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Eye on the Market Outlook 2018

J.P. MORGAN ASSET MANAGEMENT

The Decline of Western Centralization. There’s a global recovery under way that is broadening across regions. However, unlike prior recoveries,
this one is closely tied to trillions in central bank intervention and negative real policy rates. Wage inflation pressures are gradually intensifying
and will eventually force Western central banks to take the punch bowl away. 2018 looks like the last year in the cycle with rising growth, rising
corporate profits and relatively accommodative central banks, before things get more complicated in 2019–2020. While corporate profits are
growing, high valuations will constrain the upside in developed equity markets to high single digits this year. See inside cover for more details.
The punch bowl on the cover is inspired by comments made by Fed Chair William McChesney Martin in his 1955 address to the New York
chapter of the Investment Bankers Association of America:

“If we fail to apply the brakes sufficiently and in time, of course, we shall go over the cliff. If businessmen, bankers, your contemporaries
in the business and financial world, stay on the sidelines, concerned only with making profits, letting the Government bear all of the
responsibility and the burden of guidance of the economy, we shall surely fail.... In the field of monetary and credit policy, precautionary
action to prevent inflationary excesses is bound to have some onerous effects—if it did not it would be ineffective and futile. Those who
have the task of making such policy don’t expect you to applaud. The Federal Reserve, as one writer put it, after the recent increase in the
discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”

The fish on the line commemorates the giant trevally that I caught in the summer of 2017 on Fanning Atoll, Kiribati, Pacific Ocean,
3°51’28.4”N 159°21’38.6”W.

Equity and fixed income returns sourced from MSCI and Barclays as of November 27, 2017. Inflation data from the OECD.

Cover art by Gary Bullock.

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MARY CALLAHAN ERDOES

J.P. Morgan Asset & Wealth Management

Anticipating future market performance is a complicated and complex task, and 2018
willHow
be nodo
exception. Never before
you summarize inthat
a year the history
was in of central
many banking
respects has there been
indefinable? such a
On one
coordinated
hand, theliquidity
Europeaninfusion into global
sovereign markets,
debt crisis, and markets
contracting have never
housing dealt
markets andwith such
high
unemployment
a massive withdrawal.weighed heavy
Navigating theon all of our
removal minds.
of the “punchButbowl”
at therequires
same time,
adeptrecord
skills to
corporate profits and strong emerging markets growth left reason for optimism.
avoid possible unintended consequences.
So rather than look back, we’d like to look ahead. Because if there’s one thing that
For we’ve
the past 15 years,
learned frommythe
investment
past fewpartner in J.P.
years, it’s thatMorgan Asset
while we & Wealth
can’t predictManagement,
the future,
we can
Michael certainlyhas
Cembalest, help you prepare
thoughtfully andfor it.
creatively laid out a roadmap of how to position
portfolios for the coming year. In the 2018 Outlook, Michael and his team explore how the
To help guide you in the coming year, our Chief Investment Officer Michael
“Decline of Western
Cembalest Centralization”
has spent will affect
the past several markets
months and portfolios.
working with our investment
leadership across Asset Management worldwide to build a comprehensive view
of the macroeconomic
As always, we look forward landscape. In doing
to helping you so,your
evaluate we’ve uncovered
portfolio some and
strategies potentially
wealth
exciting investment opportunities, as well as some areas where we see reason to
plans to ensure you are best positioned for near- and long-term market results.
proceed with caution.

Sharing
On behalf of these
all myperspectives and opportunities
colleagues, thank is part of trust
you for your continued our deep commitment
and confidence in to
you and what we focus on each and every day. We are grateful for your continued
J.P. Morgan.
trust and confidence, and look forward to working with you in 2011.

MostMost
sincerely,
sincerely,
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
E Y E O N T H E M A R K E T  M I C H A E L C E M B A LE ST  J . P . M O R G A N January 1, 2018
FOR
E YEINSTITUTIONAL/WHOLESALE/PROFESSIONAL
ON THE MARKET  MICH CLIENTS
A E LAND
C EQUALIFIED
M B A LE INVESTORS
ST  JONLY
. P . –M
NOT
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A N USE OR DISTRIBUTION January 1, 2018

2018 Outlook: The Decline of Western Centralization


2018 Outlook: The Decline of Western Centralization
Executive Summary

EXECUTIVE
Executive Summary

SUMMARY
Well, it took 9 years and $11 trillion in central bank stimulus, but growth, equity markets and profits are
Well,
finally itpicking
took 9upyears
in aand $11 trillionway
synchronized in central bank stimulus,
across multiple regions.butGlobal
growth, equity
trade has markets and profitsfrom
actually recovered are
finally picking up in a synchronized way across multiple regions. Global trade has actually
its 2015/2016 slump, which is ironic given the fear that Trump policies would result in rising tariffs and recovered from
its 2015/2016
trade wars. A slump, which
consistent themeis ironic
from given
the Eyetheonfear
thethat Trump
Market policies
in 2016 andwould
2017 result in rising
was that tariffs
investors and
should
trade wars. A consistent theme from the Eye on the Market in 2016 and 2017 was that
remain focused on profits, inflation, P/E multiples, employment, CEO confidence and capital spending, and investors should
remainless
focus focused on profits,
on domestic inflation, P/Epolitical
or international multiples, employment,
risks. Many of the CEO confidence
worst and fears
geopolitical capital spending,
investors heldand
at
focus less on domestic or international political
1 risks. Many of the worst geopolitical fears
the beginning of 2017 didn’t materialize1, and for the most part, I think the same will be true for 2018. investors held at
the beginning of 2017 didn’t materialize , and for the most part, I think the same will be true for 2018.
Global economic expansion picks up steam Global earnings growth picking up
Global
% economic
of countries expansion
with PMI picks up
leading indicator steam mode
in expansion Global
MSCI Allearnings growth
world equity index, picking up share, y/y change
earnings per
% of countries with PMI leading indicator in expansion mode
100% MSCI All world equity index, earnings per share, y/y change
40%
100%
90% 40%
30%
90%
80% 30%
80% 20%
70%
20%
70%
60% 10%
60% 10%
50% 0%
50%
40% 0%
-10%
40%
30% -10%
30% -20%
20%
-20%
20%
10% -30%
10%
0% -30%
-40%
0% '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 -40% '88 '92 '96 '00 '04 '08 '12 '16
'05 Based
Source: '06 on
'07Markit's
'08 '09 '10 '11
35-country '12 using
universe '13 '14
data '15
as of'16 '17
Nov 2017. '88 Datastream,
'92 '96 JP Morgan
'00 Asset
'04Management.
'08 '12 '16
Source: IBES, Includes
PMI of 50
Source: denotes
Based expansion.
on Markit's November
35-country 2017. using data as of Nov 2017.
universe developed
Source: and emerging
Datastream, markets.
IBES, November
JP Morgan 2017.
Asset Management. Includes
PMI of 50 denotes expansion. November 2017. developed and emerging markets. November 2017.
Global capital spending ex-China
Global
y/y capital spending ex-China
% change Signs of a global recovery
y/y % change
14% Signs of a global recovery
14%
12%
 China’s business survey and industrial profits growth
12%
 China’s
at a 5-yearbusiness
high survey and industrial profits growth
10%
10%  at
USaservices
5-year high
surveys close to a 15 year high, highest
8%
Estimates
 US
levelservices surveys close
in the National to a 15 year
Homebuilder Indexhigh, highest
since 1999,
8%
6% Estimates level
highestin the National
US free cash Homebuilder
flow marginsIndex since since
1952 1999,
6%
4%  highest
BusinessUS free cash
surveys flow margins
are booming since 1952
in France, Sweden, the
4%  Business surveys are booming
Netherlands and Germany (highest German in France, Sweden,
IFO the
2%
2%
0%
business survey since records began in 1991)IFO
Netherlands and Germany (highest German
0%  business
Japanesesurvey
businesssince records began
confidence is closeinto1991)
the highest
-2%  Japanese business confidence is close export
to the highest
-2%2002 2005 2008 2011 2014 2017 levels since the late 1980’s, Japanese growth
2002 2005 2008 2011 2014 2017 levels
close tosince the latelevel
its highest 1980’s,
in 4Japanese
years export growth
Source: JP Morgan Economic Research. Q3-Q4 2017 are estimates.
Source: JP Morgan Economic Research. Q3-Q4 2017 are estimates.  close
Brazil,toMexico,
its highest level
India, in 4all
Russia years
in expansion mode
 Brazil, Mexico, India, Russia
Developed world unemployment all in at
expansion
a 40-yearmode
low;
 Developed
for the firstworld unemployment
time since 2008, thereatare a 40-year low;
no negative
for
Netthe first time since
Employment 2008,
Outlooks there 43
among arecountries
no negative
Net Employment Outlooks
surveyed in the Manpower survey among 43 countries
 surveyed
Best positivein the Manpower
momentum in survey
the Baltic Dry Freight
 Best positive
Index since 2010 momentum in the Baltic Dry Freight
Index since 2010

1
1
Conferences I didn’t attend in 2017 since I didn’t think the topics would impact financial markets: Implications
ofConferences I didn’t
Nationalism in German,attend in 2017
French, Dutchsince I didn’t think
and Austrian the topics
elections; would impact
A Complete Guide tofinancial markets:
the Chinese PartyImplications
Congress;
Brexit Fallout Update; Spillover risks from military activity in Qatar; Assessing the CatalonianParty
of Nationalism in German, French, Dutch and Austrian elections; A Complete Guide to the Chinese Congress;
Independence
Brexit Fallout Update; Spillover risks from military activity in Qatar; Assessing the Catalonian Independence
Movement; The Implosion of Venezuela; A Guide to Italian Election Risk; and Understanding Brazilian Parliamentary
Movement; The more
Scandals. I had Implosion
time of
to Venezuela;
fish. A Guide to Italian Election Risk; and Understanding Brazilian Parliamentary
Scandals. I had more time to fish.
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THEOF ITS AFFILIATES
PRINCIPAL AMOUNT ● SUBJECT
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RISKS, INCLUDING POSSIBLE LOSS OF THE PRINCIPAL AMOUNT INVESTED 1
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
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So, what’s not to like? While the global recovery is welcome and global corporate profits rose by 17%
in 2017, financial assets are expensive after years of negative real interest rates. Rather than cherry-
picking a single statistic, we track several valuation, volatility2 and optimism measures and compare them
EXECUTIVE
SUMMARY

to their history. As shown below, most are at the high end of their historical ranges, anywhere from the
70th to the 99th percentile of expensiveness/optimism3. P/E multiples across developed equity markets are
high as well, with some exceptions. While we expect developed equity markets to rise in 2018, the
degree to which good news is already priced in may constrain the upside to high single digits. The S&P
500 is close to the longest period since 1930 without a 5% correction (almost 400 trading days), another
sign of considerable optimism.
Market and Investor Barometers
Percentile of expensiveness vs history

General Equity P/E ratios


US Median P/E Hedge fund beta to equities
100 Independent advisor optimism 100
Mutual fund cash
95 S&P implied volatility 95 Switzerland
90 US Small cap P/E Futures market long pos. 90 United States
85 US Forward P/E High yield spreads 85 Australia
80 Netherlands
Emerging Markets P/E 80
CCC high yield spreads Denmark
75 75
Europe P/E Ireland
70 Emerging markets $ 70
credit spreads Canada
65 Portfolio manager optimism 65
Sweden
60 High grade spreads 60
Commercial Real Estate France
55 cap rates 55 United Kingdom
50 Individual investor 50 Spain
45 optimism 45 Germany
40 40
Italy
35 Institutional investor global 35
30 confidence index
30
25 25
20 20
15 15
10 10
5 5
0 0
Sources: DB, Datastream, AAII, Investors Intelligence, NAAIM, JPM, CBOE, Barclays,
Investment Company Institute, State Street. November 2017 or most recent data available. Sources: IBES, Datastream. November 2017

2
Since 1930, there have only been 2 years in which the maximum S&P drawdown was just 3%: 1995 and 2017.
3
In a report published in September 2017, a Deutsche Bank strategist computed a combined stock-bond valuation
percentile for developed economies going back to the year 1800. The result: stocks and bonds taken in aggregate
th
are trading at the 95 percentile of their historical expensiveness.

2 2
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
E Y E O N T H E M A R K E T  M I C H A E L C E M B A LE ST  J . P . M O R G A N January 1, 2018
FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY – NOT FOR RETAIL USE OR DISTRIBUTION

The other big issue for 2018 is The Decline of Western Centralization: the process by which central
banks reduce their balance sheets after accumulating more than $11 trillion in government, agency and
corporate bonds since 2009. The big 4 central banks now own 20% to 40% of their respective country’s

EXECUTIVE
SUMMARY
government bonds. While the end of the grand monetary experiment is now at hand, we expect that
2018 will still be a year of net central bank accumulation, and when the runoff begins, it is
4
expected to occur over a prolonged period of time . The charts below show [a] rolling 12-month
central bank flows and how 2018 is still an accumulation year; [b] a breakdown of flows by central bank,
and how only the Fed is projected to be in runoff mode in 2019; and [c] how prolonged the runoff is
expected to be, with central bank balance sheets projected to still be larger in 2022 than in 2017.

