EFTA00630374.pdf

From: US GIO < To: Undisclosed recipients:; Subject: The J.P. Morgan View: Due diligence on the risk rally Date: Fri, 23 Mar 2012 23:04:33 +0000 Attachments: JPM The J.P. Morgan_View_20 I 2-03-23_814713.pdf Inline-Images: ATT00001.gif J.P. Morgan Global Asset Allocation The J.P. Morgan View: Due diligence on the risk rally Click here for the full Note and disclosures. • Asset Allocation — Reduce directionality in equities (ex EM and cyclicals), but stay overall OW credit and equities versus bonds and cash. • Economics — Forecasts on hold, but greater downside risk on China. • Fixed Income — Close bearish duration positions in Europe as well as peripheral OWs. Stay short duration in the US and selectively long in EM local markets, favouring Poland, South Africa and Brazil. • Equities — We exit our OWs in EM vs. DM, our overweight in MSCI BRICs vs MSCI EM and Cyclical vs. Defensive sectors globally. • Credit — Stay with a range of credit overweights: Long US, EM and Europe. • Foreign exchange — Carry is less attractive in FX than credit as in FX it implies buying commodity currencies, threatened by a Chinese slowdown. • Commodities — Crude oil and Base metals should move lower through Q2 before rebounding in the second half of 2012. After a week of clear hesitation in the risk rally and plenty of challenges from our investors on the long-risk stance, we think it worthwhile to take stock of the case for remaining overweight credit and equities against bonds and cash. We address below each of the main challenges to the long risk position. 1. The fundamentals are no good. The world economy is at 2%, barely growing, with Europe already back in recession, profit margins peaking, and a decade of fiscal austerity holding back the private sector. — Agreed that the macroeconomic fundamentals are not enticing. But the financial fundamentals of high risk premia versus falling uncertainty are compellingly attractive and truly at the core of what defines asset price value. 2. The rally is just a house of cards built on easy money. When the liquidity music is over, the asset price bubble will deflate and give it all back. — High risk premia on equities and credit are indeed due to the near-zero yield on cash and safe government bonds, not because equity and corporate bonds are themselves that attractive. But that is how monetary stimulus works. And central banks will not take back this stimulus until the economies and markets can stand on their own feet, which is several years from now. Remember the old adage of "Don't fight the Fed". Surely one should not do so when the Fed works in concord with all other central banks in the world. 3. Every one is long now. — Speculative positions in futures and by macro hedge funds clearly show they are aggressively long risk now. At our Paris Conference last week, 2/3rds of our audience said they were long risky assets. But overall leverage by hedge funds remains subdued, and asset allocators have only shallow longs. Retail investors continue to pour more money into safer bonds funds than equities or high yield. The world as a whole has higher than average cash holdings and some 70% of world holdings offer no positive yield after taxes and inflation. See recent issues of Flows & Liquidity. EFTA00630374 What trigger is left to push up risk markets to the next level? — Accepted there is no obvious trigger as there was before EMU Summits or the Greek restructuring. And our economic growth forecasts are in line with consensus. But within our line of thinking, the true surprise, and thus trigger, is no surprises. High risk premia mean the market is priced for risks and thus negative surprises. If these risks, ill-defined as they may be, do not show up, then that is by itself an event that surprises relative to market pricing. There remain tons of risks in front of us. The US and Euro governments have simply kicked the can down the road, China is weakening dramatically, and Israel will not wait forever. — Yes, monetary easing and fiscal stopgaps have simply bought time, but time is what is needed to heal wounds. US fiscal decisions will have to await the elections while Europe has a lot of work to do to put together its fiscal compact. The US Administration will want to exhaust all diplomatic tools before making a military decision on Iran, if it ever will. The markets thus face a lull in event risk over coming months, even as long-term uncertainties remain. One risk in front of us is the dramatic slowing in Chinese activity data (see GDW). We accept the risk is not receding, but then need to assess whether a hard landing (not our call) will have a global market impact. Without belittling such an event, a local event only becomes global if it has a clear connection to world markets and economies. The strongest connection (contagion) comes through banking and energy, as all economic sectors and regions are touched by these two propagators. This is how Lehman and Greece became global disasters despite their small size. And this is how oil shocks have preceded most recessions. A Chinese hard landing affects the world through trade, but not through banking or oil, and will thus have a much less global impact. We would treat it by underweighting those sectors and countries most dependent on China, without turning overall net short risky assets. In short, the risks that are out there are not minor but are not imminent nor global. Value is exhausted. Aren't bonds in a bubble? — The rally of recent months has tightened credit spreads from recession levels to cycle averages, but they are far from expensive. Equity risk premia versus cash and government debt have moved from half-century highs to still extremely high. Bubbles require leverage and extreme expensiveness. Bonds are extremely expensive and have been bought on leverage by banks. Most of the rise in bond holdings are with central banks (QE and reserves) that can withstand losses and have no liquidity problems. Bonds are at extreme danger once inflation comes and central banks need to unwind their super easy stance. But these central banks will not want to create bond carnage and will telegraph their intentions well in advance. A super 1994 style bond blood bath is not here yet. Fixed income After last week's sharp sell-off, this week saw USTs essentially unchanged while German Bunds rallied, with 10-year yields coming down 13bp. We close our short duration position in Europe as well as peripheral OWs (GFIMS). Next week's EcoFin meeting could disappoint given continued uncertainty around the expansion of the EFSF/ESM. There is also already some resistance from Germany where unexpected regional elections have the potential to weaken the current coalition government. This coupled with a disappointing Euro area PMI is enough to remove our bearish duration bias in Europe. EM local bonds continued to back up this week with yields now around 