmap for lower prices first, higher prices later 31
Credit risk of US states: broad generalizations do not apply 34
Private equity: an update on performance vs. public markets 35
Hedge funds: generally delivering lower returns in line with risk-based benchmarks 36
How bad is Brazil, and what is the risk of contagion through sovereign default? 37
Special topics in 2015: The Millennials, and high-renewable electricity grids 39
Michael provides a deep dive into

additional special topics including
the global banking system, oil
markets, the credit risk of U.S.
states and credit market liquidity.
SPECIAL
TOPICS
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Regulatory impacts on bond market liquidity as the credit boom comes to an end
While the Volcker Rule presumably reduces the risk of proprietary trading losses affecting bank
depositors, the Rule also substantially changes the foundations of credit trading. In 2012, academics
pointed out what they saw as its eventual possible consequences:
“First, the Volcker Rule will have a negative effect on market making and liquidity provision for
many securities. The Volcker Rule will induce banks to retrench more from market making in
smaller and riskier securities where large and unexpected supply-demand shocks are more
likely, thereby reducing market making in the very securities where it is most valuable. The
securities issuers and the investors will feel the effects”. 17
Over the last couple of years, it was hard to assess its impact. After all, senior loan mutual funds saw 95
weeks of consecutive net inflows through April 2014. Over the next couple of years, we will be able to
assess the rule more clearly. From Howard Marks at Oaktree:
“Although the eventual impact of the Volcker Rule is unknown, any diminution of the banks’
likelihood of engaging in proprietary buying during crises suggests a significant reduction in
liquidity just when it may be needed most”. 18
A BIS report from August 2015 highlights the shift in the composition of fixed income ownership
away from Broker-Dealers, the decline in trading volume and dealer positions, and the declining
liquidity of high yield bond funds.
Bond holders Trading volume and inventory High yield bond funds
US$ trillions % of US resident holdings US$ billions Percent US$ billions
$2.5 5% $300 12% $500
Brokers and
ETFs Net
dealers (rhs)
$2.0 4% $240 10% assets $400
Share of
Weekly liquid
$1.5 3% $180 8% assets $300
trading
Money volume
$1.0 market 2% $120 Net dealer 6% $200
positions
$0.5 1% $60 4% $100
Mutual funds
$0.0 0% $0 2% $0
2002 2005 2008 2011 2014 2005 2008 2011 2014 2005 2007 2009 2011 2013 2015
Source: BIS, "Shifting tides - market liquidity and market-making in fixed income instruments", ICI. October 2015.
The US is not the only jurisdiction where changes to liquidity conditions are taking place. The European
Securities and Market Authority published standards relating to pre- and post-trade transparency that
are due to take effect in 2017 19. Our initial assessment: the impact could be substantial, given a market
maker’s reduced ability to hedge or offload inventory. The outcome: more fragmentation, less liquidity,
SPECIAL
TOPICS
fewer firms acting as market makers and more volatile spreads whenever trading volumes increase.
17
“The Economic Consequences of the Volcker Rule”, Anjan V. Thakor, John E. Simon Professor of Finance
Olin School of Business, Washington University in St. Louis, Summer 2012.
18
Howard Marks in Barron’s, March 26, 2015.
19
“From Mandatory Buy-ins to MiFID II”, Flows & Liquidity Report, J.P. Morgan Securities, October 2, 2015.
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The impact from stock buybacks and share count reduction is probably peaking
As shown in the first 2 charts, buybacks are surging, and the ratio of M&A and buybacks to cash flow
now surpasses 2007. The impact on equity markets is material: stock buybacks have been adding ~2%
per year to EPS growth at a time when earnings growth is scarce. While many buybacks are paid for
with cash (particularly by tech and pharma companies), some are financed via increased debt issuance.
Given rising credit spreads and elevated debt balances (see box below), contributions to EPS growth
from buybacks and M&A may fall in half by 2017. On a related M&A note, Empirical Research observes
that acquiring companies experienced positive relative stock market returns from 2010 to Q3 2015; in
Q4 2015, relative returns for acquirers turned negative.
Another later-stage market signal, shown in the last chart: less than 20% of technology IPOs in 2014
and 2015 had positive net income at their IPO date, which is almost as low as in 1999/2000 20.
Another strong year for buybacks S&P 500 M&A transactions and buybacks
Buyback announcements by S&P 500 companies, US$ billions % of earnings before interest, taxes and intangibles, 4-quarter avg.
$800 25%
Annualized
$700
20%
$600
$500 15%
$400
$300 10%
$200
5%
$100
$0 0%
'97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 1999 2001 2003 2005 2007 2009 2011 2013 2015
Source: J.P. Morgan Securities LLC. November 30, 2015. Source: J.P. Morgan Securities LLC, Bloomberg. Q3 2015.
Rising S&P 500 leverage, particularly ex-tech Remembrance of things past: low percentage of
Net debt to EBITDA technology company IPOs with profits
2.4 % of technology companies with positive net income at IPO
100%
2.1
80%
1.8
Ex-financials &
technology 60%
1.5
1.2 40%
Ex-financials
0.9 20%
0.6 0%
2000 2003 2006 2009 2012 2015 1980 1985 1990 1995 2000 2005 2010 2015
Source: Bloomberg, JPMAM. December 17, 2015.
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Source: Jay Ritter (University of Florida). August 2015.
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What’s up with US corporate leverage?
Many investors are used to seeing charts showing very low levels of leverage on US corporate balance
sheets. However, extreme sector differences can obscure important changes. The Tech sector now relies
much less on debt than it did in the past. Given its large weight in US equity markets, the Tech sector
masks an increase in leverage across the rest of the non-financial sectors since 2012. We adjust for Tech
in the chart above.
20
The pre-IPO lifespan of tech companies coming to market is longer today than it was in 1999, and price-to-sales
ratios today are much lower than 1999 levels. In other words, the tech IPO market has improved since 1999.
However, the IPO measures shown above do imply plenty of appetite for risk.
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The improved resilience of global banking systems

