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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) Here’s what our U.S. Balanced portfolio looks like right now’. This week’s note reviews some of the factors that affect these allocations: healthy private sector profits, problems left over from the recession, and interventions by the world’s legislatures, treasuries, central banks and multilateral agencies. This latter group reminds me of the ancient Greek Gods: they are very powerful, but sometimes flawed, as their interventions in the world did not always work as planned. We are getting closer to the Twilight of the Gods, a time when they are either running out of ammunition, or the ability to use it without causing even more problems. If so, the private sector will have to recover on its own. The consequence of these cross-currents: we invest in equities, but hold 10%-15% less than what we normally would at this point of the business cycle, and are positioning for a single-digit year on equities. PROFITS High Yield, Core Bonds, Leveraged 8% Loans, Structured Credit, 10% Inflation, 2% Cash, 3% Emerging JPMUS Market FX, 5% Balanced Diversified Model Portfolio Hedge Funds, 6% RealEstate, Single Strategy 3% Hard Assets, Hedge Funds 4% 18% Source: J.P. Morgan Private Bank, as of July 2011. These portfolios may notbe suitable for allinvestors & are shown for illustrative purposes only The primary (and perhaps sole) justification for carrying the levels of risk shown above relates to corporate profits. As shown below, profit margins have reached levels not seen in decades. The challenge, which we have discussed many times before: what is driving these margins’? One useful way to deconstruct profits is to measure them from peak to peak, and analyze what changed. As shown in the first chart, S&P 500 profit margins increased by ~1.3% from 2000 to 2007. There are a lot of moving parts in the margin equation, but as shown in the second chart, reductions in wages and benefits explain the majority of the net improvement in margins. This trend has continued; as we have shown several times over the last two years, US labor compensation is now at a 50-year low relative to both company sales and US GDP (see EoTM April 26, 2011). S&P 500 pre-tax margins Excluding financials, large-cap proxy used before1976 16% 15% 14% 13% 12% 11% 10% 9% 8% 1% 6% 1965 1.3% increase C? 1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: Corporate reports, Empirical Research Partners. Past performance is notindicative of future results. Labor cost reductions driving the margin expansion Peak to peak change in margins, 2000-2007, S&P 500 constituents 14% 1.2% 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% Total increase in pre-tax margins Reduction in wages and benefits as a percentage ofrevenue Source: Standard & Poor's, Empirical Research Partners. Last week’s train wreck of a labor report included the dour news that labor compensation is now firmly negative in real terms. Why is US labor compensation so low? The lingering excess labor supply from the recession is one reason, but the 2 billion people in Asia joining the global labor force over the last two decades is another. As shown on next page, EM wages for production workers remain well below US levels*. Another factor helping profit margins: increased US imports of intermediate goods from Asia. As shown in the accompanying chart, imports from Asia have been rising, and over the same time frame, Asian import prices only increased at around 1% per year. We use these portfolios to manage assets for clients who give us discretion over their funds, and to provide recommendations to those who don’t. This is one of several model portfolios we manage globally. They differ by jurisdiction, risk tolerance, tax treatment, eligibility to purchase vehicles designated for qualified purchasers, and other factors. * Empirical Research Partners does more work on corporate profits than anyone else we’ve seen. This section draws on research that Mike Goldstein at Empirical shared with us at a recent investment committee meeting. > A recent study from Boston Consulting Group maintains that the gap between China and the US will close in 5 years. BCG believes that with Chinese wages growing at 15%-20% per year, US wages growing at 3% per year, higher productivity in the US and rising shipping and inventory costs, the China advantage will disappear within the decade. Some of these assumptions seem aggressive to apply in perpetuity. 1 HOUSE_OVERSIGHT_030808