INs and OUTs
                        INsights and OUTlooks from JPMorgan Asset Management
                        Week of ...
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ance and are currently trading at a discount. Exhibit 2: ABS have seen a significant sell-off since last summer
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Heard in the Hall                                                                   Publications
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INs and OUTs

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INs and OUTs

  1. 1. INs and OUTs INsights and OUTlooks from JPMorgan Asset Management Week of February 18, 2008 MacroMinute: Market Recap Equity markets shrug off economic weakness As of February 15 If one thing was clear from last week’s market gains, it was that Last Friday’s week YTD 1-year close investors are still optimistic that much of the worst damage to Equity Indices economic and profit growth is already behind us. Stocks rallied, S&P 500 1.4% -7.8% -5.6% 1,349.99 government bonds sold off, credit spreads tightened and com- Russell 2000 0.4% -8.3% -12.9% 701.52 modity prices rose, while the economic outlook and implications MSCI World 1.8% -9.2% -4.2% 1,439.50 for financial markets dimmed. MSCI EAFE 2.2% -10.9% -4.8% 2,004.56 Stu Schweitzer MSCI Emerging Markets 3.5% -8.9% 23.7% 1,133.82 Individual data points can often be conflicting, but last week GPR 250 1.5% -6.6% -22.0% 343.40 Global Markets was one in which the numbers painted an almost uniformly Strategist negative economic picture: U.S. initial unemployment claims, Bonds (bps) (bps) (bps) now at 347,250 on a four-week average basis, have moved up by 10-yr U.S. Treasury yield 13 -26 -94 3.77% (audio) 10-yr Japan (JGB) yield 3 -5 -29 1.46% over 20% from their cycle lows and (barring the Hurricane Ka- 10-yr Europe (ECB) yield 9 -38 -9 3.96% trina related spike) now stand at their highest since June 2004; Lehman Aggregate (spread) 8 33 85 121bps the Reuters/University of Michigan consumer confidence index Currencies plunged to its lowest since February 1992 and, after last week’s USD vs. Euro -1.2% -0.6% -11.7% 1.46 retail sales figures, real consumer spending looks likely to slow JPY vs. USD 0.4% -3.5% -9.6% 107.81 to a paltry 0.5% annual growth rate in the current quarter. To USD vs. GBP -0.8% 1.2% -0.5% 1.96 top it off, the U.S. National Federation of Independent Business Commodities Investors show survey of business conditions slumped to its weakest since the Crude Oil 4.1% -0.5% 64.7% 95.50 optimism across 1990/1 recession. Gold -2.2% 8.2% 34.7% 902.50 asset classes Source: Bloomberg A slowdown in U.S. imports – confirmed by last week’s U.S. for- eign trade report – is also weighing on growth outside America. Economic data Eurozone real GDP slowed to a mere 1.7% last quarter, and a Alternatively Speaking weak, with more further slowdown seems to be underway currently. European industrial production and retail sales have each declined in the Hedge Funds disappointment • Large hedge funds are more likely than smaller managers past two and three months’ readings respectively, while Febru- potentially to come to attract institutional mandates according to a recent ary’s German ZEW analyst survey of current business condi- tions missed expectations by over 30%. study by Pensions & Investments. Of the largest manag- Vulnerable monolines ers, each managing over $20 billion, approximately It is true that equity markets generally discount economic activ- three-quarters of their assets under management are still risk worsening ity in advance, but when it comes to recessions, they tend not to the credit crisis allocated from institutional investors. bottom until around halfway through. It should therefore be of concern that outside the U.S. housing market and Western fi- Private Equity nancial sector earnings, the smoking gun has so far been elusive, • Unlike in the U.S., the liquidity market in Europe leaving more downside surprises in store from other sources. If, showed signs of weakness in 2007. The number of initial as we expect, a U.S. recession and global slowdown are in their public offerings of European venture-backed companies early stages, January’s lows may yet be retested, if not breached. fell to 38 from 89, while the number of mergers and On the credit crisis, there remains little about which to be opti- acquisitions fell 38% to 136. (VentureWire) mistic. This was obviously lost on investors, as Warren Buffet’s Real Estate offer to take over $800 billion of the municipal debt guaranteed • Year-end 2007 trends indicate apartment investment is by MBIA, Ambac and FGIC Corp (the first, second and fourth up relative to other property types, reflecting anticipation largest of the bond insurers) spurred a mid-week rally. As one of improved rents and occupancies in some markets given sage put it, the proposal was a bit like “offering someone a life the for-sale housing market weakness, as well as credit raft in exchange for their food, water and paddle” and, we might availability through Freddie Mac and Fannie Mae. (Real add, perhaps