EFTA00610119.pdf

Eye on the Market j February 19, 201 J.P.Morganj Fifty Trades of Grey: an illustrated story of investment, temptation, addiction and the cost of money Q I US retail sales were better than expected in January, despite higher tax rates, as the US consumer is still more active than European counterparts (1" chart). It's too soon to see the full impact of higher US income and payroll tax rates, but a Q4 jump in real wages, improved household balance sheets and a turnaround in housing may offset part of the headwind. We'll see in a couple of quarters. Meanwhile, in the SOTU address, the President talked about raising revenues. It will be interesting to see where they come from: after the recent tax act, top quintile tax rates are now 5 times higher than the second quintile, up from 2x in 1979 as progressivity increases further (2nd chart). Everywhere I go, however, there's a different topic on everyone's minds: what will happen when the Federal Reserve stops purchasing tens of billions in Treasury and Agency debt every month? It's possible that with a sufficiently dovish Chairperson replacing Bemanke in 2014 that they will never end, and that the US will end up like Ireland, with its Treasury perpetually beholden to its Central Bank; but I don't think so. The autobiographical story below is my view on Fed purchases and their impact on the world of investing. Auto sales: U-turns and Down-turns Percentof total population. 3 month moving average 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% Europe US 1998 2002 2006 Source: BEA. Census Bureau, ECB, EuroStat. 2010 Average federal Individual Income and social insurance (RCA) tax rate by Income group, Percent 30 2013E 25 Top I 20 Top Quintile 15 Middle Quintile 10 5 Second Quintile 0 Lowest Quintile -5 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 Source: CBO, WC. JPMAM. Lowest quintile negative due to credits/transfers. Fifty Trades of Grey "I was always the cautious type. I would wait until other people jumped into a lake to make sure it was deep enough. I have never been on a motorcycle, and have never held or fired a weapon. I once rented a Maserati for a day to see what it was like, and drove under the speed limit the entire time. So, it's not surprising that by the fall of 2007, with mounting problems in housing, over-crowding in hedge fund strategies like statistical arbitrage and very low credit spreads, I got nervous and reduced portfolio risk heading into 2008. The following fall, after the collapse, I imagined a slow and steady approach to reinvesting. It would take time to rebuild confidence after the second 40% equity market decline in a single decade, right? After recessions in 1989 and 1999, you could take your time reinvesting in credit: high yield spreads remained elevated for 3 to 4 years, allowing for a long, relaxed period of risk-taking by investors with the wherewithal to have avoided some of it in the first place. Then one day in early 2009, everything changed. The Fed Chairman's picture in the paper reminded me of a cross between Sean Connery and King Hussein of Jordan. His message was clear: he was going to shroud the markets in a warm embrace of unbounded, limitless liquidity. It was slow at first, but then appeared everywhere I looked, like an endless, pounding summer rain. The convertible bonds we bought in November 2008, and the commercial real estate-backed securities and leveraged loans we bought the following spring, rose in a passionate revival of credit markets. During the first few months of 2009, you could earn 10% or more on debtor-in-possession financing, and Fifty Trades of Grey: Fed purchases of Treasury and purchase private equity interests from overextended college Agency securities, percentof total net supply issued endowments at steep discounts. But by the late summer, as (measured in 10-year equivalents,6 month moving average) 50 the leaves turned, these opportunities began to fade as capital 70% 4 came back to credit markets. I held on tight, pulled in a 60% 2 5 39 6 convulsion of rising optimism and the search for yield. 