Since the financial crisis, bank capital ratios have increased markedly. In addition, bank reliance on
wholesale inter-bank funding and bond markets has declined as stable customer deposits make up a
greater proportion of liabilities. As a result, banks are in a better position to absorb write-downs
coming from energy-related investments and/or emerging markets exposures.
Developed world banks have increased capital... ...and reduced reliance on wholesale funding
Tier 1 capital ratio Loan-to-deposit ratio
15.0%
United Kingdom 140%
Eurozone
12.5% United States 120% Eurozone
Japan UK
US
10.0% 100%
7.5% Japan
80%
5.0% 60%
2000 2003 2006 2009 2012 2015 2000 2003 2006 2009 2012 2015
Source: Bloomberg, JPMAM. Q3 2015. Source: National central banks. Q3 2015.
Furthermore, as shown in the next 2 charts, banks hold less relative exposure to emerging markets and
energy compared to prior cycles. When leveraged banking systems are on the hook, recessions and
market corrections can be deeper. When losses are spread out amongst less leveraged corporate,
institutional (pension) and individual investors, market corrections can be less pronounced.
Foreign funding to emerging markets by creditor type US energy debt mostly from high yield market, not banks
Percent Debt shown as a % of shareholders' equity
100% 80%
90% Total energy debt
70%
80%
70% 60%
60% 50%
50% 40%
40%
30%
30% Other energy debt (bonds, commercial paper, etc.)
20% 20%
10% 10%
0% Energy bank loans
0%
1985 1990 1995 2000 2005 2010 2015 2001 2003 2005 2007 2009 2011 2013 2015
Banks Investors Corporates Other
Source: US Census, Gavekal Research. Q3 2015.
Source: Bridgewater Associates. August 2015. Note: all mining industries shown (roughly 75%-78% oil & gas extraction).
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Oil: a roadmap for lower prices first, higher prices later

There are reasons to believe that oil prices will be rangebound over the next year and may temporarily
fall to ~$30, but there are factors which we expect will push oil prices modestly higher in 2017-2018, as
forward curves currently anticipate. The charts tell the story in narrative form.
The world is currently oversupplied and there are signs that storage capacity is brimming with oil…
World oil supply balance Global floating crude oil storage
World oil production less consumption, % of production, trailing 12m Million barrels, 4-week average
5% 185
4%
160
3%
2% 135
1%
0% 110
-1%
85
-2%
-3% 60
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2010 2011 2012 2013 2014 2015
Source: Empirical Research Partners. Q3 2015. Source: Bloomberg. December 17, 2015.
The reasons for oversupply include a decline in Chinese demand, and broader declines in oil intensity…
Annual growth in Chinese crude oil demand Declines in energy intensity among major oil users
Thousand barrels per day Index, 2005 = 100, barrels of crude oil demand per unit of real GDP
100
1,000 Accumulation of
strategic reserves 95 Europe Russia
and aftermath of 2009
800 90
stimulus program Japan
85 India
600 US
80
400 75
70
200
65 China
0 60
'03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: BP, EIA. December 2015. Source: EIA, national statistics offices, Bloomberg. November 2015.
…as well as the possibility of increased Iranian oil sales, the lack of a traditional Saudi response to falling
prices, and a lot of US producers that would only be incented to shut in production at prices < $40
Iran crude oil production
Million barrels per day
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4.00
JPMS forecast Saudi Arabia refusing swing producer role this time around
assuming % change in the price of oil and output
3.75
nuclear deal
implementation 1996- 2000- 2006- 2008- 2014-
3.50
1999 2002 2007 2009 2015
3.25 Oil Price -61.2% -48.9% -34.0% -74.9% -62.9%
3.00 Saudi Output -14.1% -19.2% -8.8% -18.1% 5.4%
2.75 OPEC Output -11.7% -18.3% -4.1% -15.6% 5.9%
2.50
Source: Bloomberg. November 2015.
2010 2011 2012 2013 2014 2015 2016
Source: Bloomberg, J.P. Morgan Securities LLC. Q3 2015.
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History suggests that during an oil price bust, there is tremendous price deflation throughout the
exploration and production supply chain, driving down the marginal cost of oil and creating financial
distress, particularly for parts suppliers and other oil service companies. We hear from our managers
that $4.0mm per well developments costs have in some locations fallen to $2.2mm per well
Cost increases from 1975 to 1982 completely reversed in Oil futures project modest price rebound in 2-3 years
real terms by 1984, Index of well costs, 1975 = 100 US$ per barrel
300 $57
Costs include:
Site preparation
$53
Mobilization and rigging up
250 Formation evaluation and surveys
$49 Brent
Drilling Nominal
Tripping operations well cost
Casing placement $45
200 WTI
Well completion
$41
150 $37
Real well cost
$33
100 0 6 12 18 24 30 36
1975 1977 1979 1981 1983 1985 Months until delivery
Source: Energy Information Administration. 2008. Source: Bloomberg. December 17, 2015.
While the oil price decline caused a large decline in energy earnings and rising energy credit spreads,
investment grade producers account for 75% of US oil output; only 8% are rated B or lower. Credit
conditions alone will have a modest impact on the sector’s ability to operate and raise capital
Non-energy earnings growth stable US high yield corporate bond spreads
Calendar year earnings for S&P 500 sectors, 2014 = 100 Spread to worst over 10-year treasury
18%
120 2014 2015E 2016E 8%
5% 16%
100 14%
12%
80 Ex-energy
10%
Energy
60 8%
-59% -10% 6%
40
4%
20 2%
0 0%
Energy S&P 500 ex-Energy 1995 2000 2005 2010 2015
Source: Morgan Stanley. December 17, 2015. Y/Y % change above bars. Source: Barclays Research, Bloomberg. December 17, 2015.
Large cap energy price-to-book ratio relative to the market is now at the lowest levels in decades; if oil
prices stay where they are, 30% of energy HY issues could default by 2017
Large cap energy stocks: lowest relative valuations in