the air with which to inflate it as well; any “bail- Capital Analytics) out” plan for the monolines will be meaningless unless it frees them of exposure to the estimated $900 billion in CDOs and Infrastructure asset-backed securities that they guarantee, or injects them with • Approximately $11 billion of tax equity for renew- sufficient capital to protect against associated losses. able energy is expected to be awarded this year, a 75% In any event, it is becoming increasingly clear that the protec- increase year over year. After the success of wind in 2006 tion of local governments and their investors is the insurance and 2007, solar, utility-scale thermal power and geother- Visit our website at regulator’s real priority, not a bailout. This suggests that, unless mal energy are becoming more attractive to investors. jpmorgan.com/insight the monolines can come up with the required capital to prevent Contributors: Hedge Funds, Private Equity, Real Estate further downgrades, a carve-up of the industry into its “good” & Infrastructure teams and “bad” businesses is the most likely outcome. Crucially, this does not spare the banks. Their net exposure to bad debt will increase with any further de-rating from the agencies and this will further inhibit their ability to lend in the real economy. –Stu Schweitzer & Ehiwario Efeyini, Global Markets Strategists
  2. 2. We appreciate your feedback. If you have any questions or would like to unsub- scribe from this publication, please send an e-mail to jpmam.info@jpmorgan. com and type UNSUBSCRIBE-INS AND OUTS in the subject line. Heard in the Hall JPMorgan News Finding opportunity in the Jamie Dimon welcomed 2,300 delegates to Davos, Swit- asset-backed market zerland on Wednesday for the World Economic Forum’s (WEF) annual meeting. Held in the Swiss mountaintop On both sides of the Atlantic the market for asset-backed village every January, WEF’s annual meeting gathers securities has gone into a tailspin. New issuance has been global leaders from business, government, academia sharply curtailed, and the secondary market investor base and science to discuss issues facing the world in the year has shrunk considerably. As depressed as the market is, ahead. however, we see attractive opportunities here for risk-toler- ant investors with an intermediate-term horizon. As a co-chair, Dimon led several discussions throughout the week, focusing primarily on the topics of financial In search of “fair value” risk and corporate social responsibility. Joining Dimon There aren’t many precedents for it: A highly developed, as fellow co-chairs at the meeting this year were former sophisticated, active, multi-trillion dollar market, which British Prime Minister and JPMorgan Chase Senior was thriving as recently as early 2007, has within a matter Advisor Tony Blair and former U.S. Secretary of State of months crumbled. The older, larger U.S. ABS market, and JPMorgan Chase International Council member dominated by mortgage-backed bonds, was the first to Henry Kissinger. stagger, with last summer’s subprime collapse. The more The meeting promotes dialogue and collaboration to diverse ABS markets across Europe soon followed suit. help drive progress on meaningful issues facing the While subprime captured the headlines, it is now clear world – from economic security to global warming to that the problems were broader, and now nearly all finan- political stability. cial markets are in disarray. Dimon also addressed a gathering of delegates on the None, though, has been hit as hard as the ABS market. topic of Systemic Financial Risk, offering his view It has lost its formerly healthy flow of new issues. Its tra- on how policy makers and members of the financial ditional investor base is heading for the exits. It deals services industry can work collaboratively to anticipate in securities that even in good times require specialized future financial crises. He spoke alongside Jean-Claude knowledge and skill to evaluate. And it is confronted with Trichet, president of the European Central Bank; Wes a widespread disintegration of investor confidence. In short, Edens, chairman and CEO of Fortress Investment; and this is a market where all the usual valuation mechanisms Deputy U.S. Treasury Secretary Robert Kimmitt. have short-circuited. Consequently, we believe ABS securi- Click here to learn more about the World Economic ties can be identified which have value at current spread Forum Annual Meeting 2008. levels. And with many ABS holders highly motivated to sell, the case for cherry-picking attractive opportunities What we like becomes compelling. In the U.S., the most promising segment of the market consists of the more senior tranches of home equity loan (HEL) ABS securities (Exhibit 1). These senior bonds have prior call on the principal payments Exhibit 1: A typical HEL ABS structure is designed to protect senior investors the underlying assets generate. For the Original Tranche Avg.Life Avg Life Rating Credit time they own the bond, any default Support Lower A1 1.0 AAA risk losses in the structure are allocated A2 3.0 AAA 20–25% 