[a] G-4 central bank asset flows [b] G-4 central bank asset flows by central bank
US$ trillions, 12 month change US$ trillions, 12-month change
$3.0 $3.5
Bank of England Projections
Thousands

2018

2019
$2.5 $3.0 European Central Bank
$2.5
Bank of Japan
$2.0 Federal Reserve
$2.0
$1.5 $1.5
$1.0 $1.0
$0.5
$0.5
$0.0
$0.0
-$0.5
-$0.5 -$1.0
2008 2010 2012 2014 2016 2018 2020 2008 2010 2012 2014 2016 2018
Source: National central banks, JP Morgan Economic Research. Oct 2017. Source: National central banks, JP Morgan Economic Research. Oct 2017.

[c] G-4 central bank balance sheets expected to unwind Central bank holdings of their own government's securities
slowly, Fed/ECB/BoE/BoJ balance sheets, $US trillions % of total government securities outstanding
40%
Thousands

$15
35%
BoJ
$13 30%

$11 25% BoE


20% Fed
$9
15%
$7
10%
$5 5% ECB
$3 0%
2008 2010 2012 2014 2016 2018 2020 2022 2005 2007 2009 2011 2013 2015 2017
Source: National central banks, JP Morgan Economic Research. Oct 2017. Source: Deutsche Bank. September 2017.

4
If you are interested in the details by central bank:
 In 2018 the Fed will allow securities to begin rolling off. The annualized pace of roll-off started at $120 billion
last fall, and is expected to rise to $400 billion by 2019
 The ECB is expected to reduce its asset purchases from EUR 60 billion per month to EUR 30 billion starting in
January 2018; further reduce them to EUR 15 billion per month in the fall of 2018; end the asset purchase
program by year-end; and begin the roll-off process in 2019
 Given the Bank of Japan’s yield-targeting strategy, its government bond purchases will vary based on its 0%
target for the 10yr JGB
 The Bank of England will likely stay the course in 2018 and maintain the current size of its balance sheet (~GBP
550 billion) until 2020

3 3
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
E Y E O N T H E M A R K E T  M I C H A E L C E M B A LE ST  J . P . M O R G A N January 1, 2018
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The other component of monetary policy to consider is rates. The median Fed projection indicates
three rate hikes by the end of 2018. While most economists believe them, the “market” does not and
expects less. I understand skepticism about Fed projections, since the Fed has been over-estimating
EXECUTIVE
SUMMARY

inflation and policy rates for the better part of a decade. However, this time I expect the Fed to act
more in line with its projections. The market does not expect much policy rate tightening in 2018 from
the ECB or Japan, and we agree. 2019 will be a more interesting year for the ECB, particularly if Draghi
is replaced by Jens Weidmann or another member of the German Bundesbank.

Fed hike expectations Market-implied central bank policy rates


Number of 25bp rate hikes expected through year-end 2018 effective rate derived from overnight indexed swaps market, %
4
2.0%
Fed
1.5%

Market Expectation (Futures)


3
Median FOMC Projection

Macroeconomic Advisers

1.0% BOE
Cornerstone Macro

2
0.5%
Goldman Sachs
Morgan Stanley

Deutsche Bank
Merrill Lynch

BOJ
JP Morgan

1 0.0%
ECB
Citi

-0.5%
0 Dec-17 Jun-18 Dec-18 Jun-19 Dec-19 May-20 Nov-20
Sources: Bloomberg, WSJ, Fed, listed institutions. December 2017. Source: Bloomberg. December 13, 2017.

The risk to our projections of slow monetary withdrawal: a faster-than-expected return of inflation. While
developed world consumer price inflation is generally still below central bank targets, excess capacity
(measured by “output gaps”) in the US and Europe has been shrinking and is now closer to normal. In
other words, future economic growth could result in greater inflation than it has in recent years5. We
discussed the deflationary impact of the tech sector recently and how new revised estimates from the
Fed show a much greater rate of deflation in tech goods and services, but I don’t think we should count
on this as a permanent bulwark against rising prices.

Core consumer price inflation still generally below US "output gap" (a proxy for capacity constraints)
central bank targets, y/y % change %
4%
3.0%
Hundreds

UK 3% Shortage
Canada
2.5% 2%
2.0% 1%
0%
1.5% US Germany
-1%
1.0% -2%
France -3%
0.5% Euro Area Italy
Japan -4%
0.0% -5% Abundance
-6%
-0.5% 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
2015 2016 2017
Source: JP Morgan Economic Research. 3Q 2017. Grey bars indicate US
Source: OECD, Haver. November 2017. recession.

5
Why output gaps matter. An October 2017 piece from JP Morgan Economic Research shows the connection
between the developed world output gap and developed world inflation one year later. “The next move in global
inflation is up”, Joseph Lupton & Bruce Kasman, JP Morgan, October 6, 2017.

4 4
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
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Wage inflation is a larger concern than consumer price inflation now that developed economy
unemployment rates are 5.3%, the lowest since 1983. In the US, voluntary quits and firings are among
the many signals showing substantial tightening in labor markets (see box). All things considered, the

EXECUTIVE
SUMMARY
US looks to be at or above “full employment”. In Europe, wage inflation pressures are building as
well: compensation per employee is rising in France despite an unemployment rate of almost 10%, and
one of Germany’s most influential unions asked for a 6% pay raise (see pages 17-18 for details).
Eurozone "output gap" (a proxy for capacity constraints) Developed economies unemployment rate
% %, seasonally adjusted
4% 9.0%

Hundreds
3% Shortage
8.5%
2%
1% 8.0%
0% 7.5%
-1% 7.0%
-2%
6.5%
-3%
-4% Abundance 6.0%
-5% 5.5%
-6%
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 5.0%
1983 1987 1991 1995 1999 2003 2007 2011 2015
Source: JP Morgan Economic Research. 3Q 2017. Grey bars indicate
Eurozone recession. Source: OECD, Bloomberg. Q3 2017.

Signs of a healthy US labor market US wage inflation rising faster than goods inflation
% of labor force, 3-month average y/y % change, 3-month average (ECI is quarterly)
2.5% 1.9%
Hundreds

Hundreds

1.8% 5% Median wages


Voluntary quit rate
2.3% Average hourly earnings
1.7%
Employment cost index
1.6% 4%
2.0%
1.5%
1.4% 3%
1.8%
1.3%
2%
1.5% 1.2%
Firing rate 1.1% Core CPI & Core PCE
1%
1.3% 1.0% 1997 2000 2003 2006 2009 2012 2015
2001 2003 2005 2007 2009 2011 2013 2015 2017
Source: BLS, BEA, FRB Atlanta, JPMAM. Note: prior to 2007, average hourly
Source: Bureau of Labor Statistics, Haver Analytics. October 2017. earnings are only for production and nonsupervisory workers. Oct 2017.

Signs that the US is at or above full employment


 The percentage of part-time workers that want full-time jobs is back down to 2005 lows
 The percentage of people not in the labor force that want a job is also back down to 2005 lows
 The NFIB small business survey shows the highest percentage of respondents since 2000 saying that they
have positions that they are unable to fill
 The NFIB hiring intention survey is at its highest level since the survey began in 1974

5 5
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
E Y E O N T H E M A R K E T  M I C H A E L C E M B A LE ST  J . P . M O R G A N January 1, 2018
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Central banks don’t talk about it much, but my sense is that they are also worried about distortions that
their interventions created. Examples include negative government bond yields in Europe and Japan
(around $4.9 trillion of bonds in total), and the fact that well more than half of European and Italian high
EXECUTIVE
SUMMARY

yield bonds trade tighter than US Treasury yields. While US Treasury yields are not negative, their decline
has created distortions as well, some of which we reviewed in our Thanksgiving piece on US
foundations and the portfolio risk needed to meet 5% minimum distributions.

Government bonds trading below 0% yield Growing amount of Italian BB's yielding less than US
% of total government bonds by market value Treasuries, Face value, EUR billions
60% 40
BELOW equivalent-maturity
35 US Treasury
50%
30 ABOVE equivalent-maturity
40% 25 US Treasury

Eurozone countries
20
30%
15
Netherlands

20% 10
Germany

Denmark

Portugal
Belgium
Sweden
Finland

France
Austria
Ireland

Japan
Spain

10%
Italy

0
0% '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17
Source: J.P. Morgan Securities LLC, JPMAM. December 15, 2017. Source: Bank of America Merril Lynch. December 4, 2017.

What if something goes wrong with central bank stimulus withdrawal?


Since the stimulus is unprecedented, we can’t know all potential land mines associated with withdrawal.
How is the US financial system positioned for unexpected problems, should they occur? Household debt
and debt service have both declined since 2008. However, corporate debt is at an all-time high relative
to cash flow and equity when looking at the median company in the S&P 1500. As shown at the top of
the next page, median interest expense is rising as well, even at a time of low interest rates and credit
spreads. Some analyses show lower levels of leverage, but are distorted by cash holdings of tech and
large cap pharma companies. Easy conditions in credit markets are further confirmed by tight credit
spreads and plenty of covenant-lite issuance.

Household debt Corporate debt


Percent of disposable income (both axes) Universe = largest 1,500 stocks
140% 13.5% 0.6 2.2
Median net debt Median net debt
130% 13.0% to EBITDA 2.0
0.5 to equity
120% 12.5% 1.8
0.4
110% 12.0% 1.6
100% 11.5% 0.3 1.4
90% 11.0% 1.2
0.2
80% Household Debt 10.5% 1.0
service 0.1
70% debt 10.0% 0.8
60% 9.5% 0.0 0.6
1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 '74 '77 '80 '83 '86 '89 '92 '95 '98 '01 '04 '07 '10 '13 '16
Source: Federal Reserve. 3Q 2017. Source: Morgan Stanley. November 2017.

6 6
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
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Corporate interest expense low, but rising


Interest expense to EBIT for the S&P 1500, %

EXECUTIVE
28%

SUMMARY
26%
24%
22%
20%
18%
Aggregate
16% Median of index
14% company
12%
10%
'94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16
Source: PB Economics. Q3 2017.

On US corporate debt, there are some mitigating factors:


 The increase in median corporate debt shown above is mostly related to investment grade issuers
(93% of the S&P 1500 universe by market cap is high grade rather than high yield)
 US leveraged loan and high yield issuance was soaring in 2013, prompting the Fed to issue guidance
to banks discouraging participation in deals with high leverage. This strategy had its desired impact:
a substantial decline in net issuance of risky debt. In 2017, while gross loan issuance reached its
highest level in 10 years, the bulk was used for refinancing. The same is true in the high yield
market (around ~2/3 of issuance has been used for refinancing)
 While commercial real estate borrowing has recovered since 2009, it is below levels seen during the
real estate bubbles of the 1980’s and 2007. In addition, loan to value ratios in the commercial
mortgage backed securities market are 60%-65%, down from 80%-90% in 2006 and 2007

Fed/OCC/FDIC guidelines resulted in slower leveraged Commercial real estate borrowing well below prior peaks
loan and high yield issuance, net issuance % of GDP % of GDP
2.0% 2.5%

Guidance 2.0%
1.5%
release date 1.5%
1.0%
1.0%
0.5% 0.5%
0.0%
0.0%
-0.5%
-0.5%
-1.0%
-1.0% -1.5%
2000 2002 2004 2006 2008 2010 2012 2014 2016 '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16
Source: Bridgewater Associates. August 2017. Source: Federal Reserve Board, BEA. Q3 2017.

7 7
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
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As for the US banking system, there have been substantial improvements in capital ratios and liquidity
since 2007. The same holds true for the insurance sector, for both life and P&C companies. In other
words, in case of something worse than the run-of-the-mill recession, the US financial sector and parts of
EXECUTIVE
SUMMARY

the European financial sector are better equipped to handle it.

Bank risk-weighted capital ratio Bank liquid assets as % of short term Insurance company capitalization
18% liabilities 500% 1.1x
2007 2017 50% Life insurance risk-
16%
2007 2017 480% based capital ratio
14%
1.0x
12% 45% 460%
10% Property &
440% casualty 0.9x
8% 40%
operating
6% 420%
leverage
4% 35% 0.8x
400%
2%
0% 30% 380% 0.7x
US Europe US Europe 2004 2006 2008 2010 2012 2014 2016
Source: Federal Reserve Bank of New York, Source: FDIC, Goldman Sachs, JP Morgan. Q2 Source: SNL Financial, company reports, Barclays
Bloomberg. Q2 2017. 2017. Research. September 2017.

Another safety valve: global imbalances, measured by the degree to which current account surplus
countries pour money into deficit countries, have fallen back to normal levels. In retrospect, the first
chart below was a good indicator of how the housing bubble had increased systemic risk. There’s also a
technical factor that supports global equity markets: over the last 2 years, the global net supply of
equities has been flat. This reflects a combination of factors: fewer new listings, more stock buybacks
and more M&A, all of which are roughly offsetting primary and secondary offerings and other dilutive
corporate actions. This trend is particularly acute in the US, where the number of public companies
continues to shrink (see page 35). Net result: household and corporate savings are being invested in a
pool of equities that is no longer expanding.
A decline in global imbalances Global net equity supply
Absolute value of all country current account surpluses and deficits, Annual expansion of MSCI All Country World Index, $ bn
% of world GDP 1,400
6%
Asia manufacturers, oil exporters 1,200
5% and Northern Europe finance
1,000
housing booms in Anglo-Saxon
world (US, Australia, Ireland, UK), 800
4% and in Spain/Portugal
600
3% 400
200
2%
0
1% -200
1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 '99 '01 '03 '05 '07 '09 '11 '13 '15 '17
Source: IMF, n=193 countries. 2017. Source: MSCI, JP Morgan Equity Strategy. 2017.

