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Eye on the Market | July 11, 2011 J.P Morgan Topics: Portfolios, US corporate profits and the Twilight of the Gods (in the US, Europe, China and the IEA) Hourly compensation for production workers Share of US imports of intermediate goods from China, Share of US rate, 2005 vs. 2011 Malaysia, Thailand and Vietnam, percent 30% m 2005 14% 25% m 2011E 12% 20% 1s Q, 15% o% 6% 10% 4% 5% 2% 0% 0% Taiwan Mexico China Philippines 2000 2007 2010 Source: Bureau of Labor Statistics, Empirical Research Partners. Source: UN Comtrade, Empirical Research Partners. To summarize, we expect today’s margins to last a while longer, since relative costs won’t converge overnight. But we are not inclined to pay a high multiple for them, given their reliance on weak labor compensation, which in turn requires large government transfers. The good news: markets are not applying high multiples right now, which is why we own the equities we do. However, questions about the large but shrinking public sector toolkit knock 10%-15% off of our equity allocations, compared to where we would normally expect to be 2 years after a recession. We walk through 4 instances of this below, as it relates to US fiscal policy, oil prices, Chinese inflation and the European periphery. Twilight of the Gods, part 1: Limited room for fiscal policy to invigorate the US recovery Here’s what we know for sure about the US Federal debt ceiling debate: e The government is facing the unappealing task of having to increase the Federal debt ceiling above 100% of GDP for the first time since the end of WWII, and only the second time since the debt ceiling was established in 1917 e The government has already run out of money from traditional sources. As shown below, since May 16, 2011, the US Treasury has been raiding the cash, securities and borrowing capacity of government employee retirement and other funds. Of $270 billion of such balances which existed in May, around 75% has already been used up. There’s not much leeway left, which is why the government will probably run out of money some time in August. e The debate about the existing Federal debt is the lesser of two problems. As shown on the following page, the present value of unfunded entitlement obligations (e.g., future debt) dwarfs the existing debt. That’s why there’s so much talk about a deal to stabilize the long term trajectory of the budget deficit. The rest is all speculation. The table on the next page shows the revenue and spending factors in play. It’s too early to know what kind of deal will be crafted. We believe that the deal with be composed of 80% spending cuts and 20% revenue/tax increases (rather than 50-50), and will be closer to $2 trillion than $4 trillion. While it’s possible that another dose of fiscal stimulus will be built into the debt ceiling agreement, it might not be that large, and its impact could easily be offset by a subdued consumer response due to expectations of higher taxes in the long run (e.g., Ricardian equivalence). Statutory debt limit and debt subject to limit US Treasury: raiding the cookie jar Trillions of gross debt, USD Billions, USD 18 300 Gross debt/GDP a 109%, ; r 250 Proposed increase ———— > UE =! 200 Cash, securities & borrowing 150 capacity of gov't 12 2 employee Debt limit 100 retirement and 410 other funds 50 (as of May 16) : How much is left 8 (as of July 8) 2006 2007 2008 2009 2010 2011 0 ; ; ; Source: US Department of the Treasury, J.P. Morgan Securities LLC, J.P. Source: Stone &McCarthy. Gov'tfunds include G-Fund, Exchange Morgan Private Bank. Stabilization Fund and Civil Service Retirement and Disability Fund. 2 HOUSE_OVERSIGHT_030809