What is “money”? If you go to the Bureau of Printing and Engraving at the U.S. Treasury, you won’t actually
see the machin...
MARY CALLAHAN ERDOES
                                  Chief Executive Officer
                             J.P. Morgan As...
Eye on the Market | OUTLOOK 2011 January 1, 2011
                           January 1, 2011
2011 Outlook
The Printing Pres...
Eye on the Market | OUTLOOK 2011 January 1, 2011
                           January 1, 2011
2011 Outlook
Fast growth, infl...
Eye on the Market | OUTLOOK 2011 January 1, 2011
                         January 1, 2011
2011 Outlook
The United States: ...
Eye on the Market | OUTLOOK 2011 1, 2011 1, 2011
                             January 1, 2011
                            ...
Eye on the Market | OUTLOOK 2011 January 1, 2011
                           January 1, 2011
2011 Outlook
On our investment...
years, these equity tilts have worked well (c33). We expect these relative rankings to
                                   ...
Financial Pacific: Eye on the market, outlook 2011 (third party), january 10.2011
Financial Pacific: Eye on the market, outlook 2011 (third party), january 10.2011
Financial Pacific: Eye on the market, outlook 2011 (third party), january 10.2011
Financial Pacific: Eye on the market, outlook 2011 (third party), january 10.2011
Financial Pacific: Eye on the market, outlook 2011 (third party), january 10.2011
Financial Pacific: Eye on the market, outlook 2011 (third party), january 10.2011
Financial Pacific: Eye on the market, outlook 2011 (third party), january 10.2011
Financial Pacific: Eye on the market, outlook 2011 (third party), january 10.2011
Financial Pacific: Eye on the market, outlook 2011 (third party), january 10.2011
Financial Pacific: Eye on the market, outlook 2011 (third party), january 10.2011
Financial Pacific: Eye on the market, outlook 2011 (third party), january 10.2011
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Financial Pacific: Eye on the market, outlook 2011 (third party), january 10.2011

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Financial Pacific: Eye on the market, outlook 2011 (third party), january 10.2011

  1. 1. What is “money”? If you go to the Bureau of Printing and Engraving at the U.S. Treasury, you won’t actually see the machines running in overdrive. In an era of electronic money, the Federal Reserve can increase the monetary base (also known as “high-powered money”) by increasing bank reserves to pay for the Treasury bonds that it purchases. The same applies to government bond purchases in the United Kingdom. The other countries shown engage in a different kind of money creation: an expansion of the monetary base to fund the purchase of foreign assets instead of domestic ones, with the goal of limiting exchange rate appreciation. Most of these countries drain domestic liquidity to try and prevent inflation, but still create two separate distortions. The first is domestic: By maintaining an undervalued currency and very low real interest rates, they risk inflation of wages, goods and asset prices. The second is international: These actions contribute to the global pool of central bank savings invested in U.S. government bonds. What used to be a functioning private sector market with price signals regarding inflation and growth risks is now increasingly subject to price controls and systemic shocks. By the time QE2 is over, more than half of all Treasuries will be owned by U.S. and non-U.S. central banks. Note how the representative from the European Monetary Union, which is not engaging in this kind of activity to any large degree, looks on in despair from outside the building.
  2. 2. MARY CALLAHAN ERDOES Chief Executive Officer J.P. Morgan Asset Management How do you summarize a year that was in many respects indefinable? On one hand, the European sovereign debt crisis, contracting housing markets and high unemployment weighed heavy on all of our minds. But at the same time, record corporate profits and strong emerging markets growth left reason for optimism. So rather than look back, we’d like to look ahead. Because if there’s one thing that we’ve learned from the past few years, it’s that while we can’t predict the future, we can certainly help you prepare for it. To help guide you in the coming year, our Chief Investment Officer Michael Cembalest has spent the past several months working with our investment leadership across Asset Management worldwide to build a comprehensive view of the macroeconomic landscape. In doing so, we’ve uncovered some potentially exciting investment opportunities, as well as some areas where we see reason to proceed with caution. Sharing these perspectives and opportunities is part of our deep commitment to 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. Most sincerely,
  3. 3. Eye on the Market | OUTLOOK 2011 January 1, 2011 January 1, 2011 2011 Outlook The Printing Press As we head into 2011, global profits are rising, U.S. household incomes and debt burdens are improving, the Asian production boom continues, global services are starting to rebound, and Germany is seeing its largest manufacturing and consumer revival since reunification. The twin engines of world growth, the U.S. and China, are in expansion mode again (c1). (c1) U.S. and China manufacturing (c2) Excess capacity in the U.S. and (c3) Asia ex-Japan and Latin inflation output surveys, Index level, sa Asia, Output gap, GDP vs potential Percent, YoY change 65 4% EM Asia: no 9% Expansion U.S. excess 8% 60 2% capacity 7% 55 0% 6% 50 China 5% Headline 45 -2% U.S.: lots 4% 40 of excess 3% Food -4% capacity 35 2% Core Contraction 30 -6% 1% 2008 2009 2010 2003 2005 2007 2009 2005 2006 2007 2008 2009 2010 Given pressures for fiscal tightening in the West, it’s hard to blame monetary authorities around the globe for trying to keep these things moving. That’s why the global monetary experiment captured by the cover art continues uninterrupted. But it may be beyond traditional linear thinking to grasp all the ways this could turn out. The lowest inflation since 1958 and a large