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decades, Price-to-book ratio of Energy relative to large cap universe

1.6x Bottom-up Energy default analysis
1.4x
Energy default rate
Case Scenario 2015 2016 2017 Avg. Total
1.2x Modest
$55 oil 4.6% 3.8% 11.6% 6.7% 20.0%
1.0x
recovery
Spot
$45 oil 4.6% 6.4% 18.6% 9.9% 29.6%
0.8x market
Unsustain-
0.6x $35 oil 4.6% 20.0% 10.7% 11.8% 35.3%
ably low
Note: All above scenarios assume $2.75 gas.
0.4x
1925 1935 1945 1955 1965 1975 1985 1995 2005 2015 Source: J.P. Morgan Securities LLC. December 2015.
Source: Empirical Research Partners. December 2015.
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What could eventually drive oil prices higher? US oil production typically follows the rig count
(which is more of a drilling indicator than a production indicator). As in prior oil market adjustments,
declines in global oil capital spending are underway and will eventually result in less supply, shifting the
narrative to the 3%-5% decline rates on existing fields. Note that cash flow from operations for global
oil majors includes a large benefit from prior oil hedges, which will be rolling off in 2016-2017
Key US shale oil plays: Bakken, Eagle Ford, Permian The eventual supply adjustment is underway
Oil rig count Oil production (mm barrels/day) 2015 US$ billions, based on 97 major global oil companies
1,200 6 $575
1,000 5
$525
800 Oil production 4
$475 Annualized cash
600
Oil rigs 3 from operations
$425 Annualized capital
400 2 expenditure
200 1 $375
2016 capex
estimate
0 0 $325
2007 2008 2009 2010 2011 2012 2013 2014 2015 2011 2012 2013 2014 2015 2016
Source: Energy Information Administration. December 2015. Source: Energy Information Administration, JPMAM. Q2 2015.
Declining oil prices led to declines in Saudi Arabian Monetary Agency balances in 2015. Based on IMF
projections made in 2014, these declines could continue, given low oil prices and high levels of Saudi
entitlement spending. The Saudis may eventually tire of low oil prices, capital flight, reserve depletion
and having to issue debt to support entitlement spending. If so, they may (eventually) take steps to
tighten supply once excess oil supply is gradually absorbed. However, Saudi debt reached 100% of GDP
in the late 1990s, so there may be a long way to go before that happens
Saudi Arabian Monetary Agency balance sheet Impact of government spending and oil prices on
Saudi Riyals billions government deposits at SAMA, Saudi Riyals billions
3,000 2,000
$90 oil, 3% fiscal adjustment
Banking sector reserves, currency & other
2,500
Government deposits 1,500
$90 oil, no
2,000 Note: oil accounts for 90% of gov't adjustment
revenues and 85% of exports 1,000
1,500
500 $65 oil,
1,000 3% fiscal adjustment
500 0
$65 oil,
no adjustment
0 -500
2000 2003 2006 2009 2012 2015 2013 2014 2015 2016 2017 2018 2019
Source: Saudi Arabian Monetary Agency. November 2015. Source: IMF Article IV Consultation. September 2014. *Oil is Brent Crude
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Saudi Arabian government debt and Brent crude oil price
% of GDP US$ per barrel
120% $120
Government Oil prices may remain below $40 for a few
100% debt $100
months in 2016, but by early 2017, the
80% $80 gradual supply-demand adjustment (including
the absorption of idle storage) will be well
60% $60
Brent oil underway, at which point oil prices will likely
price
40% $40 start rising again.
20% $20
0% $0
1991 1995 1999 2003 2007 2011 2015
Source: IMF, Bloomberg. December 2015.
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Credit risk of US states: broad generalizations do not apply

Municipal bond risk will only become more important over time, as assets of some severely
underfunded plans are gradually depleted. As a result, we summarize below a prior deep-
dive analysis we published on municipal risk at the state level.
The direct indebtedness of US states (excluding revenue bonds) is $500 billion. However, bonds are just
one part of the picture: states have another trillion in future obligations related to pension and retiree
healthcare. In the summer of 2014, we conducted a deep-dive analysis of US states21, incorporating
bonds, pension obligations and retiree healthcare obligations. After reviewing over 300 Comprehensive
Annual Financial Reports from different states, we pulled together an assessment of each state’s total
debt service relative to its tax collections, incorporating the need to pay down underfunded pension and
retiree healthcare obligations. In our Executive Summary, we showed the chart below as a synopsis of
our findings. While there are five states with significant challenges, the majority of states have debt
service-to-revenue ratios that are more manageable.
As a brief summary, we computed the ratio of debt, pension and retiree healthcare payments to state
revenues. The blue bars show what states are currently paying. The orange bars show this ratio
assuming that states pay what they owe on a full-accrual basis, assuming a 30-year term for amortizing
unfunded pension and retiree healthcare obligations, and assuming a 6% return on pension plan assets.
States below the green bar are spending less than 15% of total revenues on debt, which seems
manageable from an economic and political perspective. When this ratio rises above 15%, harder
discussions in the state legislature about difficult choices begin.
The highly challenged economics of a handful of state pension and retiree healthcare plans
% of state revenue collections required to pay the sum of interest on bonded debt, plus the state's share of defined benefit plan
contributions, retiree healthcare costs and defined contribution plan expenses
45%
40% What states would have to pay assuming level payments and a 6% return
on plan assets, amortizing unfunded amounts over 30 years
35%
What states are currently paying
30%
25%
20%
15%
10%
5%
0%
WV
LA
WA
WI
IL
TN
IN
WY
TX
FL
ID
SC
UT
AR
IA
SD
CT
HI
KY
DE
CA
NM
RI
PA
AL
KS
NY
VT
VA
NH
AK
AZ
NJ
NC
NV
ND
NE
OK
MO
CO
GA
OH
MA
MD
ME
MS
MI
OR
MT
MN
Sources: J.P. Morgan Asset Management; state/pension plan Comprehensive Annual Financial Reports; BEA; Pew Research; Moody's; Census;
Merritt; Loop Capital Markets. All data as of 2012.
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It would take a long time for underfunded pension plans (e.g., 60% funded) to run out of cash, given
the long duration of plan liabilities. But as investors learned in Puerto Rico and Greece, bond markets
can drift along unconcerned with mounting fundamental problems, only to experience a rapid repricing
at times that cannot be predicted. As a reminder, this analysis applies to states and not to city, county
and other in-state issuers. Please contact your J.P. Morgan coverage team for a copy of the report.
21
“The Arc and the Covenants: Assessing the Ability of States to Service Debt, Pension and Retiree Health Care
Costs in a World of Finite Resources”, Special Edition Eye on the Market, Summer 2014.
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Private equity: an update on performance vs. public markets

