From Great Escape to Great Handoff?

Investors will remember 2009 as the year in which the collective actions of governments and central banks around the world brought the global economy and financial markets back from the brink. But if last year’s story was one of a great escape from a potential systemic collapse, 2010 is likely to prove somewhat more tricky. The central question for the year will be whether the

global economy can successfully manage a “great handoff,” with private sector activity sustaining the economic recovery as the growth impulse from public sector stimulus begins to fade and financial markets are forced to face up to the reality of normalizing monetary and fiscal policy stances.

Indeed, the early weeks of 2010 have already given investors a small taste of what could be in store this year. After a strong start to January, markets have come under renewed pressure as policymakers in China have begun to take small tightening steps and concerns have grown over the fiscal health of some of the smaller eurozone countries. Markets were able to shrug off last year’s rate hikes by central banks in Australia, Norway and Israel, as well as targeted tightening measures in a number of the emerging markets such as Brazil, India and Turkey. However, the removal of stimulus in the larger developed markets may be harder to digest and it remains to be seen how markets will react to the ending of the Federal Reserve’s purchases of agency mortgage-backed securities at the end of March or the expiration of the tax credit for U.S. homebuyers, which is currently scheduled for April. We would expect the major Western central banks

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2 | From Great Escape to Great Handoff?

From Great Escape to Great Handoff?

to refrain from rate hikes for much if not all of 2010, but emer-gency policy measures will continue to be removed and talk of “exit strategies” will only increase as the year goes on. And while President Obama is pushing Congress to approve additional fiscal stimulus to promote job growth in the U.S., the amount enacted may not be large enough to offset a falling impetus to growth from other public spending measures over the course of 2010.

The unintended consequences of government intervention will also be a cause for concern in 2010. Recent credit stresses in Dubai and Greece serve as chilling illustrations of how a loss of confidence in governments’ ability to honor their rising obligations could unsettle bond markets and threaten to undermine the cyclical recovery.

Thus, whether or not the financial markets and broader economy can stand on their own will depend on the answers to two related questions: 1) Will private demand be strong enough to take up the slack from public sector support? 2) And how will market interest rates be affected by deteriorating fiscal budgets, a cyclical recovery and potentially higher inflation expectations?

An Economic Recovery We Can Believe In Our sense is that the U.S. and world economies will grow at a slightly above-trend rate in 2010, i.e., enough to lower unemployment rates, though not by much. Company inventories (still low relative to sales across the developed world) are only in the early stages of being rebuilt, and high corporate cash balances are likely to be used in part to fund new capital expenditures, especially after the sharp cuts of 2009. Moreover, despite the popular assumption that overleveraged households spell feeble future consumer activity, this sector should also contribute positively to growth in 2010. The recovery in asset prices over the last few quarters suggests that household savings rates have already made much of their upward adjustment, and so the prospects for spending should be determined in large part by income growth. Unemployment should only fall gradually over the course of the year, so we would not expect stellar growth in household income in 2010. But with work hours already being rebuilt in the U.S., the number of employees on kurzarbeit (or shortened work weeks) in Germany beginning to fall and net hiring expected to turn positive on a sustained basis early in the year, moderate expansion in consumer spending should be expected.

J.P. Morgan Securities looks for GDP growth in the U.S. of 3.5% this year, with more subdued expansions of 1.6% in the euro-zone and 2.0% in Japan. Admittedly, these are fairly paltry fig-ures compared to what would be typical after such a deep recession, but they reflect the likelihood that private demand will nonetheless remain hampered by softness in bank credit extension, weak demand for credit as some households contin-ue to delever, only sluggish employment growth and an endur-ing glut of residential and commercial real estate properties. All this suggests that fears of a “double-dip” recession, though not an outcome we expect, are unlikely to be banished in 2010.

Stimulus side-effects will also cause some anxiety this year, but while we would expect market interest rates to rise mod-erately as the recovery progresses (and particularly as central bank asset purchases run off), we do not believe that sover-eign stresses should pose a significant near-term risk to the expansion in major economies. Interest rates have so far man-aged to stay near historic lows despite the onset of recovery, and we would expect them to remain so this year. Competition for capital is likely to remain weak as credit demand from the private sector stays low and ongoing demand for Treasuries from households, investment funds and foreign creditors should also act to keep yields subdued (see Exhibit 1).

exhibit 1: a broad-based increase in treasury demand since the recession began

479332

2,499

693 802

3,584

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

Mutual Funds Households Foreign Creditors

Q108

Q309

Dol

lars

(bill

ions

)

Source: J.P. Morgan, Federal Reserve.

This could, of course, change if rising inflation pressures force central banks to urgently scale back their monetary support of the last two years. But we would not expect this either. Abundant excess capacity in labor and manufactured-goods markets is likely to make any inflation warnings sound more like cries of “wolf” in 2010.

J.P. Morgan Asset Management | 3

Though we expect a fairly benign 2010 relative to the mayhem of the past two years, there will still be plenty to keep inves-tors on edge. On top of fears over higher interest rates or an economic “double-dip,” unease will no doubt linger over the fate of the U.S. dollar and the political response to the crisis.