output gap in the U.S. (an inexact measure of spare labor/productive capacity) give the Fed justification for its approach (c2). The same cannot be said for Asia, where the output gap is smaller (or may not exist at all), and where inflation is rising. The chart below is something we have been thinking a lot about (c4). It’s a measure of global imbalances: the extent to which some countries spend more than their incomes, and rely on other countries to finance the difference; how much they intervene in their currency markets; and how much they offset inadequate private sector demand through budget deficits. Does this matter given the good news above? When P/E multiples on global equity markets (c5) are so low? And when mountains1 of household, corporate and Sovereign Wealth Fund cash are capable of driving asset prices higher? We think it does, since the risks of unintended consequences are higher when the magnitude of imbalances (and experimentation) is this high as well. (c4) An index of global imbalances (c5) Global equity multiples (c6) Cost of money = zero Percent of global GDP Forward P/E ratio Policy rates adjusted for inflation, percent 12% 16 6% Current account and 15 Avg since 1988 EM countries 10% fiscal deficits/surpluses Current value 5% 14 8% 4% 13 12 3% 6% 11 2% Developed 4% 1% countries 10 2% 0% 9 0% 8 -1% 1970 1978 1986 1994 2002 2010 MSCI Europe MSCI USA MSCI EM 1981 1985 1989 1993 1997 2001 2006 2010 We have invested client portfolios around the globe in the belief that the world will not suffer a major relapse, with significant holdings in public and private equity, credit, hedge funds, commodities and real estate. We expect 2011 to be like 2010: volatile, rising equity markets, and modest returns on a balanced portfolio of financial assets. That these returns are made more attractive by the world’s Printing Press policy, which renders cash savings useless as a store of value (c6), is a mixed blessing at best. This publication reviews our market, investment and portfolio stance as 2011 begins. Michael Cembalest Chief Investment Officer 1 A ratio of US corporate sector cash/tangible assets is at its highest level on record. A measure of household cash and bonds as a % of discretionary financial assets is not far off. Sovereign Wealth Fund balances have grown from $1 trillion to $4 trillion since 2005. Sources for all charts and tables, as well as a list of acronyms used, appears on page 12. 1 1
  4. 4. Eye on the Market | OUTLOOK 2011 January 1, 2011 January 1, 2011 2011 Outlook Fast growth, inflation pressures: a better set of problems in Asia and the emerging world If we are not in an Asia-dominated world yet, we may be there soon. Asia’s share of world output, even when excluding Japan, is now double that of the U.S. and still growing (c7). As a result, the Asian/EM inflation question is a very important one. As shown on page 1, headline and core inflation in Asia and Latin America are rising. Inflation pressures are mostly food-driven (c8, c9), but are beginning to impact wages and prices as well. China’s inflation controls (increased bank reserve requirements, Central Bank bill issuance and legions of administrative measures) may be losing their effectiveness, as shown by frequent large spikes in its residential property markets (c10). This may be why China raised its inflation target to 4% in December. Why so much discussion about China? Like a giant tractor beam (c11), China pulls the emerging world into its orbit. A positive view of the world must assume China can continue to control inflation and deliver ~8% growth, unorthodox model and all (c12). (c7) Post-war share of world GDP (c8) Brazilian inflation fueled by food (c9) Chinese inflation driven by food Percent of total world PPP GDP 3 month percentage change, annualized as well, Percent change - YoY 35% 9% 25% Headline Asia ex-Japan 8% Food 20% 30% US 7% 6% 15% 25% 5% 10% CPI 4% 20% Europe 3% 5% 15% 2% Headline 0% 1% ex-Food Non-food 10% 0% -5% 1950 1959 1967 1975 1983 1991 1999 2008 2007 2008 2009 2010 2005 2006 2007 2008 2009 2010 (c10) Frequent overheating in Chinese (c11) Most EM countries correlated to (c12) How Chinese monetary policy property markets, Avg. daily sales, 1mma China, correlation to China GDP YoY growth works in one slide, Billions, USD 1,000 100% $2,500 FX RESERVES: China 900 80% accumulates reserves to 800 Shanghai $2,000 prevent its exchange rate 60% from rising 700 600 40% $1,500 Beijing 500 20% 400 0% $1,000 STERILIZATION: 300 China issues Central -20% 200 $500 Bank bills and raises 100 -40% 14 EM countries bank reserve Shenzhen requirements 0 -60% $0 Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 1991 1997 2003 2009 2003 2005 2007 2009 We expect EM Central Banks to cool things down, after which we expect EM growth to continue. Asian exports are already rising after their fall slowdown, particularly in countries like Korea, Taiwan and Singapore. EM ex-China bank credit is growing (c13), supporting the business cycle and employment growth (c14). This is in stark contrast with the West, where de- leveraging still rules. Should EM countries overdo monetary tightening, fiscal deficits and debt ratios are generally low enough (c15) to support additional stimulus, with some exceptions (India, Czech Rep.). In China, bank loan and money supply growth of 20% (down from 30% in 2009) indicate that the risk of over-investment and capital misallocation remains high. As in 2010, we hold positions in Asian currencies (funded vs. G3 currencies), as we believe they are undervalued. (c13) Private sector bank credit (c14) Developed and emerging world (c15) 2010 fiscal deficits growth, Percent of GDP, annualized employment growth, % change - QoQ Percent of GDP 11% 4% 0% Developed Emerging 9% 3% -2% Markets 2% 7% -4% 1% 5% -6% 0% 3% -1% -8% Emerging Developed 1% Markets ex-China -2% -10% -3% -1% -12% -4% Brazil Dev EM Europe Japan US 2000 2002 2004 2006 2008 2005 2006 2007 2008 2009 2010 Asia Asia 2 2