8 8
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The Decline of Western Centralization: summarizing the outlook for 2018


There’s an impressive global recovery underway that is broadening across regions. However, unlike prior
recoveries, this one is closely tied to trillions in monetary stimulus. All things considered, it seems like
2018 will be the last year in the cycle with rising growth, rising profits and accommodative central banks.
We expect wage inflation to eventually force the Fed and ECB to eliminate negative real policy rates,
creating a modest headwind for growth and valuations by 2019. Given high valuations, we believe that
equity market returns in 2018 will be roughly equal to profits growth. So, a year of gradually rising
markets with returns in high single digits for developed markets before things get more complicated in
2019/2020. If there’s a wildcard this year, it might be related to politics in the US rather than in Europe
(see chart at the top of page 14, which brought back a lot of memories).
This year’s Eye on the Market Outlook contains regional analyses on the US, Europe, Emerging Markets
and Japan, and sections on commodities, Brazil, hedge funds, US municipals and the issue of the
declining number of publicly traded companies in the US.

Regional analyses:
 The US: an improving outlook, with an eye on Trump tailwinds and headwinds p. 10
 Europe: another year of growth in 2018 p. 17
 Emerging Markets: the recovery continues p. 22
 Japan: some cyclical upside but no change to long term outlook p. 27

Special Topics:
 Industrial commodity prices: more room to rise as global economy recovers p. 29
 Brazil: another example of improving economics trumping deteriorating politics p. 30
 Our latest analysis of the US municipal market: debt burdens of US cities and counties p. 31
 Hedge Fund performance: modestly better in 2017, but valuation headwinds remain p. 32
 The concentration of US equity market returns in 2017 p. 34
 What should be done about the shrinking number of US public companies? p. 35

Michael Cembalest
JP Morgan Asset & Wealth Management

9
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EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
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United States: an improving outlook, with an eye on Trump tailwinds and headwinds
Business surveys point to continued US expansion in 2018 with growth at ~3%. Retail sales and
industrial production are at their strongest level in years, manufacturing surveys are in expansion
territory, and the Homebuilders Confidence Index is at its highest level since 1999. On tightness in
housing, what a difference a few years makes: existing and new home inventories as a percentage of
households are now at the lowest levels since the data begins in 1985. Capital spending projections
have picked up sharply (and are due more to the improving business outlook than the tax bill, according
to recent surveys). Another 18 months of growth, and this would be the longest expansion in US history.
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What we’re watching: (a) how quickly will tight job markets result in higher wages; (b) will rising “prices
paid” surveys result in rising core inflation; and (c) how will equity markets hold up once Fed tightening
begins. There’s a lot of debate regarding how dependent equity valuations are on low interest rates.
Our sense is that P/E multiples will contract alongside rising profits as the Fed tightens, with
the net result being a high single digit gain in the S&P 500.
A lingering concern for 2019 and beyond: even before the passage of a tax bill, the US budget deficit has
been rising, which is odd for a time in the cycle when it would typically be shrinking given improving
growth and more economic activity.

Rising capital spending plans US core capital goods


% of respondents (both axes) Rolling 3-month % change
32% 30% 4%
Average capex plans
Hundreds

3% Orders
30% across Fed regions
25% 2%
28%
1%
26% 20% 0%
24% -1%
22% 15% -2%
-3%
20% Shipments
NFIB capex plans, 10% -4%
18% 6mo average -5%
16% 5% -6%
2010 2011 2012 2013 2014 2015 2016 2017 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17
Source: NFIB, JP Morgan Economic Research. November 2017. Source: Census Bureau, J.P. Morgan Asset Management. October 2017.

Rising surveys of prices paid usually point to higher


An unusual late-cycle increase in the budget deficit
inflation US$ billion, rolling12 months
70 6%
-$400
60 5%
50 -$500
4%
40 -$600
3%
30
2% -$700
20
1% -$800
10
0%
0 -$900
-10 Philly Fed: Expectation Headline -1%
of Prices Paid CPI -2%
-$1,000
-20
-30 -3% -$1,100
1997 2001 2005 2009 2013 2017 2013 2014 2015 2016 2017
Source: Federal Reserve Bank of Philadelphia, BLS. November 2017. Source: US Treasury. November 2017.

10 10
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
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Earnings, margins and multiples. In 2017, S&P earnings per share rose by 11%, supported by solid
sales growth and rising margins. The tech sector was a standout in Q3, with 17% sales growth y/y and
81% of tech companies beating earnings expectations (see page 34 on the large contribution of tech
stocks to S&P 500 returns). In 2018, we expect S&P 500 revenue growth of 3% to 10% for the various
sectors, with the best results in tech, healthcare and energy. One supportive indicator: since Q1 2017,
consensus 2018 estimates have declined by just 2% compared to an average decline of 8% over the last
5 years. While rising labor costs will hurt margins, we expect this to be offset by rising energy profits,
financial deregulation and tax reform. Resilient US profit margins are heavily reliant on the tech sector,
whose margins increased from 10% in 2004 to 20% in 2017. Ex-tech margins are roughly flat over that

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S TAT E S
same period. We expect 8%-10% S&P 500 EPS growth in 2018, excluding the impact of tax reform,
which could add another 5%-8% (see table on page 12).

S&P 500 revenue per share and earnings per share growth S&P 500 multiples rising
Rolling 4-quarter % change Price-to-earnings ratio
20% 25
15% Earnings per share 23 Median trailing P/E
21
10%
19
5% 17
0% Revenue per share 15
-5% 13
11
-10%
9
-15%
Forward P/E
7
-20% 5
2005 2007 2009 2011 2013 2015 2017 '79 '81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11 '13 '15 '17
Source: Morgan Stanley. December 2017. 4Q17 and beyond are estimates. Source: Deutsche Bank. December 2017.

Highest profit and free cash flow margins since 1952 Investment signal rankings
% Monthly S&P return differential based on investment signal, 1985-2017
9% 1.2%
8% Profit margin
1.0%
7%
6% 0.8%

Financial Conditions
Small Bus Optimism
Forward 12m profits

Trailing 12m profits


ISM manufacturing
Leading Indicators

Policy Uncertainty
5%

Geopolitical Risk
CEO Confidence

0.6%
Payroll growth

4%
GDP growth

3% 0.4%
2%
Free cash flow margin 0.2%
1%
0% 0.0%
'52 '56 '60 '64 '68 '72 '76 '80 '84 '88 '92 '96 '00 '04 '08 '12 '16
Source: Empirical Research Partners. Excludes financials, utilities and REITs, Source: JPMAM, Conference Board, BLS, BEA, NFIB, ISM, Chicago Fed,
based on trailing 3-month basis. December 2017. S&P, Boston College, Stanford University.

In our September 2017 Eye on the Market, we discussed investment signals that have been most useful
for investors over the long run. The larger the bar in the chart above, the more powerful that signal was
in predicting future returns. That’s why we pay a lot more attention to leading indicators, CEO
confidence, job growth and earnings expectations than to political uncertainty or geopolitical risk.
Nevertheless, while we believe that politics usually don’t have much of an impact on markets, it’s still
worth considering the possible tailwinds and headwinds that the Trump administration could
create for investors in 2018. Topics include tax reform, deregulation, immigration, military
conflict, trade, and Presidential/Constitutional crises.

11 11
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
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Possible tailwind: tax reform


Please refer to these slides from our December 19th in-depth client webcast on the tax bill’s implications,
and a link to our interactive effective tax rate website
There isn’t any cyclical reason for tax cuts and fiscal stimulus at this point in the cycle. Even without any
tax cuts, the US is already running a large budget deficit at a time of full employment (see page 10), and
Federal debt is projected to hit 90% of GDP by 2027. In the next recession, the deficit could easily
exceed 6% of GDP. Furthermore, the largest beneficiaries of the tax bill are corporations and high net
worth individuals, both of which have ample cash flow, plenty of liquidity and lower propensities to
spend. So, I don’t expect too much of a growth bump from the bill, maybe 0.3%. Most companies
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S TAT E S

agree: ISM and Duke CFO surveys only show 5% to 15% of respondents saying that the tax bill would
increase their capital spending plans. Another oddity: the bill entails more than $1 trillion in tax cuts for
individuals alongside the original goal of $350 billion in corporate tax cuts. Tail wags dog.

Change in Federal taxes paid by income level Fiscal multipliers are lowest for corporate tax cuts and
US$ millions high income tax cuts, change in output per $ of fiscal policy
$20,000
Less than $50K Corporate tax cut
$0 Tax cuts
$500k-$1mm Homebuyer credit Spending
-$20,000 $1mm+ 1 yr tax cut higher income
-$40,000 $50k-$100k 2 yr tax cut lower/middle income
-$60,000 One-time payments to retirees
-$80,000 Transfer payments to low income individuals
-$100,000 Transfers to state/local (non-infrastructure)
$100k-$500k
-$120,000 Federal transfers to states for infrastructure
Fed gov purchase of goods & services
-$140,000
2019 2021 2023 2025 2027 0.0x 0.5x 1.0x 1.5x 2.0x 2.5x
Source: Joint Committee on Taxation (based on Conference Agreement).
December 18, 2017. Source: Congressional Budget Office Macroeconomic Division. Feb 2015.

Still, there would be positive structural benefits from lower taxes on US corporations. Our sense is that
the bill could boost S&P 500 EPS by 5%-8%. This estimate is based on a 21% corporate tax rate, limits
on interest expense deductibility6, repatriation taxes on foreign earnings, buybacks resulting from
repatriation and immediate expensing of capital expenditures. The bill reduces US marginal effective
corporate tax rates from 34.6% to around 19% (more in line with G7 and OECD averages), and will
probably reduce the pace of tax inversions in which US companies reincorporate overseas.
Tax scenario analysis: potential impact to S&P 500 EPS Marginal effective tax rate
HOUSE plan SENATE plan %, effective tax rate on new investment in manufacturing & services
21% rate 21% rate 40%
A S&P 500 Consensus 2018 EPS $146.00 $146.00
35%
B + Reduction in corporate tax rate + $12.90 + $12.90
30%
C - Limiting interest expense deductibility - $1.00 - $2.80
M. East and N. Africa
25%
D - One-time repatriation tax on foreign earnings - $3.80 - $4.00
E + Cash repatriation induced buybacks + $2.50 + $2.40 20%
Asia-Oceania
US (Current)

F Total benefit from tax reform (B + C + D + E) + $10.60 + $8.50 15%


US (TCJA)

Upside to consensus 2018 EPS + 7.3% + 5.8%


Canada

10%
Europe

Mexico

Africa

G S&P 500 EPS impact (A + F) $156.60 $154.50 5%


H + Immediate expensing of capex (CF benefit) + $3.80 + $3.80
0%
I Total cash flow benefit (G + H) $160.40 $158.30 Source: University of Calgary School of Public Policy, Mintz & Bazel. Corporate
Source: JP Morgan Equity Strategy. December 14, 2017. tax rates are GDP weighted. December 17, 2017.

6
Only the most highly levered companies are much worse off under the plan, and is unusual for large companies.
Based on our analysis, only 1% of S&P market cap would see free cash flow declines of more than 10% under the
stricter EBIT test; for the Russell 2000, 3% of market cap, and for the high yield market, 8%. However, the stricter
EBIT test is not applied until 2022. Until then, an EBITDA test is used, in which case the market cap of companies
affected are <1% (S&P), 2% (Russell 2000) and 4% (HY). See webcast slides for more details.
12 12
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Possible tailwind: deregulation


Aside from tax reform, another signature policy of the Trump administration has been deregulation.
Trump has issued 54 Executive Orders (the highest annual pace since Carter), revoked 67 rules,
withdrawn 630 planned regulations and delayed 944 others7. It’s hard to track the impact of these
efforts in real time, but the rise in CEO confidence and capital spending intentions after the election may
reflect expectations of deregulatory activity. As a reminder, the “Clinton Recovery” of the 1990’s was
driven in part by deregulation of electricity and telecom (which was followed by a surge in non-
residential business investment), free trade policies, a cut in the long term capital gains rate and a decline
in US military spending. A few points on government regulation:

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S TAT E S
 Regulatory activity is best understood by looking at final rules issued by Federal agencies, which are
30x-35x higher than the number of bills passed by Congress
 While the largest number of new rules from 2009 to 2015 were passed by the SEC, other
government agencies and departments were very active as well
 One consequence of this regulatory activity: the ease of starting a new business declined in the US
from 2008 to 2016 when compared to the OECD and to the rest of the world
 Only a small fraction of all new rules and regulations are analyzed with cost and benefit information
by the Office of Regulatory Affairs, and even when these reports did exist, government agencies
typically did not rely on them when making major decisions about new regulations

Regulation without representation Regulations by sector since 2009


5,000 Number of rules with at least a $100M annual economic impact
Bills passed by Congress Final rules issued by agencies Reg reductions Reg additions
4,500
Securities and Exchange Commission
4,000
Environmental Protection Agency
3,500 Department of Energy
3,000 Department of Health and Human Services
Commodity Futures Trading Commission
2,500 Federal Reserve Board
2,000 Department of Transportation
1,500 Department of Labor
Department of the Treasury
1,000 Consumer Financial Protection Bureau
500 Department of Homeland Security
Federal Deposit Insurance Corporation
0
All other
'03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15
-10 0 10 20 30 40
Source: Competitive Enterprise Inst., "Ten Thousand Commandments". 2016. Source: Government Accountability Office, Heritage Foundation. 2015.