[This section is a summary of an Eye on the Market private equity review published in August 2015]
The Public Market Equivalent is a ratio of private equity to public equity performance, accounting for the
timing of private equity cash flows and all fees. From 1980 to 2012, the PME for a large universe of
1,400 funds averaged 1.25, which is equivalent to excess returns of 3%-4% per year. Our latest review
includes 2 more vintage years (2009 and 2010), with returns on all funds through June 2014. The
additional vintage years have stiff hurdles ahead of them: since January 2009 and January 2010, the S&P
500 has risen by 158% and 104%. So far, buyout funds from these vintage years are trailing public
markets, with PMEs slightly below 1.00. To be clear, only ~20% of buyout investments from these
vintage years have been realized; their PMEs are primarily based on valuations rather than distributions,
and may change as funds exit investments through IPOs, sales to strategic buyers or other private equity
funds. Research indicates that residual values tend to be conservative estimates of the ultimate cash
returned to investors 22. Nevertheless, it’s useful to start tracking how these vintage years are doing.
We are often asked whether different weighting approaches or benchmarks would have yielded
different results. As shown below, PME results are similar whether computing average fund returns,
median fund returns, or returns weighted by size of fund. Results are also similar whether using the S&P
500, the Russell 2000 or the Russell 3000 as the public equity benchmark.
In the current environment, sector-focused funds, private credit funds, real estate funds, and growth
equity funds appear to offer better value than buyout, which is very much a seller’s market, given ample
liquidity, rising purchase multiples and plenty of competition from strategic (corporate) buyers.
US Buyout/Growth Equity PMEs by weighting US Buyout/Growth Equity PMEs by benchmark
approach, Public Market Equivalent ratio, by vintage year Average Public Market Equivalent ratio, by vintage year
1.8 2.2
Average
1.6 Weighted 1.8
average
1.4 S&P 500
1.4 Russell
1.2
3000
1.0
1.0 Russell
Median 2000
0.8 0.6
'84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10
Source: Harris, Jenkinson and Kaplan. June 2015. Source: Harris, Jenkinson and Kaplan. June 2015.
US Buyout/Growth Equity median IRR and MOI