  5. 5. Eye on the Market | OUTLOOK 2011 January 1, 2011 January 1, 2011 2011 Outlook The United States: modest private sector recovery trumps fiscal problems, for now… With many emerging economies limiting FX appreciation, a rebalancing of demand to the East will happen more slowly. As a result, the world still relies on the US consumer, whose discretionary and non-discretionary purchases make up 70% of US GDP. Recent spending data have been positive, despite weak job creation. This may reflect two factors. First, labor incomes have risen faster than job growth (c16), and second, household debt service burdens have now erased the last 15 years of excess, courtesy of both lower interest rates and defaults (c17). Credit card and early-stage mortgage delinquency rates are showing marked improvements as well. Based on a variety of recent indicators and surveys, we expect payroll gains of ~200k per month in 2011, and 3.0%-3.5% GDP growth. Corporate sector cash balances are at a 50-year high, and are finally being spent. Business and equipment spending (c19) and productivity (c20) will probably slow but remain positive. Commercial construction, at its lowest level since 1958, should stop declining. These gains will be partially offset by $80 bn of belt-tightening at the state/local level. NY is one example; absent changes to current law, its structural deficit for 2012 is $9 bn on $90 bn in expenditures. Housing is still a mess (30% of mortgages underwater, shadow inventory 2x the number of homes for sale), and credit creation remains low. (c16) A proxy for labor income (c17) Household financial obligations (c18) U.S. retail sales growth Percent change, 3 month rolling average ratio, Percent of disposable income, sa Percent change - YoY 10% Payroll proxy: hours 19.0% 15% worked times hourly 18.5% income 10% 5% 18.0% 5% 17.5% 0% 17.0% 0% 16.5% Decade of Employment household excess -5% -5% 16.0% unwound 15.5% -10% -10% 15.0% -15% 2007 2008 2009 2010 '80 '83 '86 '89 '92 '95 '98 '01 '04 '07 '10 1993 1996 1999 2002 2005 2008 2011 (c19) Business equipment and (c20) Nonfarm business productivity (c21) An expensive recovery software spending, YoY - % change Percent change - 3 year Increase in Federal Debt/GDP (%) 16% Increase in ISM manufacturing Survey (pts) 25% 38 14% 34 Through 15% 12% 30 year end 10% 26 2010 5% 8% 22 18 6% -5% 14 4% 10 2% 6 -15% 0% 2 -2 -25% -2% 52- 53- 58- 60- 70- 74- 80- 82- 91- 01- 08- 1955 1963 1971 1978 1986 1994 2002 2010 1952 1960 1968 1976 1984 1992 2000 2008 52 55 59 61 73 76 80 83 93 04 10 The elephant in the room: the eventual need for fiscal tightening. The production rebound was consistent with prior ones, but cost a lot more in terms of Federal debt to generate (c21). Tax cut extensions and payroll tax reductions will increase 2011- 2012 deficits by $800 bn compared to current law. If this “all-in” strategy results in consistent 4% growth, 2015 budget deficits could fall to 3%. Otherwise, the US will eventually need to make tough choices (c22) Short & long-term fiscal (the IMF estimates required US 2010-2020 fiscal adjustments that are greater than pressures from gov' t spending, % GDP Spain’s). Bowles-Simpson recommendations tried to spread the pain equitably (tax 25% increases and spending cuts), but were rejected by legislators on the Commission that drafted them. How does the US fiscal picture look to China? A recent paper 20% published by Peking University was entitled “Eying the Crippled Hegemon: China’s 15% Grand Strategy Thinking in the Wake of the Global Financial Crisis”. All other spending A lot of faith resides in the Fed’s “portfolio rebalancing channel” theory of 10% lowering interest rates, driving up equity markets, increasing confidence and Healthcare spending 5% consumer spending, and eventually, employment. In its interim stages, it lifts Social security financial asset prices more than employment, destroys the purchasing power of 0% savings, and may result in much higher commodity prices. Jury: still out. 1974 1986 1998 2010 2022 2034 3 3
  6. 6. Eye on the Market | OUTLOOK 2011 1, 2011 1, 2011 January 1, 2011 January2011 1, 2011 JanuaryJanuary January January 1, 2011 2011 Outlook 2011 Outlook 2011 Outlook 2011 Outlook 2011 Outlook Europe: Irreconcilable Differences? Europe: Irreconcilable Differences? Europe: Irreconcilable Differences? Europe: Irreconcilable Differences? Europe: Irreconcilable Differences? Our Our Our writingsEurope2010might have been as longlonglong asConstitution2Our2. Here’s abbreviatedin 2010 might have been as long as writings on Europe Europe might might have long as the the the EU Constitution2. an on Europe 5-point 5-point summary: writings on on in in 2010 might have been as as as EU Constitution2. Here’s an an abbreviated 5-point summary: Ourwritings on Europe in 2010 in 2010have been as been as the EU EU Constitution writingsabbreviated 5-point summary: . Here’s Here’s an abbreviated Outlook 2011 summary: 1. Germany is rebounding impressively (c23), but in Q2 and and and exports were thewere largest contributorsGerman (c23), but in Q2 a 1. 1. 1. Germany is rebounding impressivelybut butQ2 Q2 Q3, Q3, Q3, exports were largest is reboundingtoGerman German Germany is rebounding impressively (c23), (c23), in and Q2 net net net exports the thecontributors to to German Germany is rebounding impressively (c23), in but in Q3, net exports were the largest contributors impressively 1. Germany largest contributors to J growth growth Germanexport performance doesnotdoes not pull other EMU countries along German Europe: Irreconcilable growth (c24). German German performancedoesdoes helphelphelp pull other EMU countries along growth (c24). German export performance not not pull other EMU countries along (c24). (c24). export export performance help pull other EMU countries along growth (c24). export performance does not he 2011 Outlook 2. The 2. The periphery in stuck in austerity asquoquo quobilateralbilateral and2.assistance (c25), which iswhich is worsening quoin 2010 2. 