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July 11, 2011
Topics: Portfolios, US corporate profits and the Twilight of the Gods (in the US, Europe, China and the IEA)
Here’s what our U.S. Balanced portfolio looks like right now 1 .
This week’s note reviews some of the factors that affect these
allocations: healthy private sector profits, problems left
over from the recession, and interventions by the world’s
legislatures, treasuries, central banks and multilateral
agencies. This latter group reminds me of the ancient Greek
Gods: they are very powerful, but sometimes flawed, as their
interventions in the world did not always work as planned.
We are getting closer to the Twilight of the Gods, a time when
they are either running out of ammunition, or the ability to use
it without causing even more problems. If so, the private
sector will have to recover on its own. The consequence of
these cross-currents: we invest in equities, but hold 10%-15%
less than what we normally would at this point of the business
cycle, and are positioning for a single-digit year on equities.
High Yield,
Leveraged
Loans,
Structured
Credit, 10%
Emerging
Market FX, 5%
Core Bonds,
8%
Inflation, 2% Cash, 3%
Public equity,
36%
JPM US
Balanced
Model Portfolio
Diversified
Hedge Funds,
Private equity,
6%
5%
Real Estate,
Single Strategy
3% Hard Assets,
Hedge Funds,
4%
18%
Source: J.P. Morgan Private Bank, as of July 2011.
These portfolios may not be suitable for all investors & are shown for
illustrative purposes only
PROFITS
The primary (and perhaps sole) justification for carrying the levels of risk shown above relates to corporate profits. As
shown below, profit margins have reached levels not seen in decades. The challenge, which we have discussed many times
before: what is driving these margins 2 ? One useful way to deconstruct profits is to measure them from peak to peak, and
analyze what changed. As shown in the first chart, S&P 500 profit margins increased by ~1.3% from 2000 to 2007. There are a
lot of moving parts in the margin equation, but as shown in the second chart, reductions in wages and benefits explain the
majority of the net improvement in margins. This trend has continued; as we have shown several times over the last two
years, US labor compensation is now at a 50-year low relative to both company sales and US GDP (see EoTM April 26, 2011).
S&P 500 pre-tax margins
Excluding financials, large-cap proxy used before1976
16%
15%
14%
1.3% increase
13%
12%
11%
10%
9%
8%
7%
6%
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Source: Corporate reports, Empirical Research Partners. Past performance
is not indicative of future results.
Labor cost reductions driving the margin expansion
Peak to peak change in margins, 2000-2007, S&P 500 constituents
1.4%
1.2%
1.0%
0.8%
0.6%
0.4%
0.2%
0.0%
Reduction in wages and
benefits as a percentage
of revenue
Source: Standard & Poor's, Empirical Research Partners.
Total increase in
pre-tax margins
Last week’s train wreck of a labor report included the dour news that labor compensation is now firmly negative in real
terms. Why is US labor compensation so low? The lingering excess labor supply from the recession is one reason, but the 2
billion people in Asia joining the global labor force over the last two decades is another. As shown on next page, EM wages for
production workers remain well below US levels 3 . Another factor helping profit margins: increased US imports of intermediate
goods from Asia. As shown in the accompanying chart, imports from Asia have been rising, and over the same time frame,
Asian import prices only increased at around 1% per year.
1 We use these portfolios to manage assets for clients who give us discretion over their funds, and to provide recommendations to those who
don’t. This is one of several model portfolios we manage globally. They differ by jurisdiction, risk tolerance, tax treatment, eligibility to
purchase vehicles designated for qualified purchasers, and other factors.
2 Empirical Research Partners does more work on corporate profits than anyone else we’ve seen. This section draws on research that Mike
Goldstein at Empirical shared with us at a recent investment committee meeting.
3 A recent study from Boston Consulting Group maintains that the gap between China and the US will close in 5 years. BCG believes that
with Chinese wages growing at 15%-20% per year, US wages growing at 3% per year, higher productivity in the US and rising shipping and
inventory costs, the China advantage will disappear within the decade. Some of these assumptions seem aggressive to apply in perpetuity.