"Ease of starting a new business": in the US, getting Agency use of Regulatory Impact Analysis (RIA)
less easy, US percentile rank relative to world and OECD % of regulations from 2008 - 2012
100 60%

90
Easier 50%
US vs. World
40%
80
30%
70 US vs. OECD 20%
60 10%

50 0%
Harder No evidence of any Agency explained Agency explained how
40 RIA use provided how RIA affected RIA affected at least
'05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 a minor decision one major decision

Source: World Bank Doing Business, JPMAM. October 2016. N = 189. Source: Mercatus Center at George Mason University. March 2015.

7
“Trump says his regulatory rollback is the most far-reaching”, NYT, December 14, 2017.
13 13
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Potential headwind: Presidential/Constitutional crises


The challenge with analyzing market reactions to such crises is that Watergate (1973/74) and the Starr
Report (Sept 1998) also coincided with major economic and market troubles. In 1973/74, markets faced
Wage & Price controls, sharply rising inflation and unemployment, an OPEC oil embargo and a declining
dollar following the end of Bretton Woods fixed exchange rate system. In 1998, markets had to absorb
the Long Term Capital Management unwind and the Russian balance of payments crisis. Those caveats
notwithstanding, a Constitutional crisis in 2018 could negatively impact markets that would prefer to
focus on the recovery. The negative market reaction to the October 1973 Saturday Night Massacre is
one possible clue in this regard. Uncertainties related to current investigations by the Special Counsel
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S TAT E S

may turn out to be a bigger market risk in 2018 than the Fed, tariffs, immigration curbs or North Korea.
S&P 500 weakness in 1973-1974: it's not easy to determine whether stagflation or the Presidential crisis was the bigger driver
20%
S&P 500 Price level

Hundreds
US Misery Index (inflation + unemployment)
120
Senate Watergate Dean discloses Nixon Saturday Night Massacre (Cox fired,
hearings begin knowledge of Watergate Richardson and Ruckelshaus resign)
18%

110 Wage and Price


Liddy and McCord Controls end
convicted of White House cannot US unemployment hits
conspiracy explain gap in tapes post-war high of 8% 16%
100 FBI connects
Watergate to Nixon Supreme Court
re-Election effort Haldeman and Ehrlichman Nixon refuses to rejects Presidential
resign, Dean fired hand over tapes Executive Privilege,
House Judiciary 14%
90 Committee passes
Nixon announces another round of first article of
Wage and Price Controls in response impeachment
to rising inflation (Phase IV) 12%
80 October 1973 Arab/Israeli War
leads to OPEC oil embargo; by Nixon resigns
Phase II Wage and Price Controls Dec 1973, oil prices quadruple
expire, after which pent-up demand from $3 to $12 per barrel, US
causes price levels to surge headline CPI hits 10% 10%
70
10% US dollar devaluation, combined with end of the Gold Standard in
August 1971, marks the end of the Smithsonian Agreement/Bretton
Woods System of fixed exchange rates
60 8%
Sep-72 Oct-72 Dec-72 Jan-73 Mar-73 May-73 Jun-73 Aug-73 Oct-73 Nov-73 Jan-74 Mar-74 Apr-74 Jun-74 Aug-74 Sep-74 Nov-74 Dec-74
Source: JPMAM, Washington Post, US Federal Reserve, Bloomberg. 2017.

Possible headwind: deportations and restrictions on immigration


US labor markets are tightening, and part of the Sources of US population growth
reason is slow growth in the labor supply. The US population growth, %
1.4%
Census Bureau now believes that half of US
Hundreds

population growth comes from net migration. So, I 1.2%


can imagine markets reacting negatively to large- '14 Census projections
1.0%
scale deportations8, or a materially slower pace of
0.8%
US immigration. Trump’s Chair of the Council of
Economic Advisors Kevin Hassett wrote in 20139 that 0.6%
Organic
a doubling of immigrants could add 0.5% to 0.4%
growth, so we will have to see what policies actually
0.2%
emerge. There has been talk in the White House of Immigration
a merit-based system like the ones used in Australia 0.0%
'62-'67 '90-'94 '95-'99 '00-'04 '05-'09 '10-'14 '15-'19 '20-'24 '25-'29
and Canada, but details are scarce.
Source: Census Bureau, JPMAM. 2014.

8
According to a May 2017 piece in the Atlantic, arrests of undocumented immigrants in 2017 rose by 38% vs
2016. However, the pace of actual deportations was down 12%.
9
“America Needs Workers”, Kevin Hassett, American Enterprise Institute, February 12, 2013

14 14
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Possible headwind: trade wars


So far, Trump’s bark has been worse than his bite on US trade policy, which may be why the Mexican
Peso rallied in 2017. However, NAFTA discussions are at a standstill and there’s an increasing likelihood
that Trump will withdraw from NAFTA in 2018. There would be a six-month withdrawal period before it
took effect, during which negotiations could continue. But let’s assume that the US withdraws. The
impact on the US is likely to be modest:
 US trade with Canada would revert back to a prior 1988 free trade agreement
 Estimates of the cumulative gains to the US from NAFTA are only 0.1% to 0.2% of US GDP over its
10

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first 5-10 years

S TAT E S
 If tariff rates between the US and Mexico revert to Most Favored Nation levels, US tariffs applied to
11
Mexican exports would only be 1.5%-3%, which would not affect US consumer prices very much
 An average tariff rate of 5% applied by Mexico to US exports would be material, but below the
average yearly volatility in the US$/Peso

Post-election Mexican peso sell-off has reversed Effect of NAFTA withdrawal on select industries
Mexican peso spot price vs. US$ Potential tariff rates assuming withdrawal from NAFTA
22.0 16%
21.5 Mexican tariffs on US US tariffs on Mexican
14%
exports exports
21.0
12%
20.5

Engines, turbines, etc

Engines, turbines, etc


Electrical Equipment

Electrical Equipment
10%

Medical equipment
20.0
Peso weaker 8%
19.5
19.0 6%

Motor fuel

Furniture
18.5 4%
Plastics

18.0
Auto

Auto
2%
17.5
Aug-16 Oct-16 Dec-16 Feb-17 Apr-17 Jun-17 Aug-17 Oct-17 Dec-17 0%
Source: Goldman Sachs. October 2017. Universe = industries with more than
Source: Bloomberg. December 12, 2017. Red dot indicates election. $10 bn in 2016 bilateral trade.

Before the election, we showed the accompanying Full trade war and US GDP
Trillions of 2009 US$
chart from the Peterson Institute on consequences of 21.0
a full trade war. However, this drastic outcome 20.5
Full trade war
US levies 45% tariff on non-oil Baseline
assumes a 45% two-way across-the-board tariff 20.0 imports from China, and vice versa
between China and the US, and a similar 35% tariff 19.5 US levies 35% on non-oil imports
between Mexico and the US. This analysis was based 19.0 from Mexico, and vice versa
Full trade war
18.5
on comments made by Trump during the 2016 18.0
campaign, and absent an unexpected major 17.5
escalation of a trade war by all sides, is much less 17.0
relevant to what may occur in 2018. 16.5
16.0
2015 2017 2019 2021 2023 2025
Source: "Assessing Trade Agendas in the US Presidential Campaign",
Noland et al (Peterson Institute) September 2016.

10
See NAFTA study from the US Congressional Budget Office (2003); the US International Trade Commission
(2003); Rimmer and Dixon (2015; Melbourne); and Caliendo and Parro (2015; Yale/NBER/Fed).
11
While US and Mexican tariffs on the overall auto category would be 3% and 10%, sub-categories such as light
trucks could be subject to much higher tariff levels (25%-35%).
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I sympathize with those who believe that US trade A general lack of tariff reciprocity
policy has been tilted towards maintaining low US 8%
Tariff applied
consumer prices at the expense of US manufacturing BY the US BAN

jobs. Consider this chart showing the lack of 6%


reciprocity in US trade: US tariffs on foreign goods EU PAK
UAE MAL
are consistently lower than foreign tariffs on US CHE
RUS VIE EGY
4% JPN
goods. There’s a growing body of academic work CHN
TUR ARG
SAU
examining the diffuse benefits of trade compared to NOR PHL
IDN THA
AUS IND NGA
concentrated costs for US manufacturing workers, 2%
CHL MEX BRA
SGP
UNITED
S TAT E S

with particular attention paid to consequences of KOR COL


KAZ
SAF Tariff applied
ISR
China joining the World Trade Organization in 2001. 0% CAN PER TO the US

A January 2016 analysis from the Center for 0% 2% 4% 6% 8% 10% 12% 14%
Source: WTO, World Bank, JPMAM. 2015, or most recent available. Tariff is
Economic Studies (a dep’t of the US Census) found simple average of tariffs on traded goods.
that from 1992 to 2007, import competition from
China and other developing economies increased the likelihood of job loss among US manufacturing
workers with less than a high school degree, but not among workers with a college degree12. This link
explores some of these studies and conclusions. At the minimum, as MIT economics professor David
Autor writes, “it is incumbent on the literature to more convincingly estimate the gains from trade”.

Possible headwind: war with North Korea


13
Here’s a chart I pulled together in 2014 on the financial opportunity cost of the Iraq War (i.e., what else
the US could have done with $2.2 trillion, the latest estimate of the war’s cost). It’s a good place to start
regarding possible economic costs of a prolonged conflict with North Korea.

The staggering financial opportunity cost of the Iraq War


2014 USD trillions
$2.5
Civil aviation and air
traffic control Mine clean-up, broadband
access to all US households
$2.0 Dams
Includes personnel, Roads Tuition, full room & HVDC transmission grid
weapons, medical Bridges board for every Universal Pre-K (30yrs)
$1.5 and disability care Electricity grid college-bound high Protection against 1m rise in
for soldiers during Drinking and waste school graduate sea level
and after the war, water facilities needing any 5 high-speed train systems
$1.0 related homeland Levees financial aid, 2003-
security costs and Rails 2021 (four-year Bury key resid. power lines
interest costs Schools public university) (10% of total)
$0.5 Public Mass Transit
Hazardous waste PEV subsidy for 50% of
Waterways passenger car fleet
$0.0
Cost of Iraq War Fixing America's College education Various
infrastructure
Source: Brown University Watson Institute for International and Public Affairs; Neta Crawford, Boston University (cost of Iraq War); College Board; US Dept.
of Education; Edison Electric Institute; American Society of Civil Engineers; Earthworks; Hall Energy Consulting; Next Big Future; Northwestern University;
FCC; Vrije Universiteit; US Dept. of Transportation; National Affairs; US Dept. of the Interior; Scientific American; US Dept. of Energy; EIA; JPMAM. 2014.

12
Cheap imports and the loss of US manufacturing jobs”, Cooke, Kemeny and Rigby, Center for Economic Studies
(Census Bureau), January 2016.
13
When political and military leaders look back at the Iraq War, their reassessments could be similar to those written
on Vietnam. Former Defense Secretary Robert McNamara’s 1995 mea culpa on Vietnam conceded that the
war should have been avoided; that it could have been halted at several key points after it started; that he and
other advisers to President Johnson suffered from ignorance, inattention, flawed thinking and political expediency;
that their strategy had little chance of success; and that communism would not have prevailed in Asia, with the
international strategic position of the United States no worse than it is today.
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Europe: another year of growth in 2018

I wasn’t sure I would ever see Eurozone GDP growth hit 3% again, but here we are (at least that’s the
level implied by leading indicators: the Eurozone manufacturing PMI survey is at its highest level since
1997). Eurozone economic sentiment is close to a 17-year high, employment intentions are rising, and
consumer intentions to make a major purchase have increased notably in recent months. The recovery
looks broad across sectors and countries, albeit with much lower levels of corporate debt growth when
compared to pre-crisis levels. European Commission surveys show a spike in the number of companies
saying equipment is a factor limiting production, so perhaps stagnant European capital spending will
start to pick up as well. All of this has taken place despite the recent rise in the Euro.
The biggest risk for 2018: a change in ECB policy to tighter money, brought on perhaps by a sharp rise in
German inflation, and/or a “smoothing” of policies in advance of the end of Draghi’s term in late 2019.
However, other than home prices, most prices in Germany are rising at 2%, levels which do not appear
to require changes to the ECB’s timetable for scaling back asset purchases. While the board of IG
Metall’s union has requested a pay raise of 6%, in the past, the actual agreements were roughly half of

EUROPE
union demands (see chart, following page). This is something we will have to watch closely, along with
surveys showing labor shortages in the Eurozone. As in the US, wage inflation may cause more
headaches for the ECB than consumer price inflation.