2. The periphery is stuckausterityas aaas a quidquid for for bilateral and IMFandThe periphery is(c25),isOur worsening quid Theperiphery is stuck is austerity as quid quo pro pro pro for EU EU EU IMFIMF assistancewhich inworseningason Europe pro for periphery is stuck in in austerity quid a pro for bilateral EU and IMF assistance (c25), stuck worsening a is writings assistance (c25), which austerity GDP, unemployment (see (see(seepage on page worstrecord) and and and VAT declines. unemployment Europe: Irreconcilablerec GDP, unemployment on on 11, worst on on on and VAT tax declines. Canit beit sustained? In contrast, is rebounding D GDP, unemployment (seec57 c57 page11, worst onworstrecord) VAT tax declines. Can CanCan itsustained?c57 on page 11, worst on imp GDP, unemployment c57on c57page 11, 11, record) record) VAT tax tax declines.besustained? 1. contrast,contrast, GDP, it (see Germany be be sustained?contrast, In In In overoverover in Iceland, realemployment, exports, exports, stock markets and tourism rising after theirwages,growth on Europe in 2010 m Our writings (c24). German expo overin Iceland, real real wages, employment, exports, stock markets and tourismover areIceland, real their default/devaluation in Iceland, realwages, employment, exports,stock markets and tourism are rising after their default/devaluation in Iceland, wages, wages, employment, stock markets and tourism are are in after their default/devaluation rising rising after default/devaluation exports, stock employment, 3. During crises incrises in Latin America (1980s) and Asia (1990s), Argentinaand and and crises(1997) wereGermanythoughtis Asia (1990 3. 3. 3. During Latin America (1980s) and and Asia (1990s), Argentina (1984) Thailand (1997) were1. 2. firstfirst to rebounding impre During crises in Latin America (1980s) Asia (1990s), Argentina (1984) and Thailand (1997) were Americathought and stuck in au The periphery During crises in Latin America (1980s) andAsia (1990s), Argentina (1984) 3. During ThailandLatin first thought is to to (1984) Thailand in (1997) were (1980s) first thought to be exceptions, andthat that problems could ring-fenced. In bothcases, a broken broken paradigm applied to GDP, could German export be exceptions, thatproblems could be ring-fenced. In In In cases, a broken exceptions, and more countries be exceptions, problems could be be be ring-fenced. cases, broken paradigm applied to more growth countries more unemployment (see c be exceptions, and and and that problems couldring-fenced.bothbothbothacases, aparadigm applied to that problems (c24). be ring-fenced. be paradigm applied to more countries countries 4. Spain is Spainthe now Maginot Line. international banks should be ableablesurviveaaperiodnowlowlow low growth, in Iceland, real wages, Spain is is Maginot Line. Line. Its international banks should to to4. over 4. 4. 4. isnownow MaginotMaginotIts international banks should be ableto survive Spain is a oflow growth, and and Its internationalin auste Spain now the the the Line. Its Its international banks should be be able to survive of of growth, andits and its is stuck banks survive a period the MaginotThe its its period period of growth, periphery 2. Line. regionalbanks could befixed be fixed 5%-10%SpanishGDP. But there’s stillall regionalthe private privatenon- 5%-10% of Spanish G regional banks could fixedfor for for 5%-10% of GDP. GDP. there’s all the the Spanishcould be3. non-for non- in Latin Amer all all banks private sector non- banks banks be for 5%-10% of of Spanish GDP. there’s there’s stillSpanish private sector During crises regionalregionalcouldbecouldfixed5%-10% of Spanish SpanishButBut Butstill stillthe Spanish Spanishsector GDP, unemployment (see c57 fixedsector financial debt, which isamong the the highestthe the world. is not just aasovereign debtdebtdebt or sectorover exceptions,realthe world. financial debt, which is among highest highest in the world. not not not a sovereign or banking sectorproblem.highest and wages, em financial debt, among among the in in world. This is is just sovereign debt or or which is amongin Iceland, in that prob be the problem. financial debt, which iswhich isthe highest in the world. ThisThisThis is just just a sovereignbanking bankingproblem. financial debt, banking sector problem. sector 5. Germany and and andmight have to agree to agree to more direct subsidies,bilateralaid facilitiesfacilities or somethingagreethe more direc 5. 5. 5. Germany France might haveagreeto more direct subsidies, larger bilateralbilateral facilitiessomethinghavemore in to Maginot L Germany andFrance might have to have to more direct subsidies, larger largerGermany aid France 3. 4. During crises Latin Americ Germany France France might to agree to more direct subsidies, larger5. bilateral aid and or somethingSpain to now aid facilities or or something is more might moremore explicit, explicit, like “Europeangovernmentbonds”. bonds”. Will it? LastLastLastformer like President Jacques Jacques andbonds”. fixe explicit,like like “European Union government bonds”. Will theytheyit? it? month, former “EuropeanJacquesgovernmentcould be W explicit, “European Union government bonds”. Will they do it? Lastmonth, month,EU EU President Jacques banks that proble like “European Union Union government Will they do do do month, former EU President Union explicit, former EU Presidentberegional exceptions, Delors said saidresponseto the crisis that that that needs toneedsits “soul”. “soul”.2011,will will will find4. toSpainsoulthe soulwhichneeds t Delors saidin response to the the crisis Europe Europe find findfind“soul”.2011,In 2011, find find whether whether now the Maginot amo Delors in said in response to the crisis Europe needsfind its “soul”. In 2011,we we wein out out whether crisisofdebt, of we will find out whether the the of Europe is Lin out financialthat Delors in response to crisis that Europe needs to to to its its In In Delors said response the soulsoul of is Europe Europe on its national national identities, newnew Federal See pagefor Europe is thistopic. topic. Germany and or a bemight is based on on on its identities, or new a Federal See page 11 11 moreon on on this 5. regional banks France Fede Europe is based is basedits national identities,aor a orFederalone.one.one. See pagefor morethis thison its national identities,couldnewfixed Europe is based its nationalidentities, or a new Federal one. See page 11 formorefor more topic. 