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July 11, 2011
Topics: Portfolios, US corporate profits and the Twilight of the Gods (in the US, Europe, China and the IEA)
Hourly compensation for production workers
Share of US rate, 2005 vs. 2011
30%
25%
2005
2011E
Share of US imports of intermediate goods from China,
Malaysia, Thailand and Vietnam, percent
14%
12%
To summarize, we expect today’s margins to last a while longer, since relative costs won’t converge overnight. But we are not
inclined to pay a high multiple for them, given their reliance on weak labor compensation, which in turn requires large
government transfers. The good news: markets are not applying high multiples right now, which is why we own the equities
we do. However, questions about the large but shrinking public sector toolkit knock 10%-15% off of our equity
allocations, compared to where we would normally expect to be 2 years after a recession. We walk through 4 instances
of this below, as it relates to US fiscal policy, oil prices, Chinese inflation and the European periphery.
Twilight of the Gods, part 1: Limited room for fiscal policy to invigorate the US recovery
Here’s what we know for sure about the US Federal debt ceiling debate:
�
�
�
20%
15%
10%
5%
0%
Taiwan Mexico China Philippines
Source: Bureau of Labor Statistics, Empirical Research Partners.
The government is facing the unappealing task of having to increase the Federal debt ceiling above 100% of GDP for the
first time since the end of WWII, and only the second time since the debt ceiling was established in 1917
The government has already run out of money from traditional sources. As shown below, since May 16, 2011, the US
Treasury has been raiding the cash, securities and borrowing capacity of government employee retirement and other funds.
Of $270 billion of such balances which existed in May, around 75% has already been used up. There’s not much leeway
left, which is why the government will probably run out of money some time in August.
The debate about the existing Federal debt is the lesser of two problems. As shown on the following page, the present value
of unfunded entitlement obligations (e.g., future debt) dwarfs the existing debt. That’s why there’s so much talk about a
deal to stabilize the long term trajectory of the budget deficit.
The rest is all speculation. The table on the next page shows the revenue and spending factors in play. It’s too early to know
what kind of deal will be crafted. We believe that the deal with be composed of 80% spending cuts and 20% revenue/tax
increases (rather than 50-50), and will be closer to $2 trillion than $4 trillion. While it’s possible that another dose of fiscal
stimulus will be built into the debt ceiling agreement, it might not be that large, and its impact could easily be offset by a
subdued consumer response due to expectations of higher taxes in the long run (e.g., Ricardian equivalence).
10%
8%
6%
4%
2%
0%
2000 2007 2010
Source: UN Comtrade, Empirical Research Partners.
Statutory debt limit and debt subject to limit
Trillions of gross debt, USD
18
Gross debt/GDP
16
14
12
10
68%
Debt limit
69%
Proposed increase
99%
86%
78%
73%
Debt
87%
109%
8
2006 2007 2008 2009 2010 2011
Source: US Department of the Treasury, J.P. Morgan Securities LLC, J.P.
Morgan Private Bank.
US Treasury: raiding the cookie jar
Billions, USD
300
250
200
150
100
50
Cash,securities
& borrowing
capacity of gov't
employee
retirement and
other funds
(as of May 16)
How much is left
(as of July 8)
0
Source: Stone & McCarthy. Gov't funds include G-Fund, Exchange
Stabilization Fund and Civil Service Retirement and Disability Fund.
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July 11, 2011
Topics: Portfolios, US corporate profits and the Twilight of the Gods (in the US, Europe, China and the IEA)
The existing Federal debt is the lesser of 2 problems
Trillions, USD
100
90
80
70
60
50
40
30
20
Present value of
unfunded
entitlement
obligations
10
Existing debt
0
Source: US Department of the Treasury, J.P. Morgan Private Bank.