Percent, by vintage year Multiple, by vintage year Private equity firms: largely sitting out the M&A wave
40% 3.5x
While worldwide M&A activity in 2015 rose above the
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35% prior 2007 high, it was driven more by strategic
TOPICS
3.0x
30% Median investment acquisitions by companies than by buyout firms,
multiple 2.5x
25% whose activity is still less than 1/3 of 2006 levels.
2.0x Rising equity market valuations have given public
20%
1.5x companies more buying power at the same time that
15% leveraged lending by banks is constrained by new
Median 1.0x
10% IRR OCC rules governing senior debt leverage, repayment
5% 0.5x timetables for senior debt, covenants and collateral
0% 0.0x
protection. In other words, buyout firms are generally
'84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 doing a lot more selling than buying these days.
Source: Harris, Jenkinson and Kaplan. June 2015.
22
“How Fair are the Valuations of Private Equity Funds?”, Tim Jenkinson et al, University of Oxford, Working Paper,
February 2013.
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Hedge funds: generally delivering lower returns in line with risk-based benchmarks
What’s the best way to assess performance of a diversified hedge fund portfolio? Thresholds
like “8%” or “Libor + 3%” are unrealistically high in some markets, and too low in others. A common
shorthand approach compares hedge fund returns to a stock-bond portfolio with a similar risk profile, in
which “risk” is defined as the volatility of monthly returns. What stock-bond portfolio mix makes
sense? As shown by the brown line in the first chart, while a 60% Equity / 40% Bond mix is popular, it
has consistently generated a lot more volatility than the HFRI Composite. A benchmark of 45% Equity /
55% Bond is closer, albeit with a +/- 2% margin of error (blue line).
We can get closer to replicating the volatility of the HFRI Composite with a 6-factor model of US
large cap, US small cap, emerging market equities, high yield, commodities and cash (green dotted line).
Since 2001, the model’s combined equity weights are ~30% rather than 45%-50%.
With that framework in place, we can now evaluate how hedge funds have been doing. As
shown in the chart on the right, the rolling 3-year performance of hedge funds, as proxied by the HFRI
composite, has been in mid-single digits. While this is far from heroic performance, it’s more or less in
line with the composite benchmark described above, suggesting that the risk-return is a “fair” one.
In search of the best risk match for the HFRI Composite Hedge fund returns tracking risk-based benchmark
Rolling 3-year volatility less HFRI Fund Weighted Composite since 2009, Rolling 3-year total return
6%
60 S&P 500 / 40 20%
5% HFRI Fund
Barclays Agg.
4% Weighted Comp.
15%
3%
2% 10%
1%
5%
0%
-1% 6-factor 0%
-2% model 45 S&P 500 / 55
Barclays Agg. 6-factor model
-3% -5%
1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Source: Bloomberg. November 2015. Source: Bloomberg. November 2015.
Is it fair to use the HFRI Composite (which an investor cannot buy) as a proxy for a diversified
hedge fund portfolio? In other words, does it have similar risk? To examine this question, we
created 1,000 random portfolios of 20 hedge funds based on certain criteria (at least seven years of
performance, at least $750mm of AUM, and equal weighted among long-short, macro, event-driven
and relative value). The volatilities of these random portfolios were usually less than the HFRI Composite
(see chart below), so we proceeded under the assumption that the HFRI does not understate diversified
hedge fund portfolio volatility.
Distribution of return volatilities of randomly generated
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portfolios of 20 hedge funds, 2004-2013 The changing client focus of hedge fund managers
90
Volatility of HFRI
80 Composite Index, As recently as 2002, 80% of hedge fund assets under
70 2004-2013 management were invested on behalf of individuals.
60
This number has fallen to one-third, as more and
50
more institutional investors allocate to hedge funds.
40
One of the consequences: the risk-return objectives of
many institutions allocating to hedge funds are lower
30
than those of individuals. That may be contributing to
20
a decline in both hedge fund return and volatility,
10
particularly during a period of financial repression.
0
3.70% 4.20% 4.70% 5.20% 5.70% 6.20% 6.70% 7.20% 7.70%
Volatility of individual portfolios
Source: Pertrac, Bloomberg. January 2014.
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How bad is Brazil, and what is the risk of contagion through sovereign default?
What's falling in Brazil What's rising in Brazil
Fiscal deficit
Gov't interest payments
Brazilian Reais per $
Inflation
Real wages
Consensus earnings
Business confidence
Primary budget surplus
2005 2007 2009 2011 2013 2015 2005 2007 2009 2011 2013 2015
Source: FGV, IBGE, IBES. November 2015. Source: BCB, IBGE, STN. November 2015.
Brazil has been hit perhaps the hardest by the end of China’s capital spending boom and the decline in
commodity prices. The situation in Brazil is as bad as anything I have seen since working on a J.P. Morgan team
to restructure its external debt in 1994:
• Among the measures that are as bad or worse than 1994: GDP growth, the output gap (a measure
of growth relative to potential), the current account deficit and the trade balance
• Inflation and unemployment are rising sharply, growth is falling, exports are still weak despite a
collapse in the Real, and a 9% budget deficit (exacerbated by losses on Central Bank derivative
positions) will add to domestic debt which has risen close to 2002 levels
• Domestic lending rates are now around 22% for corporations and 39% for households
• Even though equities are falling, earnings projections are falling just as quickly, so that P/Es are not
at deep value levels
• J.P. Morgan Securities expects further weakness in the Real in 2016, along with refinancing risk on
maturing external debt, rising delinquencies and deteriorating asset quality
• The consequences are likely to be continued weakness in domestic Brazilian assets (note:
the Bovespa is already down 74% from its 2010 peak in US dollar terms), and write-downs
on some foreign direct investment that flowed into Brazil during the commodity boom
At some point, inflation should decline back into single digits when the Real stops falling, but that will
take time, and then there will be tough decisions to make: Brazil will have to bring its domestic debt
back down through fiscal consolidation, or monetize its public debt via the Central Bank. This will not
be fun to watch, particularly if Brazil enacts capital controls to force real interest rates down without
triggering capital flight (there may be some US academics who will counsel Brazil to do exactly this as a
reaction against “unruly and mercenary capital flows”). Legislators tasked with fiscal consolidation will
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have to confront entitlements (see box), which increased markedly during the commodity price boom.
TOPICS
Brazil and entitlements: some data points
• Brazil’s population retires on average at 54-55
• The social security deficit may hit 2% of GDP in 2016, and keep increasing since benefit adjustments are set at
prior year inflation plus 2-year lagged real GDP growth
• 90% of government expenditures are mandated by law, and many grow at a rate above inflation
• While Brazil is a “young” country (only India has a lower % of population over 60), Brazil pension spending is
9% of GDP (more than twice the EM average of 4%), and its population is aging quickly
• “Think Greece, but on a crazier, more colossal scale,” said Paulo Tafner, economist and leading authority
on Brazil’s pension system. “The entire country should be frightened to its core. The pensions Brazilians obtain
and the ages at which they start receiving them are nothing less than scandalous.” [NYT 10-20-2015]
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More bad facts: a lot of government and private sector debt and wages are indexed to
inflation, which makes the inflation-recession-currency decline-capital outflow spiral even
worse. In the 1990s, Brazil followed a path of de-indexing wages and prices, but reversed a lot of
those measures from 2003 to 2011. By some measures, collective bargaining covers 60% of labor
contracts, even higher than in Argentina, 3x higher than in India and 6x higher than in Mexico.
Even so, the risk of Brazilian sovereign default on external debt is lower than in 2002,
primarily due to a shift in sovereign financing from external to domestic debt. Public sector
external debt to GDP was 18% in 2002 and is only 5% today. The majority of Brazilian external debt is
related to the corporate sector, and Petrobras specifically. Another way of saying it: Brazil has a lot of
problems, but unlike Greece (2009) and Argentina (2001), Brazilian sovereign external debt is
NOT the core problem, and defaulting on it would probably not be a part of a solution.
To be clear, Brazil’s sovereign risk is not as low as in Thailand and Malaysia in 1998, when balance of
payments problems were mostly related to corporate leverage and exchange rates. Brazil’s public
finances are now in much worse shape; inflation-indexed and short-term debt will come back to haunt
Brazil in the form of higher debt balances and higher debt service costs. However, given Brazil’s reliance
on domestic financing, credit spreads on external debt may eventually overestimate default risk if they
keep rising (particularly as passive and active owners of sovereign and corporate debt are forced to sell
now that Brazil has been downgraded to junk status by both S&P and Fitch).
Indicators of external vulnerability: 2002 and today