11 on based topic. (c23) German retail & retail & manufacturing (c24) German GDP drivenexports exports(c25) retail periphery explicit, like(c24) German G (c23) GermanGerman manufacturing (c23) German retailmanufacturing (c23) (c25) Core vs. vs. vs. financial GDP“European Uni (c24) German GDP driven by by exports German Core & manufacturingdebt, which is amon (c23) retail & & manufacturing (c24) GermanGerman GDPby exports (c25) Core vs.Core periphery GDP (c24) GDP driven driven by (c25) periphery GDP GDP periphery surveys,surveys, Index, sa surveys, Index, sa sa surveys, Index, Index, sa Percent contribution to 2010 GDPGDPGDP Percent contribution to 2010 GDP Percent contribution to 2010 Percent contribution to 2010 surveys, Index,= 2007 =5. Germanysaid in response to ha Index, 100 sa2007 2007 Delors and France might th Index, 100 100 = 2007 = Index, 100 Percent contribut 110 110 110 110 4% 4% 4% 4% 110 105 105 105 105 4% explicit, likebased on its Union Europe is “European natio Manufacturing Manufacturing Manufacturing Manufacturing 104 104 Manufacturing Delors said in response to the 104 104 105 105 105 105 3% 3% 3% 3% Q2 Q2 Q2105 Q2 (c23) German retail & manufa 3% 103 103 103 103 100 100 100 100 Q3 Q3 Q3100 Q3 surveys,is based on its nationa Europe Index, sa 2% 2% 2% 2% 102 102 102 102 110 Core 2% CoreCoreCore 101 101 101 101 (c23) German Manufacturing retail & manufact 95 95 95 95 95 1% 1% 1% 1% 100 100 100 100 surveys, Index, sa1% 105 90 90 90 90 90 110 0% 0% 0% 0% 99 99 99 99 100 0% Manufacturing 85 85 85 85 85 98 98 98 98 105 Retail Retail -1% -1% -1% Retail Retail -1% 95 Retail PeripheryPeriphery Periphery Periphery -1% 97 97 97 97 80 80 80 80 80 100 96 96 96 96 90 -2% -2% -2% -2% -2% 75 75 75 75 75 95 Exports Capital Household Household Inv. Inv. 95 95 95 Exports Capital Household Gov't Gov't Gov't Exports Capital Household Exports Capital Gov't Inv. 95 Inv. 85 Exports Ca 1991 19911991 1994 1997 2000 2003 2006 2009 1991 1994 1994 1997 2000 2003 2006 2009 1994 1997 2000 2003 2006 2009 1997 2000 2003 2006 2009 Spending Spending Spending Consumpt. Spending Spending Consumpt. Spending Spending Consumpt. Spending Consumpt. 1991 2007 20072007 20082008 20092009 20102010 1994 1997 2008 2003 2009 20092010 2007 2000 2008 2006 2009 2010 Spe 90 Reta 80 Bottom line:line:line: while there some safesafe zones (e.g., healthbanksand and and less relianceforeign bond 85 in Italy; zones (e.g., the healt BottomBottom while there some safe zones (e.g., the health of banksofandless less relianceforeign bond buyers in Italy;in Italy; lower Bottom while there are are are some zones (e.g., the theof of banks lessreliance on foreign foreign bond buyers lower line: while there are some safe zones (e.g., the health health banks reliance on on on bond buyers safe lower Bottom line: while there arebuyers in Italy; lower some public debtdebtSpain),the concentration of red red red flashin our our our Sovereign debt in Spain), theWeexpect the questionquestion public debtin Spain), Spain), concentrationredflash points in ourSovereign Risk Scorecard is high. is concentration of question Retail public in debt in the the the concentrationflash points points Sovereign Risk Scorecard is high. We We We the the red flash point public in Spain), concentration of of of flash points in in Sovereign Risk Scorecard is high. expect expect the public Risk Scorecard high. expect question 75 80 1991 1994 1997 2000 2003 20 of the periphery to overshadow the German German recoveryis it is it is resolved in some way. to overshadow the German recovery until i of the the peripheryovershadow the the German recovery until resolved in some way. periphery of periphery to to overshadow Germanrecovery until it is resolved in someof the of the periphery to overshadow the recovery until it until resolved in some way. way. Bottom line: while there are som 75 Oct 201020102010 Oct Oct Oct 2010 Interest Interest Gross DomesticDomestic Interest Gross Gross Domestic Interest Gross Domestic Fiscal 2010 Req.Fiscal Fiscal Fiscal Oct 2010 1991NetInt'l 1997 Int'l Net Net Int'l 2000 2003 2006 Int'l Net Req.Req.Req.2010 20102010 1994 Interest Gross Unempl. Unempl. Labor Payments/ Debt/GDP Ownership Unempl. Unempl. Labor Payments/ Debt/GDP Ownership Fiscal Adjustment Payments/ Debt/GDP Ownership Fiscal Adjustment Unempl. public debt Investment the conce Labor Labor Payments/ Debt/GDP Ownership Fiscal Fiscal AdjustmentCurrent Labor Investment AdjustmentCurrent Investment Investment Current Current in Spain), Payments/ Debt/GDP Rate Tax Receipts 2012E Mobility Tax Tax Tax of Govt Debt Deficit 2010 2010-2020 Acct %GDP the periphery to overshadow of Deficit Deficit 2010-2020 of Pos. RateRateRate Mobility Receipts Receipts2012E ofGovt GovtGovt Debt2010 2010-2020 Rate AcctBottom line: Pos. %GDP are some Mobility Mobility Receipts 2012E 2012Eof DebtDebt Deficit 20102010 2010-2020 Acct Pos.Pos. while there 2012E %GDP %GDP Mobility %GDP Acct %GDP %GDPTax Receipts%GDP Portugal Portugal11.0% 7.4% Portugal Portugal11.0% 11.0% 7.4% 11.0% 7.4% 7.4%7.9% 7.9% 7.9% 101% 101%20% 7.9% 101%101% (7.3%) Portugal (7.3%) 8% public (114%) Spain), the concent 20% 20%20%(7.3%) (7.3%) 8% 8% 8%-10.3% 7.4% debt(114%) 2010 101% 11.0%-10.3% -10.3% in 7.9% -10.3% (114%) (114%) Oct Ireland Ireland 14.1% 8.2% Ireland Ireland 14.1% 14.1% 8.2% 14.1% 8.2% 8.2%9.5% 9.5% 9.5%116% 116%17% 9.5% 116%116% 17% 17%17% (11.7%) 10% 10% 10%-0.3%of8.2%periphery Unempl. 