50% 3 a 9 0 That's ancient history now. For the last fifty months, the Fed 40% Sziix : 1 11111 1111 25 has been buying Treasuries and Agencies, $2.5 trillion in all 3o% IS (measured in 10-year equivalents). As the Fed ravishes the 20% ICOT to riskless debt markets, its demand now accounts for -55% of io 10% i22 the entire net supply issued by the Treasury, Ginnie Mae, 0% Fannie Mae and Freddie Mac. My relationship with the Fed - started to change: with its relentless debt purchases and 0% to% Jan-0 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 policy rates, the Fed apparently sees me as a rentier capitalist Source: Nomura Securities... Morgan Securities, LLC. EFTA00610119 EFTA00610120 Eye on the Market j February 19, 201 J.P.Morgan Fifty Trades of Grey: an illustrated story of investment, temptation, addiction and the cost of money Lots of cash, everywhere Household and corporate cash balances, % of tangible assets 28 24 • 20 A proxy for spare capacity: the US output gap Actual output relative to a measure of full potential output (from CBO) 6% - -8% - 16 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1952 1962 1972 1982 1992 2002 2012 Source: Federal Reserve. Source: Congressional Budget Office. Positive output gap led to inflation Plenty of room to expand without inflation Nevertheless, the end of the affair will come one day, and probably when I am not expecting it. Since the Greenspan- Bernanke era of ultra-low policy rates began, the volatility of equities is even higher than before the creation of the Fed in 1913, when the US was beset by frequent recessions and depressions. So here I remain, trapped in a cycle of market passions that careen from sadness to ecstasy, and then back again. The ecstasy phase has more room to run for now, and we are seeing signs that activity (Berkshire Hathaway and 3G purchase of Heinz, Comcast purchase of GE assets, Liberty Media purchase of Virgin Global) and share repurchases are picking up, which is generally good for stocks. The Fed is looking for `substantial' labor market improvement, which means there will probably be another 12 trades of grey before its purchases end. What kind of imbalances will grow during this time? When the Fed stops buying riskless securities, we will find out how ready risky securities are to stand on their own, and how addicted investors are to Fed support. I remember the last time I was in this kind of tangled, complicated relationship. It was in 2003: the Fed set policy rates at 1%, below the rate of inflation°, and set in motion another cycle in which the value of cash was destroyed. Incredibly, investors in US T-bills earned returns below the rate of inflation until September 2005, which was well into the recovery and around the time the housini collapse began. Fed sponsorship of (another) housing boom' and the credit markets was great while it lasted, and I thought the affair would never end. But it did end, with sadness and with betrayal: when it came time for the Federal Reserve to warn me about possible consequences of surging home ownership costs, I didn't even get an email, or a salacious text. Instead, I read one day in the newspaper that the subprime issue was 'contained'. Love means never having to say you're sorry." Michael Cembalest M. Morgan Asset Management US home price to rent ratio, and periods of negative real interest rates 140 135 130 125 120 115 110 105 100 95 90 1970 1975 1981 1986 1992 1997 2003 2008 0% -2% Index,1/1/1970 =100 -4% -6% 1970 1975 1981 1986 1992 1997 2003 2008 Source: Federal Housim Finance Agency, Bureau of Labor Statistics, SL Louis Federal Reserve \A" Negative returns on 3-month T-ills 6 Inflation was at the same level in 2003 as it was in 1997, yet policy rates were 4.5% higher in 1997. This is a point that Stanford's John Taylor, a critic of current Fed policy, made last November at the Centennial Celebration of Milton Friedman at the University of Chicago. 7 The Fed had plenty of company: homeowners, banks, mortgage originators and guarantors, broker-dealers, rating agencies, US government- sponsored enterprises, Congress, regulators and of course, the Department of Housing and Urban Development, which by the year 2000, required that 50% of all Fannie/Freddie origination went to affordable housing borrowers, which in turn resulted in a surge in 3% down- payments. There have been a lot of rule changes in the financial system in response: so far, Dodd-Frank is 34% complete and has generated over 11,000 pages of new regulations. On the other hand, half the volume of all home purchase loans from 2009 to 2011 were underwritten by the Federal Housing Administration, Veterans Affairs and the Department of Agriculture with average down-payments of.....3%. 4 EFTA00610121 Eye on the Market j February 19, 201 J.P.Morgan Filly Trades of Grey: an illustrated story of investment, temptation, addiction and the cost of money BEA Bureau of Economic Analysis CMBS Commercial mortgage backed securities CLO Collateralized loan issuance CBO Congressional Budget Office FICA Federal Insurance Contributions Act QE Quantitative easing SOW State of the Union TPC Tax Policy Center (Brookings) IRS Circular 230 Disclosure: JPMorgan Chase & Co. and its affiliates do not provide tar advice. 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