% of GDP % of exports % of int'l reserves
2002 2015 2002 2015 2002 2015
Gross external debt 44% 34% 325% 246% 598% 151%
Non-bank public sector 18% 5% 134% 40% 246% 24%
2-year amortization 15% 13% 112% 95% 205% 58%
Non-bank public sector 7% <1% 49% 4% 91% 3%
Source: Barclays Research, "Brazil: Where are the risks in a 'muddle through' scenario?" Oct 2015.
Brazil credit spread on external sovereign debt Foreign financial exposure to Brazil
5-year credit default swap, basis points % of world GDP ex-Brazil, 4-quarter average
2,000 2.5%
1,600 2.0%
October 2002
peak: 3,950 1.5%
1,200
1.0%
800
0.5%
400
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0.0%
0 1980 1985 1990 1995 2000 2005 2010 2015
2001 2003 2005 2007 2009 2011 2013 2015
Source: Banco Central do Brasil, IMF, Bridgewater Associates. Q3 2015.
Source: Bloomberg. December 17, 2015. Exposure includes direct investment, portfolio investment, loans and other.
What about “Petrobranchitis”? Petrobras debt quintupled from 2009 to 2014, and the company
hasn’t generated free cash flow since 2008. Its financing challenges will have to be resolved in 2016,
given US$ 24 billion of debt maturities over the next 2 years. By the end of 2016, Petrobras could burn
through all of its cash in the absence of (a) asset sales, (b) extraordinary government support, (c) balance
sheet expansion by local banks to replace international bondholders or (d) a substantially dilutive equity
offering. Moody’s and S&P believe there’s a high probability of government support, but it’s unclear
what form this support would take. Caution is warranted here, despite yields in the 12%-14% range.
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Special topics in 2015: The Millennials, and high-renewable electricity grids

We published 3 Special Edition Eye on the Market issues in 2015. The first was on oil (covered in this
document on pages 31-33); the second was on millennials, and the third was our annual energy paper.
The Millennials used fictional case studies to determine the amount of savings needed for retirement.
Standard retirement calculations incorporate the possibility of below-average investment returns, but we
also wanted to incorporate other real-life issues people face. According to Boston College, over any 10-
year period, more than 3/4 of adults aged 50-60 experience job layoffs, widowhood, divorce, new
health problems, or the onset of frailty among parents or in-laws. The first chart shows required savings
rates needed to maintain solvency throughout retirement, even if adverse events take place. Savings
rates are defined as pre-tax contributions to qualified plans by both spouses, starting at age 25. The 2nd
chart shows what happens if millennials don’t save enough; their retirement spending as a % of pre-
retirement income collapses. You can find the Executive Summary of The Millennials here.
Recommended annual pre-tax contribution to savings by Income replacement ratios if no savings adjustments
each working spouse to offset impact of adverse events take place to offset adverse events
% of pre-tax income Retiree spending as a % of pre-retirement disposable income
20%
100% After impact of
Original target
negative events
16%
90%
12%
80%
8%
4% 70%
0% 60%
Median-income Affluent High net worth Median-income Affluent High net worth
households households households households households households
In addition to contributions shown, households are assumed to save 2% of See the Production Notes in the full Millennials white paper for an
after-tax income, and benefit from a 50% employer match of pre-tax explanation of initial income replacement ratios and the trajectory of
savings, capped at 3%. Savings begin at age 25. Source: JPMAM. 2015. retirement spending adjusted for inflation. Source: JPMAM. 2015.
Brave New World. In our last few annual energy notes, we analyzed the individual components of the
electricity grid: coal, nuclear, natural gas, wind, solar and energy storage. This year, we looked at how
they fit together in a system dominated by renewable energy, with a focus on cost and CO2 emissions.
The importance of understanding such systems is amplified by President Obama’s “Clean Power Plan”, a
by-product of which will likely be greater use of renewable energy for electricity generation.
There’s variability in wind and solar generation, even across large geographic areas. For example,
assuming California increased wind capacity by 5x and solar capacity by 8x, it could meet 91% of
demand with renewable energy in June, but only 52% of demand in January. How would electricity
demand be met at times of low renewable generation, and how much will it cost? Will demand
be met by time-shifted storage of surplus renewable energy? Via backup thermal power (coal or natural
SPECIAL
TOPICS
gas)? Could geographic diversification of renewable energy reduce backup power needs? Or will
demand management be required, which aims to reconfigure consumer demand to match renewable
generation? And what about places that are not blessed with ample solar and wind resources? These
are the questions we analyzed in this year’s paper, entitled “Brave New World”.
The bottom line: while a high renewable system can result in 70%-80% reductions in CO2 emissions, its
cost is significantly higher than current systems, even when assuming learning curves on wind, solar and
storage. Grid expansion, storing electricity in electric car batteries, demand management and renewable
energy overbuilding are interesting ideas, but rely to some extent on conjecture, insufficient empirical
support and/or incomplete assessments of related costs. And where wind/solar capacity factors are low,
costs will be even higher. You can find the Executive Summary of our annual energy paper here.
39 39
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J . P . M O R2016
GAN QUALIFIED INVESTORS ONLY – NOT FOR RETAIL USE OR DISTRIBUTION
JANUARY
J a n u a r y1,12016
, 2016
Sources and acronyms