116% th (11.7%) (11.7%) (11.7%) Ireland 10% 14.1% -0.3% the (102%) 9.5% overshadow -0.3%-0.3% (102%) to (102%) (102%) Labo Italy Italy Italy8.6% Italy 8.6% 8.6%0.8% 0.8%10.6% 10.6% 8.6% 0.8% 0.8% 10.6% 10.6% 133% 133% 133%48% 133% 48% 48%48%(5.0%) (5.0%) 4% 4% 4% -3.3% 0.8% (20%) 10.6% (5.0%) Italy 4% (5.0%) 8.6% -3.3% -3.3%(20%) (20%) -3.3% (20%) Rate 133% Mobili Oct 2010 Greece Greece 12.2% 0.7% Greece Greece 12.2% 12.2% 0.7% 12.2% 0.7% 0.7%13.1% 13.1% 13.1% 13.1% 142% 142% 142%33% 142% 33% 33%33%(9.6%) (9.6%) 9% 9% 9%-10.5% 0.7% (87%) 13.1% (9.6%) Greece (9.6%) 9% 12.2%-10.5% -10.5% (87%)11.0% -10.5% Portugal (87%) (87%) 142% 7.4% Unempl. Labor Spain Spain 20.7% 0.7% SpainSpain 20.7% 20.7% 0.7% 20.7% 0.7% 0.7%4.2% 4.2% 4.2%80% 80%80%56% 56%56%(9.3%) (9.3%) 10%10%-5.5% 0.7% (98%) 4.2% 4.2% 80% 56% (9.3%) Spain 10% 20.7% -5.5% -5.5%(98%) (98%) (9.3%) 10% -5.5% Ireland(98%)14.1% 80%8.2% Rate Mobility Price/wage Price/wage Price/wage Price/wage Q3 201020102010 2010Q3 2010GDP, Bank foreign World cup /cupItaly / World 8.6% Q3 2010Q3 Q3 20102010Q3 GDP,Q3 Bank foreign World cup / Portugal Q3 Q3 Q3 Q3 Q3 GDP, Bank foreign World GDP, Price/wage World / World 11.0% Bank foreign cupWorld World 0.8% Q3 2010 7.4% differential Tradables ECBECBECB Borr.PMIPMI PMI PMI PMI PMIQoQQoQQoQlender lender EuroEuroGreece 14.1% % differential differentialTradables ECBBorr.Borr. % PMI differential Tradables TradablesBorr.%% % PMI QoQ reserve 12.2% lenderdifferential cup cup cup reserve lender Euro cup Ireland ECBreserve Euro Tradables reserve Borr. 0.7% PMI 8.2% vs Germany %GDP %GDP assets Services vs Germany %GDP Bank vs Bank assets ServicesManufact. Annualized Bank Services Manufact. Annualized victories victories Bank 20.7% Spain in: in: vs GermanyGermany%GDP Bankassets assets ServicesManufact. Annualizedreliance Germany victoriescurrencycurrency in: Services Manufact. Annualizedreliance victories %GDP currency assets reliance reliance vs currency in: 8.6% Italy 0.7% 0.8% Portugal Portugal13% Portugal 11% 11%11% 13% 62%62% 7.2% Portugal 11% 13% 13% 62% 62% 7.2% 7.2% N/A N/A N/A N/A N/A N/A 1.6% Portugal 28%28% 0 062%1450-1530Price/wage 0.7% 7.2% N/A N/A 1.6% 1.6%1.6% 28% 11% 13% 0 28% 0 1450-15307.2% Greece 1450-1530 1450-1530 12.2% N/A Ireland Ireland25%25% -3% 164% Ireland Ireland25% -3% -3% 164% 25% -3% 164% 164%7.8% 7.8% 7.8%50.8 50.8 50.851.2 51.2 51.2N/A N/A N/A 32% 32%32% 0 7.8% 50.8 51.2 N/A Ireland32% 25% -3% 0 0 Spain N/A N/Adifferential 0.7% 164% N/A 7.8% 0 N/A 20.7% 50.8 Tradab Italy Italy Italy 10%10% 35% 46%46% 0.8% Italy 10% 35% 35% 46% 10% 35% 46% 0.8% 0.8%54.4 54.4 54.452.0 52.0 52.00.7% Italy 8% 10% 8% 5 546% 200BC-275AD 0.8% 54.4 52.0 0.7% 0.7%0.7% 8% 8% 35% 5 200BC-275AD Germany 54.4 5 200BC-275AD 0.8% 200BC-275AD vs %GD Price/wage Greece Greece 20% 20%20% 42%42%17.5% 17.5%N/A N/A N/A 43.9 43.9 43.9 (4.5%) Greece 19% 19%19% 42% Greece19% 20% 42% 17.5% 17.5% N/A 43.9 (4.5%) (4.5%)15%19% 20%1 142% 500BC-200BC 13% N/A (4.5%) Greece 15%15% 1 15% 1 500BC-200BC 500BC-200BC 17.5% 500BC-200BC Portugal differential 11% 62% Tradables Spain Spain 20%20% 33% 53%53% 2.1% SpainSpain 20% 33% 33% 53% 20% 33% 53% 2.1% 2.1%48.3 48.3 48.349.1 49.1 49.10.1% Spain15% 15%15% 3 353%1530-1640 25% -3% 48.3 2.1% 48.3 49.1 0.1% 0.1%0.1% 15%20% 33% 3 3 1530-16402.1% 1530-1640 1530-1640 Ireland vs Germany 164% %GDP Italy 10% 35% 46% Notes: “Net“Net“Net International Investment Position” measures debt debt debt external assets (loans, bonds, equity).largernegative 11% measures external Notes: (loans, bonds, Investment Position” number 62% Portugal Notes: International Investment Position” measures external less external assets (loans, bonds, equity). A larger A larger negative number International Investment Position” measures external external less less external assetsbonds, equity). equity). negativenumber Notes: “Net International Investment Position” measures external debt less external assets (loans, International A A larger negative Notes: “Net 13% number Ireland thoseofQ3 20% Q3 42% Greece 25% -3% 19% indicates indicates anetexternal liability; liability; thoseareamong are the highest in the world. Price/wage differentials vsliability; Germany as are among indicatesaagreater net external external those shown are among are the highest in the world. Price/wage differentials vsGermany as ofasQ3 Q3 indicates a greater net external liability; those shown are among are the highest in the world. Price/wage differentialsGermany as shown of greater greater net liability; those shown shown are among are the highest in the world. Price/wage differentials vs indicates a greater net external vs Germany of 164% a Spain 10% 35% Italy 20% 33% 46%53% 20102010 basedconsumerprices and unit labor costscostsmanufacturing, both bothboth to December 1998.consumer prices and unit labor costswage 2010based on based on consumer prices unit unit labor costsmanufacturing, indexed indexed to December 1998. Theconsidersthe wagethe for manufactu based onconsumer prices and and and labor for manufacturing, both indexed to December 1998. The OECD considersconsiderswage 2010 on consumer prices unit labor costs for for for manufacturing, indexed2010 based on1998. The OECD considers wage to December The OECD OECD the the measuremeasure more relevantassessing competitiveness. Ireland was was world’s reserve currency,currency,accordingGreece author Thomas Investme more relevant for for for competitiveness. Ireland Ireland never the the world’s reserve relevant for according to International 42% reserve more but according toauthor Thomas 20% to author 19% measure more relevant for assessingassessing competitiveness.was never theneverworld’smeasure currency,according toNotes:competitiveness. Ireland wa measure more relevant assessingcompetitiveness. Ireland was never the world’s reserve currency,but but but assessing “Net Thomas author Thomas Spainthem.20% 33% 53% Cahill, its monks safeguarded Western civilization during the DarkDark AgestranscribingCahill, before Barbarians burned them. civilization during theliab Cahill, its monks safeguarded WesternWestern civilizationthe Darkthe Dark transcribing works itsworks before Barbariansthem. a greater net external Dar Cahill, its monks safeguarded Western civilization during the Ages by Ages by transcribing monks safeguarded burned Cahill, its monks safeguarded civilization during during Ages by by transcribing works before Barbarians Western them. works before Barbarians burned burned indicates 2010 based on consumer prices and Notes: “Net International Investment 22 The original “Treaty for aaConstitution in Europe” was 784 pages. The 2009The 2009Treatywas whittled down toa280measure more relevant for 784 page TheThe The original for for afor a Constitution in Europe” was pages. The 2009 LisbonThe waswas was whittled down to pages. Europe” was assessin 2 2 2 original “Treaty “Treaty Constitution in Europe” was 784 784The 2009Lisbon Treaty original whittled forto 280pages.a greater net external liabili original “Treaty Constitution in Europe” was 784 pages. pages. Lisbon Lisbon Treaty “Treaty downConstitution pages. Treaty whittled down indicates to 280 280 in pages. 4 4 4 4 Cahill, its monks safeguarded West 2010 based on consumer prices and u 4 measure more relevant for assessing c Cahill, its monks safeguarded Wester 2