Eurozone GDP growth approaching 3% Eurozone sentiment trending up


q/q % change Eurozone confidence indicators
4% 40
Services
30
3% Actual GDP Manufacturing
20
10
2%
0
1% -10
-20
0% -30 Consumer
Growth estimate derived
from PMI index -40
-1%
-50 Construction
-2% -60
2010 2011 2012 2013 2014 2015 2016 2017 1985 1989 1993 1997 2001 2005 2009 2013 2017
Source: Markit, Eurostat, JP Morgan Economic Research. November 2017. Source: European Commission. November 2017.

Eurozone bank lending to non-financial corporations German inflation showing up in housing, but not in
y/y % change, adjusted for loan sales and securitizations wages or prices, y/y % change
30%
7% House prices
25% 6%
Spain Nowhere near pre-crisis levels,
20% 5%
but improving from abysmal
15% France 2013-2015 period 4% Hourly
10% 3% wages
Italy 2%
5%
1%
0% GDP deflator Core CPI
0%
-5% Germany -1% Unit labor cost
-10% -2%
'05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 2010 2011 2012 2013 2014 2015 2016 2017
Source: European Central Bank, Haver Analytics. October 2017. Source: Bundesbank, Statistisches Bundesamt, Haver, JPMAM. Q3 2017.

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IG Metall (Germany) wage demands and outcomes Euro area: increasingly hard to find workers
y/y % change Survey data, % indicating labor as a factor limiting production
12%
8 Union demand

Hundreds
7 Ultimate agreement 10%

6 8%
5
6%
4
3 4%
2
2%
1
0%
0
'07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17
'97 '99 '01 '03 '05 '07 '09 '11 '13 '15 '17
Source: IG Metall, J.P. Morgan. 2017. Source: European Commission. 3Q 2017.

Eurozone earnings have a lot of catching up to do vs the US. The good news for investors in the
EUROPE

Eurozone: the region has higher “operating leverage” than the US, UK or emerging economies. In other
words, one unit of revenue growth results in larger amounts of net income. To be clear, all regions have
substantial operating leverage, which means that rising global growth should translate into continued
strong earnings growth, even if margins are no longer expanding. The last chart shows how regional
earnings growth estimates for FY2018 are roughly the same as in FY2017, with the exception of EM.

European earnings levels lagging US Operating leverage highest in continental Europe


12-month trailing EPS, Index, Jan 2006 = 100 Ratio of y/y pre-tax income growth to revenue growth
170 4.5x
EM "How much do earnings benefit
160
4.0x from additional revenue growth?"
150 US
S&P 500
140 3.5x UK
130
3.0x Continental Europe
120 Stoxx 600 (Eurozone
+ Den, Swi, Swe, UK) 2.5x
110
100 2.0x
90
1.5x
80
MSCI Eurozone
70 1.0x
'06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 1990 through 1999 2000 through 2009 2010 through 2017

Source: IBES, JPMAM. November 2017. Source: Empirical Research. February 2017.

Earnings growth estimates


Expected y/y % change
25%
FY 2017 FY 2018
20%

15%

10%

5%

0%
US Europe Japan EM
Source: IBES. December 2017. Indices used: S&P500, Stoxx600, MSCI
Japan, MSCI EM.

18 18
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However, return on equity for European industries are generally below US levels, which may
14
explain why European valuations are below US levels as well . Furthermore, the benefits of
investing in the Eurozone in 2017 compared to the US were modest, and entirely due to the rally in the
Euro. In local currency terms, the Eurozone underperformed the US again in 2017. We have written for
many years about the benefits of a barbell in which equity investors overweight the US and EM vs
underweight positions in Europe and Japan. While the barbell’s outperformance was small in 2017, it
was still positive. It’s remarkable how consistently the barbell’s outperformance has occurred since 1988.
In 2017, the strong performance in EM vs Japan offset the modest outperformance of Europe vs the US.
We don’t have a very strong view on the barbell for 2018, and recommend a balanced global portfolio.

Europe vs. US: return on equity Europe: large P/E discount vs the US, but nowhere near
Difference in ROE by sector, Europe minus US deep value
25% Stoxx 600 P/E discount vs US S&P based on forward earnings
20% 0%
Comm Serv

15%
Insurance

-5%
Energy

10%
-10%

EUROPE
5%
0% -15%
Autos

Semis

Telecomms
Cons Dur

Real Estate

Retailing
Food & Bev
Pharma

Div Fin
Utilities

Househ. Prod

Banks
Healthcare

Cap Goods

Transport
Software
Media

Materials

Food Retail

Tech Hardware
-5% -20%
Cons Serv
-10%
-25%
-15%
-20% -30%
-25% -35%
-30% '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17
Source: MSCI, Bloomberg, JPMAM. November 2017. Source: Datastream, J.P. Morgan Asset Management. Dec 15, 2017.

Benefits of overweighting US/EM, underweighting Regional equity market performance


Europe/Japan, 3-year rolling out (under) performance
10%
Region US EM EUR JPN
8% MSCI Weight 57% 12% 22% 9%
6% Delta vs MSCI 10% 5% -10% -5%
4% Barbell weights 67% 17% 12% 4%
2% $ return 22% 34% 25% 24%
0%
Local cur return 22% 28% 14% 20%
Source: Bloomberg. December 19, 2017.
-2%
-4%
1991 1994 1997 2000 2003 2006 2009 2012 2015
Overweight US-EM, Underweight EUR-JPN,
Source: Bloomberg, J.P. Morgan Asset Management. Q3 2017. All equity year to date return, percent 0.3%
portfolio is rebalanced quarterly and assumes no currency hedging.

14
Start dates. Our relative P/E chart starts in 2006. Before 2006, IFRS required European companies to amortize
goodwill, and the amounts involved were at times substantial. As a result, pre-2006 P/E multiples for Europe are
not exactly comparable to post-2006 multiples, and can distort time series comparisons vs the US.
Sector differences. The S&P 500 has much higher weights to technology than the Stoxx 600, and lower weights to
Financials and Consumer Staples. Even when we adjust for these differences and compute “sector-neutral P/E
ratios”, the P/E discount for Europe looks very similar to the one shown above.
19 19
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While there’s a lot of optimism regarding the Eurozone’s recovery, there are still plenty of
unresolved structural issues. In our view, they will become more relevant for markets when the next
recession hits, perhaps in 2020 or later:
 Foreign exchange reserves allocated by global central banks to the Euro declined from 2010 to 2016
and have now only begun to stabilize, a sign that central banks may not be not totally convinced in
the Euro as a store of value
 Germany’s economy continues to power ahead of France, a by-product of the structural issues that
we have written about many times before. Note in the last chart how German banks are less and
less interested in lending to Spain and Italy, requiring the ECB to do a lot of heavy lifting
 There’s positive news in France on its own reforms: new rules designed to make its notoriously rigid
labor markets more flexible15, elimination of the asset tax and reduced capital gains taxes. However, I
do not believe that Macron’s calls for Eurozone-level reforms will be happening anytime soon
(fiscal, military, asylum and tax harmonization across Eurozone countries)
EUROPE

Global currency reserves Franco-German wealth gap


% of global currency reserves allocated to the euro and US dollar Germany real per capita GDP divided by France, ratio
1.40
72%
27% 1.35
Euro
70% 1.30
25%
1.25
68% 23% 1.20
1.15
66% 21% 1.10
64% 1.05
19%
US Dollar 1.00
62% 17% 0.95
0.90
60% 15% 1850 1865 1880 1895 1910 1925 1940 1955 1970 1985 2000 2015
'99 '01 '03 '05 '07 '09 '11 '13 '15 '17
Source: Angus Maddison, Conference Board, JPMAM. 2017.
Source: International Monetary Fund, FactSet, JPMAM. 2017.

Death in Venice German banks less willing to lend to periphery banks


Industrial Production Index, 12/31/1999 = 100 German outbound lending , US$ billion
$350
Thousands

130 Germany
Economic cycles more $300
synchronous before the Euro German bank lending to Italy
120
$250
110
$200
100
France
$150
90

80 Euro exchange $100 German bank lending to Spain


rate fixed Italy
70 $50
1980 1985 1990 1995 2000 2005 2010 2015 2005 2007 2009 2011 2013 2015 2017
Source: Respective national statistical agencies. October 2017. Source: Bank for International Settlements. 2Q 2017.

15
Macron’s labor market reforms are the kind of thing that right-of-center French politicians have been
trying to do for decades. One key component is the decentralization of collective bargaining down to individual
companies instead of across entire industries, with even more flexibility for companies with less than 50 workers
who can now negotiate directly with employees instead of their unions.
20 20
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What about the UK? The market is doing a good job distinguishing between winners (exporters,
manufacturing) and losers (banks, domestically focused companies and construction) resulting from a
weaker pound. It’s hard to say what UK separation from the EU might look like, since at the rate things
are going, new arrangements may not be in place by the scheduled exit of April 2019. Exit payments in
the tens of billions of Euros, the rights of EU and UK citizens in each other’s jurisdictions and issues
related to the UK-Ireland border haven’t been concretely figured out yet. The UK could be subject to the
European Economic Agreement, but that would subject the UK to its trade, immigration and regulatory
policies. Reverting to WTO standards would give the UK more independence, but reduce access to the
single market. Some refer to the EU’s position as the “Impossible Trinity”16, since the following 3
positions cannot all be adhered to:
1. No hard border between the Republic of Ireland and Northern Ireland
2. No internal trade frictions inside the United Kingdom
3. The United Kingdom leaves the Single Market and Customs Union
However, it could take years before the impossibility of this trinity comes to a head and forces more

EUROPE
concrete decisions. It looks like a “Hard Brexit” is off the table, since Prime Minster May appears to have
accepted EU negotiating demands on budget payments, EU citizens’ rights and the Irish Border. I would
not be surprised if the person writing the Eye on the Market Outlook in 2021 is still discussing Brexit
negotiations and timetables, given transition period extensions that may occur in the future.

Brexit winners and losers Brexit impact on business surveys


Index, 100 = June 23, 2016 Index, 50+ = expansion
140 66
Brexit FTSE exporters 64 Brexit
130
62
120 60
Manufacturing
58
110 56
FTSE 100 equal-weighted 54
100
52
90 50
FTSE domestics 48
80 46 Construction
70 44
Apr-16 Jul-16 Oct-16 Jan-17 May-17 Aug-17 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17

Source: FTSE, J.P. Morgan, Bloomberg. November 2017. Source: Markit. November 2017.

16
“Brexit: Can kicked to 2021 at least”, Lombard Street Research, December 8, 2017
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Emerging Markets: the recovery continues


In our 2016 Outlook, we focused on opportunities in emerging markets by highlighting the following:
 low levels of investor optimism on EM equities, and low levels of investor positioning
 EM price to book ratios vs developed markets that had converged toward levels last seen during the
1998 crisis
 declines in EM currencies (ex-China) that could help resolve balance of payments problems
So, we’re not surprised to see emerging market equity gains of 50% on the MSCI EM index since Jan 1
2016. While EM optimism, valuations and currencies have picked up since then, we believe there’s still
time left in the current EM cycle for investors. The stabilization of Chinese data has been an important
factor supporting the global recovery. An illustrative data point: Chinese auto sales are up by 5 million
units over the last 2 years, an amount not that far below combined auto sales in Germany and France17.

Emerging markets: real effective exchange rates MSCI Emerging Markets price-to-earnings ratio
GDP-weighted broad REER (excluding China) Price to 12-month forward earnings ratio
105 15
14

100 13
12
11
EMERGING
MARKETS

95
10
9
90 8
7
85 6
1995 2000 2005 2010 2015 '01 '03 '05 '07 '09 '11 '13 '15 '17
Source: Bank for International Settlements, IMF, JPMAM. October 2017. Source: IBES, Datastream. November 2017.

MSCI Emerging Markets profit margins strengthening China economy: stable to improving
%
13% Legend: employment surveys, exports,
business conditions, GDP, corporate earnings,
12% industrial production, retail sales, non-state
owned enterprise fixed asset investment
11%
10%
9%
8%
7%
6%
5%
2001 2003 2005 2007 2009 2011 2013 2015 2017 2011 2012 2013 2014 2015 2016 2017
Source: Bloomberg. 3Q 2017. Source: CFLP, Markit, CC, PBOC, CNBS, MSCI, JPMAM. November 2017.

17
Suttle Economics Daily Comment, December 11, 2017
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EM lending conditions are starting to pick up, foreign direct investment is returning, exports have
rebounded to pre-2014 levels and the pick-up in EM growth has coincided with a recovery in US oil &
gas investment.

EM bank lending conditions improving Capital inflows (FDI and portfolio investment) into EM
Diffusion index US$ billions
65 $1,600
Trade finance

Thousands
$1,400
60
$1,200

55 Demand for loans $1,000


$800
50 $600
$400
45
$200
Performing loan health
40 $0
2009 2010 2011 2012 2013 2014 2015 2016 2017 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Source: IIF. September 2017. 3Q 2017 is an estimate. Source: IIF. September 2017. 2016, 2017, and 2018 are estimates.