75–80% of the deal “from the bottom up.” Senior holders A3 6.0 AAA will thus be impacted only after such M1 4.5 AA+ losses have been fully distributed to Mortgage Pool M2 4.5 AA 14–20% holders of the lower-rated subordinate M3 4.5 AA– tranches. M4 4.3 A+ M5 4.3 A 9–14% In some instances the prices of many M6 4.3 A– M7 4.1 BBB+ of these HEL bonds have now declined M8 4.1 BBB 3–9% to levels where, in the view of our U.S. M9 4.1 BBB– Losses Higher ABS team, they represent attractive allocated risk B 4.1 BB+ 1.0–3% from the investments on a risk-reward basis bottom up (Exhibit 2). The team is focusing par- Overcollateralization 1.5–3.0% ticularly on those shorter bonds (ex- Excess Spread pected average life of one to two years) Source: JPMorgan Asset Management that were rated AAA at time of issu- 2 of 4
  3. 3. ance and are currently trading at a discount. Exhibit 2: ABS have seen a significant sell-off since last summer Our interest in these securities does not, we ABX 06-1 AAA ABX 06-2 AAA stress, spring from a more optimistic economic ABX 07-1 AAA ABX 07-2 AAA outlook than the markets now endorse. Rath- 100 er, we contend that, at a discount dollar price and a short average life, these bonds offer val- 90 ue because they can be expected to pay par as promised in a relatively short time, even under 80 dire financial or economic scenarios. We are also finding other opportunities across 70 the beleaguered ABS market. With the cur- rent shortage of liquidity, capital is at a pre- 60 Sep-07 Dec-07 Jan-08 Oct-07 Aug-07 Nov-07 mium and those with cash to invest may find Jul-07 value, for example, in seasoned, short, wrapped auto transactions where one can ascertain the credit quality of the underlying pool without Source: MorganMarkets the wrap, as well as in short-dated ABS backed Note: Data series shown are HEL ABS derivative indices, by vintage. by prime auto, credit card or FFELP (Federal classes with strong collateral performance within economi- Family Education Loan Program) loans. cally healthy jurisdictions. As in the U.S., we are focus- In Europe the opportunity set, like the ABS market it- ing on the mortgage-backed markets in particular. While self, is somewhat more varied. Here too, the investor base the U.K. residential market is starting to show (limited) has been depleted and lacks confidence, causing a gen- signs of deterioration, on the Continent homeowners have eral decline in prices that has made certain segments of generally smaller mortgages and the MBS markets there- the market quite attractive. Our European ABS team is fore have stronger fundamentals. With declines in these looking at short duration, high-quality bonds in asset markets driven primarily by technical factors, we believe AAA–rated residential mortgage-based securities (RMBS) Webcasts from Holland and even the U.K. are attractively priced. So too are certain seasoned RMBS in Spain, even though To hear a replay of: house prices there have been falling. We also see value in Sharpening Your Aim on Target Date Fund Design: commercial mortgage-backed securities (CMBS) linked to Our latest research on participant (mis)behavior across diversified pools of retail properties or office buildings in industries some Continental markets. Dial 1-800-642-1687; access number: 32835143. From outside the In both the U.S. and Europe, we believe, sound security U.S. and Canada, dial 1-706-645-9291. This recording will be selection is critical to making the most of these opportuni- available through February 26. ties. Sophisticated analytical tools and mathematical mod- Speakers: els are needed to ferret out good value — to gauge the Anne Lester, Managing Director, Senior Portfolio Manager, historical performance of comparable assets and the per- Global Multi–Asset Group formance potential of the securitization itself. The bonds Katherine Santiago, Quantitative Research Analyst, we have identified as most attractive can be substituted for Global Multi–Asset Group short floating-rate securities in a fixed income or diversified portfolio, and make most sense for investors who can hold Kristine Olson, Vice President Communications, them until maturity. Retirement Plan Services Our speakers seek to answer the following questions: As the saying goes, it is always darkest before the dawn, • Should variance in participant behavior across industries or and these opportunities may be the first glimmer of recov- companies affect the selection of target funds ? ery for the beaten-down ABS market. • Do the changes under PPA go far enough? Contributors — Asset-Backed Securities (ABS) team: • How can communication help modify participant behavior? U.S.: Mark Stancher, Kyongsoo Noh To view our previous webcasts, go to jpmorgan.com/webcasts. Europe: Liliana Slavova, Nicholas Yaxley 3 of 4