“Agricultural Policy Monitoring and Evaluation 2015”, OECD, August 2015.
“An Exploding Pension Crisis Feeds Brazil’s Political Turmoil”, New York Times, October 20, 2015.
Bridgewater Daily Observations: 8/18/2015, 9/15/2015, 10/27/2015 and 11/2/2015.
“Buyout firms restrained in record takeover year”, WSJ, November 23, 2015.
“France’s Macron is wrong to think fiscal union is solution to Eurozone’s woes”, The Telegraph,
September 27, 2015.
“German ECB policy-setter breaks ranks with Draghi over QE”, CNBC News, November 24, 2015.
“The Global Oil Revolution”, Lombard Street Research, November 3, 2015.
“Health Care’s Correction: A Technical Matter? Arbitrage risk and the Long Side, Buybacks,
Untarnished”, Empirical Research Partners, October 28, 2015.
“High yield – not a concern for the S&P 500”, Barclays Research, October 19, 2015.
“How Do Private Equity Investments Perform Compared to Public Equity?”, Harris (UVA Darden),
Jenkinson (Oxford), and Kaplan (Chicago Booth), June 2015.
“Japan’s Deal Of The Decade”, Gavekal Research, October 19, 2015.
“Macro Update: The Next Step Down In Growth”, Gavekal Research, September 2015.
Odoxa French presidential election polls: April and May 2015.
“The U.S. Consumer: Research and Results – If Amazon Grows at +20%, What’s Left for Everyone
Else?”, Empirical Research Partners, December 2015.
“Where Are We In the Credit Cycle?”, J.P. Morgan Securities LLC, October 19, 2015.
AUM: Assets under management; BCB: Banco Central do Brasil; BEA: Bureau of Economic Analysis;
BIS: Bank for International Settlements; BLS: Bureau of Labor Statistics; BoJ: Bank of Japan; CAO: The
Cabinet Office (of Japan); CBO: Congressional Budget Office; CDC: Centers for Disease Control and
Prevention; CNBS: China National Bureau of Statistics; CPI: Consumer price index; CSI: China Securities
Index Company; EBITDA: Earnings before interest, taxes, depreciation and amortization; ECB: European
Central Bank; ECI: Employment Cost Index; EIA: Energy Information Administration; EIU: Economist
Intelligence Unit; EMBI: Emerging Market Bond Index; EPA: Environmental Protection Agency; EPS:
Earnings per share; ESRI: The Economic and Social Research Institute; ETF: Exchange-traded fund; EU:
European Union; EUR: Euro; FINRA: Financial Industry Regulatory Authority; FOMC: Federal Open
Market Committee; FRB: Federal Reserve Board; FGV: Fundaçâo Getúlio Vargas; FX: Foreign exchange;
GDP: Gross Domestic Product; IBES: Institutional Brokers’ Estimate System; IBGE: Instituto Brasileiro de
Geografia e Estatística; ICI: Investment Company Institute; IFO: Income from Operations; IG: Investment
grade; IMF: International Monetary Fund; IPO: Initial public offering; IRR: Internal rate of return; ISM:
Institute for Supply Management; J-REIT: Japanese real estate investment trust; JGB: Japanese
Government Bond; JPMAM: J.P. Morgan Asset Management; M&A: Mergers and acquisitions; MiFID:
Markets in Financial Instruments Directive; MOI: Multiple of invested capital, MSCI: Morgan Stanley
Capital International; NBER: The National Bureau of Economic Research; NFIB: National Federation of
Independent Business; NIH: National Institutes for Health; NIIP: Net international investment position;
NPL: Non-performing loan; OCC: Office of the Comptroller of the Currency; OECD: Organisation for
Economic Co-operation and Development; OPEC: Organization of the Petroleum Exporting Countries;
P/B: Price-to-book; P/E: Price-to-earnings; P/S: Price-to-sales; PIIGS: Portugal, Italy, Ireland, Greece and
Spain; PMI: Purchasing Managers’ Index; PV: Photovoltaic; R&D: Research and Development; REER:
Real effective exchange rate; RMB: Chinese Renminbi; SAMA: Saudi Arabian Monetary Agency; S&P:
Standard and Poor’s; SOE: State-owned enterprise; STN: Secretaria do Tesouro Nacional; TPP: Trans-
Pacific Partnership; TRACE: Trade Reporting and Compliance Engine; UMP: Union pour un mouvement
populaire; US$: US dollar; USGS: US Geological Survey; WTI: West Texas Intermediate
40
40
EYE ON THE MARKET  J . P . M O R G A N A S SE T M A N A G E M E N T
FEYE
OR INON
S TI TU TI ON A L / W H OL ES FOR
T SINSTITUTIONAL/WHOLESALE/PROFESSIONAL
A N D Q U A L I F IED IN V ES TO RS O N LCLIENTS
Y – AND
THE MARKET • AOUTLOOK
L E/ PROF ES S ION A L CL I EN
2016 QUALIFIED INVESTORS ONLY – NOT FOR RETAIL USE OR DISTRIBUTION xJANUARY
x x xx x x X X1,, 22016
015
N O T F OR RETA I L U S E OR D IS TRI BU TION
NOT FOR RETAIL DISTRIBUTION: This communication has been prepared exclusively for
institutional/wholesale/professional clients and qualified investors only as defined by local laws and
regulations.
This document has been produced for information purposes only and as such the views contained herein are not to be taken as
an advice or recommendation to buy or sell any investment or interest thereto. Reliance upon information in this material is at
the sole discretion of the reader. The material was prepared without regard to specific objectives, financial situation or needs of
any particular receiver. Any research in this document has been obtained and may have been acted upon by J.P. Morgan Asset
Management for its own purpose. The results of such research are being made available as additional information and do not
necessarily reflect the views of J.P. Morgan Asset Management.
Any forecasts, figures, opinions, statements of financial market trends or investment techniques and strategies expressed are
those of JPMorgan Asset Management, unless otherwise stated, as of the date of issuance. They are considered to be reliable at
the time of writing, but no warranty as to the accuracy, and reliability or completeness in respect of any error or omission is
accepted. They may be subject to change without reference or notification to you.
J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates
worldwide. This communication is issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK)
Limited, which is authorized and regulated by the Financial Conduct Authority; in other EU jurisdictions by JPMorgan Asset
Management (Europe) S.à r.l.; in Switzerland by J.P. Morgan (Suisse) SA, which is regulated by the Swiss Financial Market
Supervisory Authority FINMA; in Hong Kong by JF Asset Management Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan
Asset Management Real Assets (Asia) Limited; in India by JPMorgan Asset Management India Private Limited; in Singapore by
JPMorgan Asset Management (Singapore) Limited, or JPMorgan Asset Management Real Assets (Singapore) Pte Ltd; in Australia
by JPMorgan Asset Management (Australia) Limited ; in Taiwan by JPMorgan Asset Management (Taiwan) Limited ; in Brazil by
Banco J.P. Morgan S.A.; in Canada by JPMorgan Asset Management (Canada) Inc., and in the United States by JPMorgan
Distribution Services Inc. and J.P. Morgan Institutional Investments, Inc., both members of FINRA/SIPC.; and J.P. Morgan
Investment Management Inc.
Copyright 2016 JPMorgan Chase & Co. All rights reserved. 1115-1024-02
41
EYE ON THE MARKET • OUTLOOK 2016 QUALIFIED INVESTORS ONLY – NOT FOR RETAIL USE OR DISTRIBUTION
JANUARY 1, 2016
MICHAEL CEMBALEST is the Chairman of Market and Investment Strategy for
J.P. Morgan Asset Management, a global leader in investment management and
private banking with $1.7 trillion of client assets under management worldwide (as of
September 30, 2015). He is responsible for leading the strategic market and investment
insights across the firm’s Institutional, Funds and Private Banking businesses.
Mr. Cembalest is also a member of the J.P. Morgan Asset Management Investment
Committee and a member of the Investment Committee for the J.P. Morgan Retirement
Plan for the firm’s more than 250,000 employees.
Mr. Cembalest was most recently Chief Investment Officer for the firm’s Global Private
Bank, a role he held for eight years. He was previously head of a fixed income division
of Investment Management, with responsibility for high grade, high yield, emerging
markets and municipal bonds.
Before joining Asset Management, Mr. Cembalest served as head strategist for Emerging
Markets Fixed Income at J.P. Morgan Securities. Mr. Cembalest joined J.P. Morgan in
1987 as a member of the firm’s Corporate Finance division.
Mr. Cembalest earned an M.A. from the Columbia School of International and Public
Affairs in 1986 and a B.A. from Tufts University in 1984.
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Eye on the Market Outlook 2016