Emerging Asian exports rebounding Commodity supercycle downturn comes to an end


Export value, y/y % change, 3mma y/y % change y/y % change
30%
90%
25% 5.2%

EMERGING
MARKETS
20% Emerging economy
real GDP growth 60%
4.9%
15%
10% 4.6% 30%
5%
4.3% 0%
0%
-5% US oil/gas real -30%
4.0%
-10% investment
-15% 3.7% -60%
'11 '12 '13 '14 '15 '16 '17 2012 2013 2014 2015 2016 2017
Source: IMF Direction of Trade, Suttle Economics, JPMAM. August 2017. Source: JP Morgan Economic Research. Q317.

23 23
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Times have changed since the 1980’s and 1990’s when most EM economies ran large current
account deficits and relied extensively on foreign capital. Of 15 EM economies with the largest
investible equity and fixed income markets, only Argentina and Turkey still run large external deficits.
Most other countries are close to balanced, or run a surplus. Furthermore, since 2014, EM countries as a
whole have reduced their reliance on foreign capital.
Another sea change: EM foreign exchange reserve levels are higher, which gives many EM countries
greater flexibility to manage exchange rate declines, monetary policy and growth when capital outflows
accelerate. In our view, this is why the balance of payments problems which hit some emerging market
economies in 2014 were less severe than prior episodes, at least as it relates to the impact on investors.
You can see evidence of this in the last chart, which also shows how a balanced approach with EM debt
and EM equity delivered a less volatile ride than EM equities alone.

Current account balance EM reliance on foreign capital: at lows for the cycle
% of GDP % of EM countries significantly reliant on foreign capital
15% 90%
80%
10% 70%
60%
5% 50%
40%
0% 30%
EMERGING
MARKETS

Argentina

India

Poland

Thailand
South Korea
Brazil

China

Indonesia

Taiwan
Malaysia

Mexico

Philippines

South Africa

Turkey

Venezuela

20%
-5% 10%
0%
1975 1980 1985 1990 1995 2000 2005 2010 2015
-10%
Source: Central banks. 2017. Source: Bridgewater Associates. July 2016.

Emerging markets FX reserves Emerging markets portfolio returns


Median level of country reserves as % of GDP Index, 100 = December 1993
25% 800
Blended weights
40% EM equities (MSCI) Blended
20% 20% EM dollar debt (EMBI)
400
20% EM T-bills (ELMI Plus)
15% 20% EM local bonds (ELMI/GBI)
200
10% Equities

5% 100

0%
50
'80 '84 '88 '92 '96 '00 '04 '08 '12 '16
'93 '95 '97 '99 '01 '03 '05 '07 '09 '11 '13 '15 '17
Source: IMF, World Bank, Haver. 2017. Source: Bloomberg, JPMAM. November 2017.

As for China, all eyes are on the rise in its debt. The IMF estimates that China would have grown by
5.5% from 2012 to 2016 instead of 7.25% without this increase18. In the same report, the IMF noted
that in 43 cases where debt/GDP rose by more than 30% over 5 years, only 5 did not lead to a crisis, and
that China’s debt service ratio is higher than the US ratio in 2007. China has been gradually tightening
the cost of money, which is showing up in slightly lower rates of growth and rising defaults.

18
“People’s Republic of China: Selected Issues”, IMF Country Report No. 17/248, August 2017.
24 24
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However, unlike many of the countries in the IMF analysis, China is not a free-market country. Its
government controls many of the levers which were catalysts in Western banking crises:
 The majority of China’s debt is internally held (external debt is only ~15 % of GDP, the lowest in the
emerging world), and its banks hold foreign assets that are $500 billion greater than their external
liabilities. Debt resolution via asset management vehicles and debt for equity swaps may dampen
growth, but are unlikely to cause large balance of payment problems
 Around 55%-60% of “corporate” debt has been issued by centrally or locally controlled state-owned
enterprises, which we believe entails government backing, or at worst, “controlled” default
 A lot of this bad debt is held by China’s largest 5 banks and its Postal Savings Bank, which are
wholly- or majority-owned by the central government, allowing the leadership to control the process
by which losses are recognized
 Stable retail deposits represent 80% of liabilities for China’s state owned banks, implying much less
reliance on bonds or wholesale funding than Western banks
Total China economy-wide debt Pre-crisis household and corporate debt
% of GDP % of GDP
300 250
Corporate Debt Ireland
230 Japan Spain
250 Household Debt 210
200 Government Debt 190 China
164 167 166 166 Thailand US
139 153 170

EMERGING
134 Sweden

MARKETS
150 127
113 119 117 150
100 89 98 130
33 35 39 44 46 47 48 110
23 26 27 29
50 18 17 90
42 40 50 49 49 51 55 59 58 58 56 56 56
0 70
50
1Q17

2Q17

3Q17
2010
2007

2008

2009

2011

2012

2013

2014

2015

2016

1980 1984 1988 1992 1996 2000 2004 2008 2012 2016
Source: People's Bank of China, NBS, JPM Economic Research. 3Q17. Source: Bank for International Settlements. 2017.

The good news on the long run: rising profits from “new economy” sectors. China has a long
journey ahead in its transition to a more balanced economy from one reliant on capital spending (see
chart, left). Now that China has the highest production wages in developing Asia, it will need greater
efficiencies in the years ahead, rather than simply relying on inexpensive human capital. However, while
old economy sectors are still a large part of the Chinese corporate sector, there’s a growing contribution
from new economy sectors: consumer staples, consumer discretionary, healthcare and technology.
Slowly switching from investment to consumption China A-share reported profits
% of GDP, both axes RMB, trillion
Gross fixed capital formation

China (2011) 1.20


45
Industrial and emerging 1.00
` (2016)
China economies, 2008-14 average
0.80
35 Old economy
0.60
Energy
25 0.40

0.20
New economy
15 0.00
30 40 50 60 70 80 90 2008 2009 2010 2011 2012 2013 2014 2015 2016
Private consumption Source: Bloomberg, JPMAM, Gavekal. 2016. Energy includes 6 Sinopec &
Source: World Economic Outlook and IMF. 2017. PetroChina companies.

25 25
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
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Other good news on the long run: progress on restructuring state owned enterprises. In
addition to the trends below, our China analysts also observe ongoing efficiency improvements in
industrial enterprises, including a gradual decline in industrial enterprise liability-to-asset ratios, lower
product inventory turnover days and reduced product unit costs19. FX outflows have also slowed, a
consequence of enforced capital controls, a more stable Yuan and foreign inflows into China’s short
term bond markets, which yield round 4.5% for six month paper.

Chinese steel capacity Steel sector profitability has returned


million tonnes Share of Chinese companies making a profit, %
1,100 100%
Projections 90%
1,000 80%
70%
900 60%
50%
800 40%
30%
700 20%
10%
600 0%
'07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 '19 '20 Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Jun-17
Source: Credit Suisse. April 12, 2017. Source: Mysteel, JP Morgan Economic Research. November 2017.
EMERGING
MARKETS

Chinese industrial enterprises' profits and sales revenue Chinese manufacturing fixed asset investment &
y/y % change industrial enterprise sales revenue, y/y % change
40%
25%
Industrial profits
30%
Industrial sales Manufacturing fixed asset
20% investment (3mma)
20% 15%

10% 10%

0% Sales revenue
5%

-10% 0%
2011 2012 2013 2014 2015 2016 2017 2012 2013 2014 2015 2016 2017
Source: NBS, JP Morgan Economic Research. October 2017. Source: NBS, JP Morgan Economic Research. October 2017.

Chinese industrial enterprise capacity utilization index


Diffusion index, seasonally adjusted
45

43

41

39

37

35
2011 2012 2013 2014 2015 2016 2017
Source: NBS, People's Bank of China, JPM Economic Research. Sep 2017.

19
“China: Industrial profit growth picked up to 24%oya in August”, J.P. Morgan Asia Pacific Economic Research,
Grace Ng and Haibin Zhu, September 27, 2017
26 26
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Japan: some cyclical upside but no change to long term outlook

Japan is also participating in the global recovery: 7 straight quarters of real GDP growth, exports growing
at the fastest pace in 4 years, and increases in labor demand, factory output, machinery orders, capital
spending and wholesale prices. The first chart shows the Tankan survey of business conditions, now at
its highest level since the early 1990’s. The second chart shows how Japanese equities have decoupled,
at least temporarily, from every minor movement in the Yen.

Japanese business conditions improving Japan equities and the Yen


Tankan survey, diffusion index of favorable less unfavorable Exchange rate Index level
40% ¥130 1100
Hundreds

30% ¥125 USD/Yen FX rate


1000
¥120
20%
¥115 900
10% ¥110
0% ¥105 800
-10% ¥100 700
-20% ¥95
¥90 600
-30%
¥85
-40% MSCI Japan equities 500
¥80
-50% ¥75 400
'90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 2010 2011 2012 2013 2014 2015 2016 2017
Source: Bank of Japan. 3Q 2017. Source: Bloomberg. December 15, 2017.

Corporate profits are booming in Japan, so much so that they became a political football in the
recent elections, with opposition politicians calling for a tax on corporate reserves to encourage
companies to invest more and raise wages. The larger problem for Japan is that over the last few years,
while corporate profits have recovered, household incomes have not; this is one of the reasons for
chronically low GDP growth in Japan. This stands in contrast to the US, where household incomes rose
alongside rising profits after the global recession in 2009. Maybe this will change now that the Japanese

JAPAN
employment market is tight (the ratio of vacancies to applicants at its highest since 1974, and there has
been a surge in the number of companies reporting labor shortages). But this has been the Achilles heel
of the Japanese recovery, and investors seem reluctant to muster much enthusiasm to be overweight
Japan given such a one-legged recovery20.

Both the US and Japan had a profits rebound... ...but household incomes only rose in the US
Earnings per share, trailing 12-months (both axes) Real HH earnings index (both axes), Japan is 3-mo. avg.
$130 ¥70 101
122 100
$120 S&P 500 ¥60
US 99
$110 118
¥50 98
$100 114 97
¥40
$90 96
¥30 110
MSCI Japan 95
$80 Japan
¥20 106 94
$70
93
$60 ¥10 102
92
$50 ¥0 98 91
2007 2009 2011 2013 2015 2017 2007 2009 2011 2013 2015 2017
Source: Thomson Reuters IBES, Datastream. November 2017. Source: BLS, BEA, Japanese Ministry of Health. October 2017.

20
Flow analyses by JP Morgan Global Economic Research suggest that foreign non-leveraged institutional and retail
investors stand currently mid-way between the pre-Abenomics lows of 2012 and the post Abenomics peak of mid-
2015, and have a neutral position on Japanese equities.
27 27
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
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Even so, we feel better about exposure to Japan than we have in a very long time. There are a couple of
trends taking place that are worth discussing. First, there’s the emergence of a Japanese corporate
governance renaissance: a pickup in M&A and buybacks, more companies adopting targets for return
on assets and return on equity, and an increasing number of companies with independent directors and
performance-based compensation for management. These trends indicate a greater focus on investor
concerns, and represent a departure from the last couple of decades. Second, as shown in the last chart,
Japan has finally been able to create a set of policies that has led to increased female participation in
the labor force.

Announced cash M&A and buybacks in Japan Companies citing ROE/ROA targets in medium term
% of GDP, 4-quarter moving average plans, % of companies (n=841)
3.0% 45%
40% Return on assets target
2.5%
35%
2.0% 30% Return on equity target
25%
1.5%
20%
1.0% 15%
10%
0.5%
5%
0.0% 0%
'06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 2014 2016
Source: Bloomberg. Q3 2017. Source: Japan Ministry of Economy, Trade, & Industry, Goldman Sachs. 2016.

Performance based compensation and independent Increasing female employment in Japan


outside directors, # of companies Number of employed females, millions
90 400 29.0
Performance based
80 350 28.5
compensation
70 300
JAPAN

28.0
60
250
50 27.5
Large companies with 200
40 27.0
independent outside 150
30 directors 26.5
20 100
50 26.0
10
0 0 25.5
2008 2009 2010 2011 2012 2013 2014 2015 2016 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16
Source: Goldman Sachs, Willis Towers Watson. 2016. Source: Ministry of Internal Affairs and Communications. October 2017.

Japan still has a gargantuan amount of government debt and the worst demographics in the developed
world, but from a medium term cyclical perspective, Japan seems poised to offer more opportunity to
investors than it has in some time. Abe retained a two thirds supermajority in the snap elections last
October, allowing the government to continue its efforts to reflate Japan. While Japan’s deflation era
(2000-2012) has ended, inflation is still well below 1% and the government’s target of around 2%.

28 28
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[ST1] Industrial commodity prices: more room to rise as global economy recovers
In February 2016, some analysts thought the commodity super-cycle unwind still had a long way to go,
since in prior episodes, it took 15-30 years after the peak for the commodity super-cycle to end21.
However, in prior instances, commodity prices fell by ~50%, which is how far they had already fallen by
the spring of 2016. As a result, we wrote that the worst was probably over and that it was time to look
for opportunity in commodity-related investments again. In January 2017, we noted how the decline in
industrial metals exploration and production spending had fallen sharply from its 2008-2012 levels, and
that even though inventory levels were still high, we believed that the E&P decline would be more
important to markets22. Since then, industrial metals prices have risen back to 2014 levels.