26bp above the near record lows seen in mid Feb. Flows into EM bond funds remain strong but investors continue to favour hard over local-currency funds. We remain selectively long in EM local markets, focusing on Poland, South Africa and Brazil where monetary policy favours long duration positions (see EM Cross Product Strategy Weekly, Beinstein et al, 19 Mar) Equities The disappointment in this week's flash PMIs in China and the Euro area is blurring the near-term picture for both Cyclical and EM equities. Although these releases do not materially change our medium-term call for a soft-landing and a bottom in China's growth pace at 7.2%qlq ar in the current quarter, they create uncertainty for the next few months. As a result, we tactically abandon our overweight in EM vs. DM equities, our overweight in MSCI BRICs vs MSCI EM and our overweight in Cyclical vs. Defensive sectors globally. All these trades are up YTD, but suffered heavily in March. Our models justify these changes. A strategy that uses return momentum (2-month) and economic momentum (relative IP growth) has moved to a negative stance on EM vs. DM equities. Two-month return momentum is negative vs the end of January. Relative IP growth (12-month) at 4.5% remains below the 5% threshold in the most recent release for December (see The EM vs. Developed Markets equity allocation, Koo and Panigirtzoglou, April 2009). The decline in flash PMIs in both China and the Euro area makes it likely that the global manufacturing PMI to be released on Apr 1 will also decline. A simple regression of the monthly change in the global manufacturing PMI against the monthly change in the Chinese and Euro area flash PMI points to a decline of 1 point in March. This will move the 2- EFTA00630375 month change in the global manufacturing PMI to negative territory, pointing to an underweight in Cyclical vs Defensive equity sectors. Credit This week, markets jittered on fresh growth concerns and spreads finished slightly wider across the board. Weak PMIs in Europe and China and some US disappointments saw yields rise from their record lows. But the fundamental picture remains supportive Absent major growth shocks, credit is a good place to be in a low default rate, low interest rate and low (ish) growth rate world. As such, flows remain robust and supply is clearly meeting this demand. We see no reason to change course as the major credit supportive factors, i.e. abundant liquidity and low policy rates, are still firmly in place. In the US, our Credit Investor Survey suggests investors have become slightly more bullish relative to February but the lack of consensus on the near-term direction of spreads remains (See this week's CMOS). Hedge funds remain the most bearish (40% expect wider spreads) and insurance companies are the most bullish (45% expect tighter spreads). The Greek CDS Auction played out smoothly last Monday. Consistent with our prediction, the final recovery rate was 21.5%, down from an initial price 21.75% after €300m of open interest to sell bonds in the auction. More generally, attention in the CDS market has been focussed on the index rolls into Series 18 of the CDX and 17 of the iTraxx this week. Among other changes, Cyprus replaces Greece in the SovX (see Global CDS Indices, March 19). Foreign Exchange A familiar explanation for recent dollar strength, the March pattern has been US economic outperformance: since China is slowing, Europe stagnating and US labor markets plus housing improving, US rates will rise and US assets will outperform. This reasoning also underpins expectations for a regime change in which the dollar becomes pro- cyclical, or positively correlated with growth and stocks. This hope has been a familiar one in the three years since the Fed cut rates to zero. Rarely does it hold for more than a month or two, and 2012 shouldn't be much different — there are too many obstacles to a trend rise in US rates. Rather than turning on US outperformance, currencies will probably continue adjusting in coming weeks to global mediocrity in which most major and EM economies deliver below-trend growth in the first half of the year, and in which the carry trade, which might normally deliver high returns in this environment, ironically underperforms since most high yielders in the currency world are also commodity exporters, so too exposed to China. Thus carry makes less sense in FX than in bonds or credit until China bottoms. Two weeks ago we advised selling calls on commodity currencies to express these China risks. In the macro portfolio this week, we add three similar trades given stretched valuations on some currencies like CAD, the erosion of USD/JPY support as US rates stabilize and ongoing softness in Chinese data. In cash, sell CAD/JPY. In options, buy a bullish EUR/CAD risk reversal and an AUD/USD put struck at parity. In the technical portfolio, stay long EUR/NZD and sell NZD/JPY. In the derivatives portfolio, take profits on NZD/USD vs USD/CLP vols swaps and EUR/CAD vs EUFt/MXN. Stay long straddles in GBP/USD and EUR/CAD; and stay long AUD/USD vs USD/BRL vol. Commodities Commodities are slightly down again this week led lower by energy and base metals. Oil supply problems persist in Syria, Yemen, Sudan and Canada as well as in Iran where production has declined due to upcoming sanctions. This has been offset by strong output from remaining OPEC countries, including Libya, which has almost returned to pre- crisis levels. However, the Brent futures curve remains backwardated (spot above forwards), which shows the oil market remains tight. We believe this reflects stronger demand, likely in part due to China building up strategic reserves. Recent PMIs in China and Europe raise some downside risk to demand and we continue to expect crude prices to move lower as we head into Q2 before rebounding in the second half of 2012. Base metals are now 7% below this year's peak seen in early Feb and have given back around half of the gain made in the first few weeks of 2012. This recent underperformance versus other commodities largely reflects weak Chinese demand given tight credit conditions and policy makers' crack-down on the real estate sector. Chinese imports of metal have been relatively strong but their actual consumption has so far this year have been flat vs. the same period in 2011 (see Base and Precious Metals Daily: Where Have You Been?, Jansen, Mar 20). Now that Chinese inflation has come down significantly, Beijing can begin supporting economic growth in earnest. We thus expect base metals and other industrial commodities to pick-up sharply as we head into the summer and through the second half of the year. Jan Loeys (AC) EFTA00630376 JPMorgan Chase Bank NA John Normand J.P. Morgan Securities Ltd. Nikolaos Pani irtzoglou J.P. Morgan Securities Ltd. Seamus Mac Gorain J.P. f,,lorgan Securities Ltd. 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