Items on the table in discussions to reduce the deficit
Revenue raises
Spending cuts
Carried interest taxed at Discretionary spending cuts
ordinary income rates
Increased taxes on ordinary Changing formulas affecting
income, capital gains and inflation indexation for
qualified dividends
entitlements
"Bracket creep": higher tax Defense spending cuts
brackets applying to lower
incomes more quickly
Phase-out of personal Expenditure caps
exemptions or caps on
itemized deductions
Changes to grantor retained Change in entitlement
annuity trust required terms eligibility requirements
Twilight of the Gods, part 2: Can releases of strategic oil reserves keep oil prices down for more than a few weeks?
International Energy Agency member countries agreed to release strategic petroleum reserves to bring oil prices down. They
have a lot of ammunition to do so; government-controlled oil inventories are at least 1.5 billion barrels, and so far, all they have
done is authorize the release of 60 million barrels. The timeline suggests that oil markets began focusing on the release of the
SPR after the Libyan shutdown, the lack of a sufficient OPEC supply response, and weak economic data in the US. As shown
below, oil prices have been rising since the announcement of the supply increase. Are IEA members committed to doing it
again if oil prices reach their May levels?
Brent oil price and timeline of SPR release
USD/bbl
130
125
120
115
110
105
100
95
90
Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11
Source: Bloomberg.
The problem for the IEA is that the tightness in oil markets
is not just a sudden supply shock. As shown in the bottom
chart we first published in March, there was not much slack
even before the Libyan shutdown, and oil demand is expected
to rise 1-2 mm bpd as the developed and emerging world
continue to grow. One of our colleagues used to work at the
IEA, and in a recent piece 4 , argued that the impact of the SPR
release will be limited to Q3 2011, and that upside oil price
risks to 2012 have increased. Why? The SPR release came at a
time when OPEC tanker traffic made it clear that producing
countries were having problems meeting prior pledges: “As
such, it is difficult to conclude anything except that there is
little or no spare capacity in the oil market”. If that’s the case,
future interventions may not have a lasting impact either.
A
B
C
D E F
G
[A] May 2: Advisors lay out SPR release plan to Obama
[B] May 6: Obama calls Abdullah (S.A.) and Sabah al-Ahmad (Kuw)
to discuss SPR release
[C] May 19: IEA urges OPEC to increase production or else member
nations are prepared to use “all tools” to protect global economy
[D] May 27: Former White House energy advisor predicts IEA SPR
release
[E] June 8: OPEC does not agree on production increase
[F] June 17: Obama authorizes IEA-SPR release feasibility study
[G] June 23: SPR release announced
Post-Libya OPEC spare capacity running out
Millions of barrels per day
6.0
5.0
4.0
3.0
2.0
1.0
0.0
Pre-crisis OPEC
spare capacity
Pre-crisis "real"
OPEC spare
capacity
Source: J.P. Morgan Securities LLC.
Post-crisis "real"
OPEC spare
capacity
2011 additional
global demand
(estimated)
4 “Oil Market Monthly: Living with No Spare Capacity”, Lawrence Eagles, Commodities Research, JP Morgan Chase Bank NA, 7/7/ 2011
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July 11, 2011
Topics: Portfolios, US corporate profits and the Twilight of the Gods (in the US, Europe, China and the IEA)
Twilight of the Gods part 3: Why is everyone assuming that the next Chinese tightening is the last one?
Every time China tightened monetary policy this year, most China research maintained that the tightening cycle is close to its
end. Perhaps; Premier Wen has stated that the country’s efforts to control inflation have worked, that price stability is in an
acceptable range, and that it will drop steadily from here. But last week’s headline inflation release of 6.4% hit a three year
high, and it is not clear to us that China is about to end its various inflation control policy measures.
In favor of Wen’s argument, food inflation has been a large contributor, some of which should be transitory. Blue-ear pig virus
(PRRS) killed hundreds of thousands of pigs in 2010, which affected this year’s supply (2006 was worse). As shown below,
pork prices have soared, but should come down if the supply situation normalizes. [Note: a “Strategic Pork Reserve” can be
released to mitigate price increases]. However, according to the Food and Agriculture Organization 5 , new virulent strains of
the virus have a fatality rate of 20% (even higher for piglets), and what is considered a temporary supply shock may be more
permanent. Chinese pig facilities have the highest animal densities in the world, contributing to the spread of disease to 25 of
China’s 33 provinces. Antibiotics have proven ineffective, and once one pig gets the disease, it tends to spread to the entire
herd in 7-10 days. China has vaccinated 100 million of its 500 million pigs, but existing vaccines do not prevent infection, they
only slow the rate of transmission to other pigs.