Global copper, aluminum, nickel, zinc and oil capital Industrial metals prices
spending, Index, 2000 = 100 Price index, Jan. 2013 = 100
1,600 105
1,400 100

1,200 95
90
1,000
85
800
80
600 Zinc
Copper 75
400 Nickel 70
200 Oil 65
Aluminum
0 60
'00 '02 '04 '06 '08 '10 '12 '14 '16 2013 2014 2015 2016 2017
Source: Wood Mackenzie, Barclays. Dec 2015. Dot is an estimate for 2016. Source: Bloomberg. December 15, 2017.

Given our outlook for a continued global expansion in 2018, and since there are few signs that industrial
metal capital spending is rising yet, we believe there is more upside for prices in 2018. Note below how
alternative asset managers have very little exposure to commodities, which could contribute to upward
price momentum if these allocations were to change.
Top 100 alternative investment managers
% of aggregate assets under management by asset class
Infrastructure Commodities
Fund of hedge 4% 0.5%

SPECIAL
TOPICS
funds
6%
Real estate
Illiquid credit 35%
9%

Private equity
FoF
12%

Hedge funds
17% Private equity
17%
Source: Willis Towers Watson. 2017.

21
Eye on the Market, February 17, 2016
22
Eye on the Market 2017 Outlook, January 1, 2017
29 29
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
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[ST2] Brazil: another example of improving economics trumping deteriorating politics


Is there a country with more bad press over the last 2 years than Brazil? Its political scandals seem
unending, and even ESPN is piling on: “After the Flame: The 2016 Summer Games were supposed to
bring Rio and Brazil to new financial and athletic heights. What's left behind? A city and country
shrouded by corruption, debt and broken promises”. Perhaps, but Brazil is also undergoing a typical
balance of payments adjustment and market recovery. The narrative, as usual, goes like this:
 The currency declines, crushing imports and boosting exports, bringing spending in line with income
(signified by a closing of the current account deficit)
 Growth slows, bringing down wage and price inflation, which in turn allows the Central Bank to ease
 Credit creation, employment and foreign direct investment eventually begin to rise, and in the case of
Brazil, there are additional benefits from rising industrial metals prices. FDI flows have been boosted
by privatizations and asset sales by Federal and State governments, Vale, Petrobras and Eletrobras.
This might help Brazil in the long run given its very low relative rankings in infrastructure, regulation,
labor market efficiency and bureaucracy (source: World Economic Forum)
 As consumer and business confidence pick up, so do equity markets, in spite of “Operation Car
Wash” and its aftermath

Brazil current account deficit Brazil inflation and policy rate Brazil: business and consumer
% of GDP USD/BRL (inverted) y/y % change Policy rate, % confidence, Index, Jan. 2013 = 100
1% 1.5 12% 16% 110

0% Business
2.0 10% 100
14% confidence
-1% 90
8%
2.5 12%
-2%
USD/BRL 6% 80
-3% 3.0
10% 70
4%
-4% 3.5 Policy rate Consumer 60 Consumer
Current 2% price 8%
-5% account confidence
4.0 inflation 50
-6% deficit 0% 6% 2013 2014 2015 2016 2017
2013 2014 2015 2016 2017 2013 2014 2015 2016 2017
Source: Fundaçâo Getúlio Vargas, Confederaçâo
Source: BCB, Haver. Bloomberg. Oct 2017. Source: OECD, Haver. October 2017. Nacional da Indústria. November 2017.
SPECIAL

Brazil: employment growth Industrial metals prices Brazil equity markets


TOPICS

y/y % change of 3-month moving average Price index, Jan. 2013 = 100 MSCI Brazil Index, 2013 = 100
105 110
Dots= major developments
2% 100 100 in "Operation Car Wash"
95 90
1%
90
80
0% 85
70
80
-1% 60
75
70 50
-2%
65 40
-3%
60 30
2013 2014 2015 2016 2017
2013 2014 2015 2016 2017 2013 2014 2015 2016 2017
Source: Instituto Brasileiro de Geografia e
Estatística. October 2017. Source: Bloomberg. December 15, 2017. Source: Bloomberg. December 15, 2017.

30 30
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
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[ST3] Our latest analysis of the US municipal market: debt burdens of US cities and counties
As managers of over $70 billion in municipal bonds, we keep very close tabs on the total debt burdens of
municipal issuers, including their unfunded pension and retiree healthcare obligations. In the fall of
2017, we published a deep dive analysis of US cities and counties. As with the states, we found a very
heterogeneous picture: some issuers have manageable debt burdens, while others face significant
challenges. The chart below shows the results of our analysis: the percentage of municipal revenue
required to fully meet all future projected obligations, assuming a 6% return on assets.
Population and revenue growth mitigate some of these burdens, which is why we also developed a more
comprehensive measure which takes these factors into account as well. Given the asymmetric risk of
fixed income, we would rather be early in identifying unwanted sources of portfolio risk than be reacting
too late. Across our various municipal bond portfolios, our exposure to the general obligation bonds of
the highest risk cities and counties as designated in our analyses is around 1% of total assets.
To review the Executive Summary of the paper and our conclusions, click here. These conclusions
appear to be even more important to consider in the wake of the Tax Cuts and Jobs Act, given the
pressures that high tax states may face in the form of out-migration by high income residents.

The IPOD ratio: State, City and County debt burdens


% of municipality's revenues required to pay the sum of interest on net direct debt, the municipality's share of unfunded pension and retiree
healthcare liabilities, and defined contribution plan payments; assuming 6% plan return and 30 year level dollar amortization

70% Chi Lubb BatRou Pho


Atl Aust LA
Hon Hou
60% Pitt
Oak San Jo FortW
Dal Omaha
Sac
50%
Pr.Georges(MD) El Paso
IL Shelby(TN) JersCt
40% King(WA)
NJ SanClara(CA)
CT
Cities
KY
30% Bexar(TX)
HI Montgom(MD)
Clark(NV)
ME Bergen(NJ) Counties
20%

10%
States

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0%
Source: J.P. Morgan Asset Management, Center for Retirement Research at Boston College, CAFRs, Moody's. FY 2015.

31 31
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
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[ST4] Hedge Fund performance: modestly better, but valuation compression still a headwind
2017 was a modestly better year for hedge fund stock-pickers, certainly better than the industry’s subpar
performance in 2016. There are two ways we track this. First, in the chart on the left, we look at the
asset-weighted returns by month for all long-short hedge fund managers reporting to HFRI. 2017 looks
better than most years since 2010, although the bar is admittedly low.
However, since only 1/3 of managers report to HFRI, other return measures are worth tracking as well.
Some Prime Brokerage departments aggregate the stock-picking activity of their hedge fund clients, and
create synthetic return estimates based on an assumed market-neutral portfolio. One such exercise
appears in the chart on the right, and shows how 2017 was a better year for stock-pickers even with the
sharp drop in performance due to December profit-taking in tech and other growth sectors. How this
translates into actual hedge fund returns is complicated given dispersion of returns across funds,
leverage, cash holdings, etc., but this approach gives us a sense for whether stock-picking is yielding
positive results or not.

HFRI long/short performance Prime Brokerage-based assessment of HF stock picking


YTD returns, asset weighted, Index = Jan 1 YTD alpha (long appreciation-short appreciation), asset weighted
120
2013 12% 2017 2015
115 10% 2013
2017 8%
2012
110 2012
6% 2010
2010 2011
105 4% 2014
2014
2016 2%
100 0%
2015
-2% 2016
95
-4%
2011
90 -6%
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Source: HFRI. November 2017. Source: Morgan Stanley. December 5, 2017.
________________________________________________________________________________________________________________________________________________________________________

Starfish chart: coverage overlap of hedge fund performance databases


Lipper
TASS
SPECIAL
TOPICS

The sum of all the shaded HFR segments is


17.2 HFR
(32.7%)
32% (i.e., HFR does not track performance
Morningstar for ~70% of all hedge funds). This is not
0.6 0.3
0.9
1.2
1.5
0.6
unique to HFR; the 5 providers shown cover
1.1 1.5 14.3 from 25%-35% of all managers
13.4 0.9
1.5
0.5
1.1 1.9 1.1 3.4
1.2
0.5 0.4
0.9
0.6
0.4
0.3 0.3
0.4 1.6
1.3
16.5
BarclayHedge
12.6

EurekaHedge

Source: “Hedge Fund Performance: What Do We Know?” Joenväärä, Kosowski,


Tolonen. March 2016.

32 32
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
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What helped stock–pickers in 2017? The correlation among stocks has finally fallen, meaning that the
stocks are no longer behaving like a giant flock of geese flying in the same direction at once. Hedge
fund manager preferences for growth-oriented sectors (tech and healthcare) helped as well.

S&P 500 and its average stock correlations


Avg. pair correlations using 100 daily rate of change data
0.7

0.6

0.5

0.4

0.3

0.2

0.1

0.0
1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
Source: Gavekal. September 2017.

23
However, one big challenge remains for hedge funds: compression of valuations . While the correlation
among stocks has declined, the dispersion of valuations across stocks is still quite low, so that the
amount of return that can be earned by identifying cheap stocks vs expensive ones is still constrained
compared to history. We view this as another distortion resulting from trillions of dollars in central bank
stimulus, which have compressed valuations in equity, corporate, municipal and real estate markets. It
might take until 2020 or later for the lingering impact of central bank intervention to disappear from
financial markets.

Valuation dispersions across stocks: lowest on record


90th percentile minus 10th percentile by factor, Index, 100 = Jan '78
200
Earnings yield
180
Free cash flow yield
160 Dividend yield
140 Book to price
120 Sales yield
100

SPECIAL
TOPICS
80
60
40
20
1978 1982 1986 1990 1994 1998 2002 2006 2010 2014
Source: ClariFi, Morgan Stanley Research, JPMAM. August 2017.

23
For each of the five series, stocks with low valuations (90th percentile of cheapness) are compared to stocks with
high valuations (10th percentile of cheapness). The difference is indexed to 100 in 1978. The gap between cheap
and expensive stocks has narrowed by 50%-75% since the 1980’s, and is close to the narrowest on record.
33 33
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
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[ST5] The concentration of US equity market returns in 2017


In 2017, S&P 500 returns were concentrated in a few stocks: the top 5 stocks contributed 5.0% of the
index’s total return of 21.9%24. FAAMG25 sales growth hit 21% y/y in Q3 2017, supporting their price
advances. How abnormal is it for a small group of stocks to represent such a large portion of the overall
market return? From 1991-2016, the average return contribution of the top 5 stocks in the S&P 500 was
3.4%, with a median of 2.6%. So in that regard, 2017 was higher than usual. Regarding the
contribution share of market returns, the top 5 stocks contributed around 25%, which is roughly average
for a year of positive returns.

Impact of removing top 5 S&P 500 stocks each year Share of market returns from top 5 stocks
Total return foregone Percent, capped at 50%
9% 50%
8% 45%
7% 40%
6% 35%
30%
5%
25%
4%
20%
3%
15%
2% 10%
1% 5%
0% 0%
2001

2014
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000

2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013

2015
2016
2017

1993

2000

2007

2013
1991
1992

1994
1995
1996
1997
1998
1999

2001
2002
2003
2004
2005
2006

2008
2009
2010
2011
2012

2014
2015
2016
2017
Source: Bloomberg, JPMAM. November 2017. 2017 numbers are YTD. Source: Bloomberg, JPMAM. November 2017. 2017 numbers are YTD.

In 2017, all 5 of the FAAMG stocks are making repeat appearances in the top 5 stock list. It’s not
unusual for companies to repeat in multiple years. Microsoft’s 13 appearances are the second most of
any company (behind GE), and 2017 marks its 5th straight appearance. Apple, the largest return
contributor in 2017, has appeared 9 times, all from 2005-2017. As a result, 2017 seems normal in this
regard, as it’s common for the top 5 stocks to repeat from year to year. From 1991-2017, more
companies (26) have repeated as a top 5 contributor than have shown up only once (20).

Top S&P 500 Contributors in 2017


Rank Company Contribution Years in top 5 (1991-2017)
1 APPLE INC 1.62% 2005, 2007, 2009, 2010, 2011, 2012, 2014, 2016, 2017
2 MICROSOFT CORP 1.04% 1996, 1997, 1998, 1999, 2001, 2006, 2007, 2009, 2013, 2014, 2015, 2016, 2017
SPECIAL
TOPICS

3 AMAZON.COM INC 1.02% 2015, 2017


4 FACEBOOK INC-A 0.76% 2014, 2017
5 ALPHABET INC-C 0.50% 2015, 2017
Source: Bloomberg, JPMAM. December 15, 2017.

24
We calculate contribution to an index return as the stock’s weight in the index at the beginning of the year times
its total return over the calendar year. Returns are as of December 15, 2017.
25
Facebook, Apple, Amazon, Microsoft, Google
34 34
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
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[ST6] What should be done about the shrinking number of US public companies?
The US has a “listing gap”: while the number of publicly listed firms is rising in the rest of the world, in
the US, it’s shrinking. The declining number of US public companies is remarkable, and in our view,
troublesome. Why is this happening? As shown in the chart on the right, the decline is due to both
increased de-listings and fewer new listings. More on each topic below.