J.P. MORGAN ASSET MANAGEMENT

Cover art by Norm Bendell.

FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY –

J.P. Morgan Asset Management

Planet of the Aches: Executive Summary 1

Japan: government intervention in equities overrides macroeconomic weakness 17

Why all the focus on emerging markets? 19

Sources and acronyms 40

Click on the video to hear Michael

The emerging markets component of the global slowdown

A divergence in bank credit growth... ...and in real retail sales

2,100 1,050 12%

Where do we go from here?

Do 2016 consensus projections make sense?

Emerging market 275 more liquid

The Planet of the Aches: a world of low returns on diversified portfolios

intervention may provide a slightly higher boost to 1.2x

A low inflation world

Any discussion of the US should start with the dollar.

trade-weighted dollar has been range-bound, even

after the Chinese devaluation in August. Looking

Steady employment growth Consumer credit growth

Private wages normalizing Home and auto sales trending higher

What about the Fed?

Spain credit demand Italy credit demand

Even with these improvements, the Eurozone appears headed

-20% rates were set at negative levels, there have been

One big question for 2017: German inflation

German inflation showing up in housing, but not in Death in Venice

North America vs. European Monetary Union

“ECBotulism”: ECB policy and its impact on non-Eurozone countries

Japan: government intervention in equities overrides macroeconomic weakness

Japan real GDP and components

Why all the focus on emerging markets?

The gravitational pull of China

While Russia faces the prospects of no growth in 2016

Markets generally rise before economies do; are we there yet?

except currency which is through November 2015.

There are bright spots, like India

Note: MSCI indices used for each country.

As for emerging markets dollar-denominated A modest rise in EM dollar debt yields

debt in most countries, along with much higher 14%

Let’s start with the good news:

25% 14% 25%

20% Private 12% Industrial 20%

Government spending starting to pick up China's foreign currency reserves

Rising levels of corporate debt in China China industrial profits

The improved resilience of global banking systems 30

Oil: a roadmap for lower prices first, higher prices later 31

Credit risk of US states: broad generalizations do not apply 34

Private equity: an update on performance vs. public markets 35

Special topics in 2015: The Millennials, and high-renewable electricity grids 39

Michael provides a deep dive into

The improved resilience of global banking systems

Oil: a roadmap for lower prices first, higher prices later

3.00 Saudi Output -14.1% -19.2% -8.8% -18.1% 5.4%

2.75 OPEC Output -11.7% -18.3% -4.1% -15.6% 5.9%

Large cap energy stocks: lowest relative valuations in

decades, Price-to-book ratio of Energy relative to large cap universe

Credit risk of US states: broad generalizations do not apply

Private equity: an update on performance vs. public markets

US Buyout/Growth Equity median IRR and MOI