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Eye on the Market | October 22, 2012 J.P Morgan The most important energy developments of 2012: how countries are planning for Independence Day First, a few updates: e It looks like sub-2.5% global GDP growth is showing up in the weak outlook provided by some bell-weather cyclical companies that reported so far (AMD, APD, BHI, CAT, ETFC, GE, GOOG, IBM, MCD, MSFT, PH). We’re about to see how resilient an equity market is when one of its key selling points is how expensive bonds are. The recent pick-up in leading indicators suggests that earnings expectations may stabilize early in the new year. e September US retail sales were strong and US housing data continue to improve, although as noted last week, the degree of housing’s contribution to growth remains the big question. There will be economic headwinds next year even if the fiscal cliff is negotiated down. See October 9" EoTM for the full Monty on the fiscal cliff mechanics. e We modeled the President’s tax proposals on various demographics of high net worth taxpayers’. The results: increases in effective tax rates (as % of adjusted gross income) from 4% to 12%, depending on income, investible assets, stock-bond ownership, state of domicile, etc. It’s unlikely to be enacted as scripted unless there’s a Democratic sweep, but its contours probably indicate where HNW taxation is eventually heading. We don’t have enough info to analyze Romney’s tax plan in comparable detail. On the latter, the Tax Policy Center released a study indicating that capping itemized deductions at $25k for all taxpayers only offsets 32% of the estimated revenue loss from a 20% reduction in income tax rates. e Production, capital spending and export data from China show improvement from the weak pace over the summer, although details reveal a continued decline in manufacturing growth offset by rising gov’t infrastructure spending. China ran a 600 billion RMB budget surplus through September, and targets an 800 bn RMB budget deficit this year. I wouldn’t argue that all that gov’t spending is going to have a huge productivity benefit, but it should keep things moving. Chinese earnings growth and business climate surveys remain weak, an unsurprising consequence of excess industrial capacity. e Jn Europe, financial markets continue to rally in the Periphery. Five -year Spanish credit spreads have fallen below 3% from over 6% last July, and without the ECB firing a single shot (e.g. buying any bonds). The economic data is still bad (a collapse in auto sales similar to 2009), but now it’s just “run-of-the-mill” terrible instead of “look-out-for-that-bank/country- it’s-about-to-default” terrible. What is impossible to assess: the ability of Southern Europe to withstand rising social and political pressures of massive unemployment. Also: watch out for France, where there is a large, growing economic gap vs. Germany, and where its President is resisting German demands for centralized budgetary supervision. Our annual energy discussion with Vaclav Every year, I sit down with Vaclav Smil from the University of Manitoba to discuss “the year in energy”. Vaclav is one of the world’s foremost experts on energy issues, and has written over 30 books and 300 papers on the subject. In this note, we walk through what Vaclav identified as the 5 notable energy developments of 2012”: energy independence initiatives in the US, Europe and Japan; geopolitical implications of rising Chinese oil demand; and another rough year for the electric car. The political backdrop in the Middle East, European concerns about natural gas dependence on Russia, and lingering concerns about nuclear power after Fukushima are factors driving countries to seek greater energy independence. In the US, prospects for energy independence rely mostly on domestically produced oil and natural gas, while in Europe and Japan, they rely on rising renewable energy targets. What’s remarkable is the official sector confidence in Germany and Japan that the transition cost to renewables will be manageable. One indicative data point: the cost of building connections between offshore wind farms and the electricity grid (excluding the cost of the wind turbine itself) can be greater than the cost of building an entire brand new natural gas plant. As always, a renewable energy discussion involves facts, figures, emotion and a large dose of the unknown. The outcome will have important consequences for growth, the cost and availability of electricity and the global balance of payments. These developments argue for greater growth and productivity potential in the US, although energy costs are just one part of the larger economic and profits equation. Even among US manufacturing companies, energy generally represents only 5% of total expenses, and is dwarfed by labor costs. Michael Cembalest J.P. Morgan Asset Management ' Proposed changes affecting U.S. high net worth taxpayers: increased tax rates on ordinary income, dividends and realized capital gains; increased Medicare taxes on earned and unearned income; rising limitations on itemized deductions (state & local taxes, mortgage interest and charitable deductions); partial inclusion of municipal income, 401k contributions and employer-paid health benefits in taxable income. * Other items we could have discussed: continued growth of global hydropower, politics around the Keystone XL pipeline, the apparent end of Exxon’s collaboration with Craig Venter to develop fuels from genetically modified algae, and the EU’s decision to deemphasize crop- based biofuels due to concerns about greater carbon emissions than the diesel they replace, and high food prices. HOUSE_OVERSIGHT_024194