  7. 7. Eye on the Market | OUTLOOK 2011 January 1, 2011 January 1, 2011 2011 Outlook On our investment portfolios Equities: pricing in a fair bit of pessimism The prior pages refer to challenges the world is still facing; the good news is that equity markets are pricing a lot of them in. Forward P/E multiples for the US, Europe and the Emerging Markets are clumped together around 10x-13x (c26). That’s why we are comfortable holding 35%-45% equities in Balanced and Growth portfolios (both figures exclude additional equity exposure through private equity and certain hedge fund categories). Growth stocks in particular look cheaply priced (c27), although there is something strange going on in the large cap technology space3, where P/E multiples are low and cash holdings are extremely elevated (c28). A ratio of P/E to earnings growth is at a 20-year low for the S&P 500, another sign of market pessimism. Flows into equities have been negative this year, suggesting a lot of underweight positions. (c26) Forward P/E equity multiples (c27) Growth stocks price in a lot of (c28) Cash balances and P/E multiples Ratios pessimism, P/E relative to market of mega-tech stocks, Billions, USD 20 2.5x 70x $220 For topdecile of growth stocks Price to Earnings 18 $200 Emerging 2.3x 60x Ratio (LHS) 16 Markets $180 US 2.0x 50x Cash & $160 14 Equivalents 1.8x 40x (RHS) $140 12 $120 1.5x 30x 10 $100 8 Europe 1.3x 20x Current $80 6 1.0x 10x $60 2003 2004 2005 2006 2007 2008 2009 2010 1978 1986 1994 2002 2010 2000 2001 2003 2005 2006 2008 2010 US profits growth and margins are in good shape, which is why the US is our largest regional equity allocation. Keep this in mind: S&P 500 revenues over the last 15 years have been more linked to World GDP growth than US GDP growth (c29), driving offshore profits higher as a % of GDP (c30), and to 35% of total US profits. Another positive: the S&P 500 tends to have less exposure to the US consumer than the US economy does, and more exposure to capital spending, energy and healthcare. In terms of valuation, technology and healthcare appear most attractively priced. We prefer large cap to small cap as the latter trades at a 30% P/E premium, and generally prefer growth over value. (c29) S&P revenues tied to global (c30) U.S. corporate profits from the (c31) Share of S&P 500 earnings by growth, not U.S. growth, Avg 1996 - 2010 rest of the world, Percent of GDP end-market Medical 6.5% 3.5% Business 14% Consumer 3.0% Staples 6.0% U.S. 2.5% 5.5% 21% 18% 2.0% 5.0% 1.5% 4.5% 1.0% 17% 14% 4.0% 0.5% 16% S&P 500 World GDP GDP Final Sales Energy & Consumer Core to Domestic 0.0% Commodities Disc. Revenues Purchasers 1948 1960 1973 1985 1997 2010 Financials Analysts have underestimated S&P 500 earnings by around 10% per quarter (c32) U.S. profit drivers since Jan 2009. During the recession, US companies kept costs down as demand Percent plunged. Now, as demand rises, incremental margins on new revenues are high. 70% 68% We expect this to continue in 2011. We expect 8%-10% earnings growth and 65% stock buybacks (now running at 2% of market cap) to deliver roughly 10% S&P 63% 500 returns in 2011, with some bumps along the way. 60% Labor Cost as % of Sales While US profit margins are high, US corporate sales are at a 50-year low (c32). 58% 55% How can these 2 things co-exist? Because labor costs as a % of revenues are 53% at their lowest levels, by some measures since 1929. That’s why we’re reluctant 50% Sales as % of GDP to forecast much higher multiples; earnings are too reliant on low real wages. 48% 45% 1947 1959 1972 1984 1997 2010 3 Stocks used for this analysis include: Microsoft, IBM, Apple, Intel, Hewlett-Packard, Cisco, Oracle, Google, Qualcomm, Corning 5 5
  8. 8. years, these equity tilts have worked well (c33). We expect these relative rankings to to suffer the risk of inflation in the emerging world than the risk of deflation in E exposure is tied to German exporters, whose stock prices generated strong gains in 20 Eye on the Market | OUTLOOK 2011 January 1, 2011 as the bulk of our emerging markets exposure, with smaller exposures i January 1, 2011 We hold Asia Brazil, we are encouraged by the development of the middle class (c34), and increase 2011 Outlook agricultural exports to China have quadrupled since 2004). But there are some risks r After the US, emerging markets are our next largest equity allocation, followed by Europe and then Japan. Over the last 1 and 3Our pre rate, and reliance on portfolios inflows rather than foreign direct investment. years, these equity tilts have worked well (c33). We expectparticular involves longto continue in 2011; private equityinclined Brazil in these relative rankings and short positions; we are more investments, part to suffer the risk of inflation in the emerging world than the risk of deflation in Europe. Within Europe, investments in local Brazi which are only 10%-15% of the Bovespa (see page 8); and most of our equity exposure is tied to German exporters, whose stock prices generated strong gains in 2010. (c33) Global equity returns (c34) Ascent of Brazil's middle class We hold Asia as the bulk of our emerging markets Total returns through 12/10/10 exposure, with smaller exposures in Latin America andMillions ofEurope. On consumer, Eastern people Local currency 120 Brazil, we are encouraged by the development of the middle class (c34), and increased international trade (its mining, oil and