  4. 4. Heard in the Hall Publications The latest chapter in the The latest intellectual capital brought to you by our investment professionals: dash-for-cash story • NEW! 2008 Hedge Fund Strategy Outlook The latest edition of the Merrill Lynch Global Fund Man- ager survey hints at a denouement of the dash-for-cash sto- • The European Alternative Asset Survey 2007 — Are alter- natives mainstream? ry that has rocked markets over the past 6–9 months. The survey showed that a net 41% of global fund managers are • Emerging Market Trends: With new opportunities and currently running cash overweights — the highest in the choices… where do we go from here? history of the survey. The survey also showed that global • How Does Your Pension Plan Measure Up? managers have taken their stock/bond positions down to • Real Estate Insights – December 2007 underweight for the first time in five years. Interestingly, • Turmoil in the Credit Markets: Where do we go from here? the aggregate bond position was neutral rather than over- • Pension Extension: FAQs on strategies for extending duration weight, which was surprising given the shift down in yields until late January. At present stocks are valued at extreme levels. Relative to Perhaps the overriding message of this survey is the ex- their own history the major equity markets look very cheap treme level of risk aversion that is overhanging markets at — with U.S. equities at minus 3.2 standard deviations on present. This continues to show up in the Credit Suisse risk our composite valuation indicator — the most extreme appetite measure too, although that index has eased slight- undervaluation in 17 years of data. Relative to bonds, our ly. Nevertheless, it is clear that investors are taking limited proprietary model shows that equities are very attractively bets at present and that large directional exposures to eq- valued versus bonds, with an equity risk premium of 5.1% uities or bonds are not on the agenda. It therefore seems (based on aggregated bottom-up data). This is within an reasonable to assume that fixed-income exposure has been ace of the all-time high ERP of 5.3% in September 2002. in the form of steepeners (buying short-dated bonds and Moreover, two-year US bond yields have fallen to the same selling longer dated maturities), rather than taking direct level as the dividend yield on the equity market, suggest- duration positions. High levels of cash not only reflect risk ing the market is pricing in little or no long term growth. aversion but also the risk of redemption. However, fund So, while stocks look cheap and overly pessimistic, any managers are not paid to be bankers and it seems reason- shift back into equities will require evidence of a revival of able to assess the factors that might tilt this wall of cash growth or signs of faster credit demand. into markets (equities or bonds). Contributor: David Shairp, Global Markets Strategist, London About INs and OUTs Our two-page brief provides insightful commentary on news and events shaping today’s global markets. We welcome your feedback. If you have questions, please send an e-mail to jpmam.info@jpmorgan.com. If you would like to unsubscribe, please type UNSUBSCRIBE-INS AND OUTS in the subject line. For more information on our publications and webcasts, visit our website at www.jpmorgan.com/insight. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The view and strategies described may not be suitable for all investors. Past performance is not indicative of future returns. The inclusion of past performance figures is for illustrative purposes only. Indices do not include fees or operating expenses and are not available for actual investment. Indices presented are representative of various broad base asset classes. They are unmanaged and shown for illustrative purposes only. The S&P 500 Index is an unmanaged broad-based index that is used as representation of the U.S. stock market. It includes 500 widely held common stocks. Total return figures reflect the reinvestment of dividends. The NASDAQ Composite Index includes all of the domestic and foreign companies listed on the NASDAQ Stock Market, almost 5,000 in all. The Russell 2000 Index measures small company stock market performance. The MSCI World IndexSM is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance. The MSCI EAFE Index is an un- managed index generally representative of the performance of the international stock markets. The MSCI Emerging Markets Equity Index measures emerg- ing stock market performance. The GPR 250 index is a free float weighted index that tracks the performance of the 250 leading and most liquid property companies worldwide. The Lehman Aggregate Bond Index is a broad base index often used to represent investment grade bonds being traded in U.S. An index does not include fees or expenses. An individual cannot invest directly in an index. Past performance is not indicative of future returns. JPMorgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include J.P. Morgan Investment Management Inc. and its affiliates, including, without limitation, JPMorgan Investment Advisors Inc., Security Capital Research & Manage- ment Incorporated, and J.P. Morgan Alternative Asset Management, Inc. jpmorgan.com/insight © 2008 JPMorgan Chase & Co. JPMorgan Asset Management • 245 Park Avenue, New York, NY 10167 • www.jpmorgan.com/insight

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