Despite the dollar’s recent reprieve, we would not expect the currency to exhibit sustained, broad-based strength. Indeed, we continue to harbor longer-term concerns, particularly over the substantial dollar reserve holdings of foreign central banks. In the near term, however, we do expect the dollar to show more resilience against the other major developed market currencies (euro, yen and pound). The similar headwinds from low interest rates and large projected deficits, the weaker growth prospects in those economies and the substantial gains those currencies have made since last March all suggest that further strength against the dollar may be limited. However, a self-sustaining recovery led by China and the emerging markets should see commodity currencies continue to outperform.

Political risk is also likely to be a concern for investors this year. In the early weeks of 2010, markets responded negatively to the proposed “financial crisis responsibility fee” for U.S. banks, as well as the so-called “Volcker plan” that would prohibit deposit-taking banks from engaging in proprietary trading. Similarly, the recent decision by the U.K. government to intro-duce a payroll tax on discretionary bonus payments by financial institutions highlights the populist sentiment that the crisis has unleashed. The top rate of income tax is already set to rise in the U.K. this year while, in the U.S., the Bush tax cuts are sched-uled to expire in 2011 and the Obama administration is consid-ering an extension of the Medicare payroll tax to investment income. We would not rule out other redistributive measures being discussed or enacted over the course of 2010 (especially as elections approach in both the U.S. and U.K.) and this repre-sents another potential source of unease.

Despite the risks, we expect that a self-sustaining economic recovery, underpinned by strong corporate profit growth and supported by still easy (if gradually normalizing) monetary policy should allow the market trends that began in late 2008 and early 2009 to largely remain intact this year; i.e., higher prices for risk assets, rising bond yields and narrower credit spreads. But given the size of last year’s moves and the pros-pect of a less friendly policy environment, their vigor and con-sistency are unlikely to be maintained. We fully expect periods of unease and even crisis aftershocks in 2010, but an improve-ment in underlying macroeconomic conditions should make for positive—if moderate—returns for the year.

An Uneasy Calm for MarketsS&P 500 operating earnings per share are expected to rise by 25% or more this year, as sustained cost containment and moderate economic growth allow firms to benefit from both revenue gains and wider profit margins. In addition, U.S. equities still look very attractive on a free cash flow valuation basis, especially given today’s low borrowing costs (see Exhibit 2).

exhibit 2: corPorate free cash flow yields remain high relative to borrowing costs

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

55 60 65 70 75 80 85 90 95 00 05 10

Year

U.S

. Equ

ity

Free

Cas

h Fl

ow Y

ield

/Ba

a Co

rpor

ate

Bond

Yie

ld (r

atio

)

Source: Empirical Research Partners Analysis, J.P. Morgan. Data as of December 2009. Based on a universe of large-capitalization U.S. stocks.

Local currency returns in non-U.S. developed markets—where labor shedding has been less aggressive, productivity growth has been weaker and slower economic activity is expected—may continue to trail behind the U.S. as they did last year (particularly in Japan, which remains stuck in deflation). However, we ultimately look for emerging mar-kets to continue leading the way in 2010. In the near term, the warning shots being fired by Chinese policymakers may continue to weigh on emerging market equity performance, especially after last year’s strong investor inflows and sub-stantial price gains. But the familiar Western challenges of private sector deleveraging and rising government deficits do not apply in the emerging economies, where overall debt-to-GDP ratios are relatively low. And at around 6%, GDP growth for 2010 in the emerging world is expected to dwarf that of the developed economies this year. Add to this a potent cocktail of “imported” monetary policy accommo-dation and still reasonable valuations, and the case for emerging equities remains firm.

From Great Escape to Great Handoff?

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This document is intended solely to report on various investment views held by senior leaders at J.P. Morgan Asset Management. The views described herein do not necessarily represent the views held by J.P. Morgan Asset Management or its affiliates. Assumptions or claims made in some cases were based on proprietary research which may or may not have been verified. The research report has been created for educational use only. It should not be relied on to make investment decision. Opinions, estimates, forecasts, and statements of financial market trends are based on past and current market conditions, constitute the judgment of the preparer and are subject to change without notice. The information provided here is believed to have come from reliable sources but should not be assumed to be accurate or complete. The views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations.

The value of investments (equity, fixed income, real estate hedge fund, private equity) and the income from them will fluctuate and your investment is not guaranteed. Please note current performance may be higher or lower than the performance data shown. Please note that investments in foreign markets are subject to special currency, political, and economic risks. Exchange rates may cause the value of underlying overseas investments to go down or up. Investments in emerging markets may be more volatile than other markets and the risk to your capital is therefore greater. Also, the economic and political situations may be more volatile than in established economies and these may adversely influence the value of investments made.

All case studies are shown for illustrative purposes only and should not be relied upon as advice or interpreted as a recommendation. Results shown are not meant to be representative of actual investment results. Any securities mentioned throughout the presentation are shown for illustrative purposes only and should not be interpreted as recommendations to buy or sell. A full list of firm recommendations for the past year is available upon request.

J.P. Morgan Asset Management is the marketing name for the asset management business of J.P. Morgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc.

© 2010 JPMorgan Chase & Co. | Portfolio 2010

authors

Stu SchweitzerManaging Director Global Markets Strategist stuart.a.schweitzer@jpmorgan.com

Ehiwario EfeyiniVice President Global Markets Strategist ehiwario.o.efeyini@jpmorgan.com