The growing listing gap between the US and the world Additions and subtractions to listed companies
Thousands Number of listed firms
9 45 9,000
8 Domestic US-listed 40 New listings
companies 8,000 Listed firms
7 35
Delists
6 30 7,000
5 25
6,000
4 20
3 Non-US listings 15 5,000

2 10 4,000
1 5
3,000
0 0 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016
1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 2015
Source: "The U.S. Listing Gap," Journal of Financial Economics, Doidge,
Source: World Bank, World Federation of Exchanges. 2015. Karolyi and Stulz, Credit Suisse. 2017.

De-listings are usually the result of M&A activity or business failure. Regarding M&A, there are signs
that US businesses are getting larger and more consolidated. The average US company has a market cap
of $7 billion,10x higher in real terms than in 1976. Another stat: the Herfindahl index, which measures
industry concentration by market share, increased by 45% from 1995 to 2015. Some studies attribute
these trends to more lax enforcement of antitrust laws, while others attribute them to the economies of
scale accruing to large companies in a global marketplace. Either way, the annual pace of de-listings has
kept pretty constant at 8%-10% of listed firms since 2002.
26
On the decline in new listings, there are two primary reasons :
 Increased regulatory cost and complexity of being public, including litigation risks. In a PwC survey,
45% of firms indicated that the cost of being public exceeded their expectations. US companies
spend 166% more on legal services per dollar of revenue compared to global counterparts.
 Deregulation of private capital, effectively making it easier for private companies to remain private:

SPECIAL
TOPICS
o “Accredited investors” are those allowed to invest in securities not registered with the SEC, such
as hedge funds, private equity and venture capital. In 1982, Regulation D Rule 501 defined an
accredited investor as an individual with income of >$200K, or with net worth of > $1mm.
27
These dollar values have not been updated to account for inflation since 1982
o In 2016, Congress expanded the definition of an accredited investor to include registered
brokers, investment advisors and individuals with sufficient knowledge of unregistered securities
o In 2012, the JOBS Act repealed the prohibition on general solicitations under Regulation D,
allowing private placements to be advertised publicly; created a federal exemption to allow
crowdfunding; increased the number of shareholders a private company can have before having
to register/publicly report from 500 to 2,000; and provided a “Regulation A+” exemption to
allow small companies to offer and sell up to $50 mm of securities in a one-year period, subject
to eligibility, disclosure and reporting requirements

26
Other reasons for falling new listings include lower capital needs of technology and social media companies with
high sales per employee, and tight high grade/high yield spreads, prompting companies to finance the marginal
dollar with debt rather than equity.
27
The 1982 rule, if applied in current dollars, would raise the accredited investor minimum to $2.5 mm from $1mm.
35 35
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
E Y E O N T H E M A R K E T  M I C H A E L C E M B A LE ST  J . P . M O R G A N January 1, 2018
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The consequences of private capital deregulation: a sharp increase in US venture capital investment,
and longer periods of time before tech companies go public. In 2006, VC investors funded 2,888 private
US companies; in 2015, they funded 4,244 companies. As of November 2017, there’s still $1 trillion in
unspent private equity and VC funds available for investment in private companies.
Global venture capital investment by quarter Waiting longer to go public
Billions, US$ Median age of technology companies at IPO, years

45 14
40 Rest of world
35 United States 12
30
25 10
20
8
15
10
6
5
0 4
Q1 '13

Q1 '17
Q1 '10

Q3 '10

Q1 '11

Q3 '11

Q1 '12

Q3 '12

Q3 '13

Q1 '14

Q3 '14

Q1 '15

Q3 '15

Q1 '16

Q3 '16
1980 1984 1988 1992 1996 2000 2004 2008 2012 2016
Source: "Initial Public Offerings: Median Age of IPOs Through 2016," Jay
Source: KPMG, PitchBook. 2017. Ritter, University of Florida. 2017.

Before considering what might be done, why does it matter? In our view, there are two problems with
US capital markets having a smaller and smaller number of public companies:
 Fairness to the average investor. The status quo Number of participants in pension plans
deprives many investors of the gains accruing to pre- Million of participants
100
IPO investments, since most rely extensively on Defined contribution
90
defined contribution plans to finance retirement.
80
DC plans are becoming more prevalent as DB plans
70
stagnate, and I don’t think the right answer is to 60
allow risky and less liquid alternative investments 50
into DC plans. Wealth creation that is no longer 40
accessible to large numbers of investors, combined 30 Defined benefit
with instances of poor post-IPO performance, 20
furthers the notion of a class divide and a “rigged” 10
system that works against the average investor 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011
Source: Department of Labor. 2014.
SPECIAL
TOPICS

 Less market knowledge for the investing public, and free-riding by private companies. Disclosures from
public companies benefit the investing public, and allow analysts to conduct more informed research.
As such, fewer public companies means less information for investors. There are also substantial
strategic benefits accruing to private companies that “free-ride” on information provided by public
companies. How valuable is this information? It’s hard to quantify, but we do know this: expert
information networks like GLG can cost up to $1,000 per hour. As a result, fewer public companies
tilts the disclosure burden even further upon ones that remain. In a 2017 paper, Duke Law Professor
Elisabeth de Fontenay argues that the current equilibrium is unsustainable28: “While public companies
are being compelled to disclose ever more information, they are losing their very reason for doing so”,
given the ease of raising capital in private markets, the explicit costs of being public and the less visible
but real costs of free-riding by private competitors

28
“Deregulation of Private Capital and the Decline of the Public Company,” de Fontenay (Duke Law). March 2017.

36 36
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
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What could arrest the decline in the number of US public companies? Some don’t see it as a problem,
since much of the decline relates to fewer micro-cap stocks rather than large or mid cap stocks. Still, I
like the ideas outlined below, which would level the playing field between the costs and benefits of
being public vs private.

Objective Policy change


Allow public companies to focus more on their core  Modernize and update the requirements for submitting a
business by ensuring that proxy voting proposals shareholder proposal (including minimum ownership
have meaningful shareholder backing amount and holding period) and eliminate repetitive,
unsuccessful proposals that are not relevant to companies’
29
long-term economic value
 Adopt the “Choice Act”, which would increase shareholder
support thresholds required before proxy proposals can be
introduced if they have already been rejected
Reduce the regulatory burden of being public  Raise the “Emerging Growth Company” (EGC) designation
set by the 2012 JOBS Act from $1.1 bn in annual revenues
to $5.0 bn; below the EGC threshold, companies are
exempt from certain reporting and disclosure requirements
 Remove the automatic expiration of EGC status which
occurs 5 years after IPO
 Allow EGCs to report less frequently (i.e. semi-annually
rather than quarterly)
Minimize tax treatment difference between public  Take steps to minimize the incentive to remain private (in
and private companies the form of a pass-through entity only subject to one layer
of tax) rather than going public (which typically results in
two layers of tax, with the exceptions of REITs, MLPs, and
30
other publicly traded pass-through vehicles)
Enhance protections against spurious shareholder  Require disclosure of third party financing; sanction
31
litigation attorneys deemed to bring frivolous lawsuits; limit plaintiff
fees; require loser to pay legal fees of the winner (i.e.,
English system)
Ensure adequate protections for smaller and less  Index accredited investor minimums to inflation so that the
sophisticated investors accredited investor universe does not continue to expand
beyond its intended purpose; consider raising accredited

SPECIAL
TOPICS
investor limits to the inflation-adjusted levels implied by the
original rule
Reduce pressure on public companies to meet short  Extend the short term capital gains window from 1 year to
term earnings targets in order to satisfy short term 3 years
holders of their stock

Improve the liquidity of small and medium sized  Allow smaller companies to concentrate their trading
companies activity on a single exchange, rather than being spread over
multiple exchanges at the expense of liquidity (i.e., exempt
them from Unlisted Trading Privilege obligations)

29
In 2016, according to the annual proxy monitor from The Manhattan Institute, 6 investors and their families
sponsored one third of all shareholder proxy proposals.
30
The Tax Cuts and Jobs Act helped narrow the gap: tax rates for C-corporations declined from 35% to 21%, while
pass-through entities benefit from a deduction reducing top marginal rates from 37% to around 30%.
31
In 2016, there was a record number of securities class action suits, and a record number of dismissals. The mere
filing of a securities class action has been estimated to wipe out ~3.5% of the equity value of a company.
37 37
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
E Y E O N T H E M A R K E T  M I C H A E L C E M B A LE ST  J . P . M O R G A N January 1, 2018
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Sources
“China: Industrial profit growth picked up to 24%oya in August,” JP Morgan Global Economic Research.
September 2017.
“China: Known Unknowns, Set Up for a Debt Crisis,” Empirical Research Partners. October 2017.
“Considering an IPO? The costs of going and being public may surprise you,” PwC.
“Flows & Liquidity: Has the Nikkei/yen correlation broken down?” JP Morgan Global Economic Research.
October 2017.
“Flows & Liquidity: Another year of zero net equity supply”, JP Morgan Global Economic Research,
October 2017.
“A Global Leader – And Not In A Good Way,” Acritas Research, May 2017.
“The Incredible Shrinking Universe of Stocks: The Causes and Consequences of Fewer U.S. Equities,”
Credit Suisse Global Financial Strategies. March 2017.
“Long-Term Asset Return Study: the Next Financial Crisis,” Deutsche Bank Research, September 2017.
“US Daily: Thoughts on the Potential US Withdrawal from NAFTA,” Goldman Sachs Economic Research.
October 2017.
“Looking behind the declining number of public companies,” Brorsen (Harvard Law). May 2017.
“The Promise of Market Reform: Reigniting America’s Economic Engine,” Nasdaq. 2017.
“Why Vanguard Isn’t Freaking Out About Fewer Public Companies,” Institutional Investor, Nov 2017.

Acronyms
BoE: Bank of England
BoJ: Bank of Japan
CPI: Consumer Price Index
EBIT: earnings before interest and taxes
EBITDA: earnings before interest, taxes, depreciation and amortization
ECB: European Central Bank
ECI: Employment Cost Index
EM: emerging markets
ELMI: emerging local markets index
EMBI: emerging markets bond index
FDI: foreign direct investment
FOMC: Federal Open Market Committee
GBI: global bond index
GBP: Pound Sterling
IFO: IFO Institute
IFRS: International Financial Reporting Standards
IMF: International Monetary Fund
JGB: Japanese Government Bond
M&A: mergers and acquisitions
NAFTA: North American Free Trade Agreement
NFIB: National Federation of Independent Business
OECD: Organization for Economic Co-operation and Development
P&C: property and casualty
P/E: price-to-earnings
PMI: Purchasing Managers’ Index
REER: real effective exchange rate
WTO: World Trade Organization

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E Y E O N T H E M A R K E T  M I C H A E L C E M B A L E ST  J . P . M O R G A N A S SE T M A N A G E M E N T
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
F O R I N S TI TU TI O N A L / W H O L ES A L E/ PRO F ES S I O N A L CL I EN T S A N D Q U A L I F I ED I N V ES TO RS O N L Y –
N O TINSTITUTIONAL/WHOLESALE/PROFESSIONAL
F O R RETA I L U S E O R D I S TRI BU TICLIENTS
ON
Xxxxx xx, 2017
FOR AND QUALIFIED INVESTORS ONLY – NOT FOR RETAIL USE OR DISTRIBUTION

NOT FOR RETAIL DISTRIBUTION: This communication has been prepared exclusively for institutional, wholesale, professional clients
and qualified investors only, as defined by local laws and regulations.

This material is for information purposes only. The views, opinions, estimates and strategies expressed herein constitutes Michael Cembalest’s
judgment based on current market conditions and are subject to change without notice, and may differ from those expressed by other areas of J.P.
Morgan. This information in no way constitutes J.P. Morgan Research and should not be treated as such.

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EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN JANUARY 1, 2018
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MICHAEL CEMBALEST is the Chairman of Market and Investment Strategy for
J.P. Morgan Asset & Wealth Management, a global leader in investment management
and private banking with $1.9 trillion of client assets under management worldwide
(as of September 30, 2017). He is responsible for leading the strategic market and
investment insights across the firm’s Institutional, Funds and Private Banking businesses.

Mr. Cembalest is also a member of the J.P. Morgan Asset & Wealth Management
Investment Committee and a member of the Investment Committee for the J.P. Morgan
Retirement Plan for the firm’s more than 250,000 employees.

Mr. Cembalest was most recently Chief Investment Officer for the firm’s Global Private
Bank, a role he held for eight years. He was previously head of a fixed income division
of Investment Management, with responsibility for high grade, high yield, emerging
markets and municipal bonds.

Before joining Asset Management, Mr. Cembalest served as head strategist for Emerging
Markets Fixed Income at J.P. Morgan Securities. Mr. Cembalest joined J.P. Morgan in 1987
as a member of the firm’s Corporate Finance division.

Mr. Cembalest earned an M.A. from the Columbia School of International and Public
Affairs in 1986 and a B.A. from Tufts University in 1984.

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