agricultural exports to China have quadrupled since 2004). But there are some risksterms USD terms related to 100 inflation, an overvalued exchange 2003 2009 rate, and reliance on portfolios inflows rather than foreign direct investment. Ouryear 3 yearapproach to Latin America and 1 year 3 year 1 preferred 2014 Brazil in particular involves long and short positions; private equity investments, particularly in80 consumer-related companies S&P 500 15% (4%) 15% (4%) which are only 10%-15% of the Bovespa (see page 8); and investments in local Brazilian credit60 interest rate markets. and MSCI EM 18% (2%) 15% (1%) (c34) Ascent of Brazil's middle class BRAZIL: Pluses and Minuses 40 (c33) Global equity returns Total returns through 12/10/10 Local currency consumer, Millions of people (2%) 16% Positives 20 MSCI EM Asia 19% (0%) Negatives 120 MSCI Europe 5% (10%) 11% * Household credit: low * Wage & price inflation risks (6%) USD terms terms 2003 0 100 MSCI Japan 9% 4% * Rapidly growing trade * Real exchange Lower (7%) 2009 (16%) Upperclass Middle rate: Bottom 1 year 3 year 1 year 3 year 2014 class class class 80 with China/Asia looking expensive S&P 500 15% (4%) 15% (4%) Fixed income: government bonds and credit * Higher institutional * Increased reliance on 60 The global Printing Press creates money that in equity to find a home. Atforeign participation needs portfolio flows over the same time MSCI EM 18% (2%) 15% (1%) 40 negative: while Federal and municipal issuance grew, companies and households redu markets direct investment MSCI EM Asia 19% (2%) 16% (0%) 20 The result: a supply-demand imbalance that supported global bond prices. Thin MSCI Europe 5% (10%) 11% (6%) the Fed will own 1/3 of all Treasuries outstanding in 4-20High corporate tax rate finance * P/E multiples: 12x * year maturities, and 0 MSCI Japan 9% (7%) 4% (16%) Upperclass Middle and EM Central Banks to continue to buy Treasuries. However, our expect G3 banks Lower Bottom * 50% poverty decline * Among world's highest low, given limited yield benefits of longer duration paper, and therate of higher yield class class class since 2000 real interest risk bond market risks). Our current underweight to government bonds is one of the large Fixed income: government bonds and credit The global Printing Press creates money that needs to expect home. At theof stable credit spreads, althoughUS has been be markedly low We find a another year same time, total issuance in the returns will negative: while Federal and municipal issuance grew, companieshave households reduced issuance at an bank loans alongside high yield much spreads and already tightened. We hold senior even faster pace (c35). The result: a supply-demand imbalance that supported global bond prices. Think about this: by the trim high yield positions in 201 spread of 600 bps after last year’s rally. We expect to time QE2 is finished, the Fed will own 1/3 of all Treasuries outstanding decline in default rates (c36)financeexplain why 2011 Treasury deficit. We much, but in 4-20 year maturities, and helps 94% of the spreads have tightened this expect G3 banks and EM Central Banks to continue to buy Treasuries. of credit. our sovereign and municipal durations remain affecting the pricing However, low, given limited yield benefits of longer duration paper, and the risk of higher yields at some point (seecorporate default on (c36) U.S. page 10 for more rates (c35) Net issuance of U.S. Credit bond market risks). Our current underweight to government bonds is last 12 months ($blns) Percent of parportfolios. Instruments over one of the largest active positions in value 16% We expect another year of stable credit spreads, although returns will be markedly lower than in 2009 and 2010 given how Treasuries $1,468 14% much spreads have already tightened. We hold senior bank loans alongside high yield, which is still reasonably priced at a Agencies -$70 Municipals $94 12% spread of 600 bps after last year’s rally. We expect to trim high yield positions in 2011 as spreads tighten further. The current Bonds Corporate tightened this much, but liquidity conditions are undeniably decline in default rates (c36) helps explain why spreads have & Asset Backed -$129 10% affecting the pricing of credit. Mortgages -$598 8% Bank Loans -$424 6% (c35) Net issuance of U.S. Credit (c36) U.S. corporate default rates Consumer Credit (c37) Property decline cushion, AAA -$47 Instruments over last 12 months ($blns) Percent of par value 4% Loans CMBS subordination adjusted for LTVs 16% Commercial Paper -$249 Treasuries $1,468 45% 2% Other loans -$241 14% 40% Agencies -$70 Total -$195 0% A 5% property decline Municipals $94 12% Bonds 35% 2000 would have exposed 2008 2002 2004 2006 2010 Corporate & Asset Backed -$129 10% 30% AAA investors to losses The structured credit market reached25% Icarus moment in 2007, when it offered little its Mortgages -$598 8% CMBS investor could barely sustain 20% property losses before losing principal (c37) any Bank Loans -$424 6% to clients during this period for this reason. Since then, subordination protections hav 15% Consumer Credit -$47 4% wider. As a result, we have been adding structured credit to portfolios since markets r Loans 10% Commercial Paper -$249 Other loans -$241 2% We also see opportunities in US bank5% preferred stock that may be called early as bank Total -$195 0% 0% 2000 2002 2004 2006 2008 2010 2001 2003 2005 2007 2010 The structured credit market reached its Icarus moment in 2007, when it offered little value to investors. At that time, a AAA- CMBS investor could barely sustain any property losses before losing principal (c37). We did not recommend structured credit to clients during this period for this reason. Since then, subordination protections have improved substantially, and spreads are wider. As a result, we have been adding structured credit to portfolios since markets re-priced this kind of risk in early 2009. We also see opportunities in US bank preferred stock that may be called early as banks restructure their capital. 6 6

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