8
2006 2007 2008 2009 2010 2011
Source: China Ministry of Commerce.
A separate issue is that China is doing a lot more to control the supply of money than the cost of money. As shown below, there
have been a lot more increases in bank reserve requirements than interest rate increases. Deposit rates are still negative in real
terms, and bank reserve requirements only affect banks, and not the shadow banking system, which is growing in China.
China reserve requirement ratio for large banks
Percent
23%
21%
19%
17%
15%
13%
11%
9%
7%
5%
2005 2006 2007 2008 2009 2010 2011
Source: People's Bank of China.
Chinese wholesale pork price
RMB per kilogram
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Forward-looking manufacturing surveys have declined and interbank lending rates (Shibor) have surged, so it’s clear that the
tightening steps are working. But private sector credit is still growing in China, and real estate prices are still rising. The
bottom line is that the substantial stimulus provided by Chinese and other Asian policymakers in the wake of the
recession has not yet been adequately withdrawn, and that more steps will need to be taken to do so.
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22
20
18
16
14
12
10
Begining of
PRRS outbreak
China one-year deposit rate still negative in real terms
Percent, year on year
10%
8%
6%
4%
2%
0%
Deposit rate
-2%
2005 2006 2007 2008 2009 2010 2011
Source: People's Bank of China, National Bureau of Statistics.
CPI
5 “Porcine reproductive and respiratory syndrome (PRRS) virulence jumps and persistent circulation in Southeast Asia”, Food and
Agriculture Organization Emergency Prevention System, Issue number 5, 2011.
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July 11, 2011
Topics: Portfolios, US corporate profits and the Twilight of the Gods (in the US, Europe, China and the IEA)
Twilight of the Gods, part 4:
Is Europe just trying to save its banking system, or is a more comprehensive move towards Federalism underway?
I expected French proposals on a Greek debt exchange to begin to spell out the sacrifices private sector investors will have to
make as Greece spirals towards insolvency. As shown below, I was wrong about that. French proposals don’t entail any
specific commitments by banks, and are merely non-binding indications of interest by banks to roll over debt at some point in
the future as it matures. If bank rollovers of Greek debt or Greek government asset sales fall short of the mark, the EU and IMF
appear committed to providing Greece with funds to pay off maturing debt anyway. The EU taxpayer continues to foot the bill.
Binding commitments from EU banks to roll over
Greek debt as per French posposal, Euros in billions
This chart intentionally left blank since there are
no binding committments at all
Italy gross debt to GDP
Percent
120%
110%
100%
90%
80%
Little progress on debt
reduction despite 20 years of
primary budget surpluses
70%
60%
Maastricht limit
So to be clear, the Twilight of the Gods has not arrived in Europe, since the EU appears determined to spend more money
to prevent a sovereign default. I see why they are worried about contagion. The latest signs: Portugal downgraded to junk;
long-term debt of 3 French banks put on downgrade watch; and stress in European unsecured interbank markets 6 , now affecting
Italian banks which rely heavily on them. Italian bank and insurance company holdings of their own government bonds is 2x-
3x higher than the rest of the region, creating the potential for a vicious circle if something goes wrong. Italian banks are bettercapitalized
and have higher quality assets than banks in other European countries, since Italy did not experience a large boombust
in residential property, or a consumer debt binge. However, like Greece and Ireland, Italy’s debt/GDP ratio is above 100%,
and the country suffers from low growth (the lowest in the world from 2000-2010 other than Zimbabwe and Haiti, according to
the Economist). Think about this: Italy has run a primary budget surplus (i.e. ex-interest payments) every year since 1992,
but still hasn’t been able to bring its debt ratios below 100% of GDP. Italy was making progress, but the recession derailed
them, leaving Italy with the same elevated debt burden they started with 20 years ago.
I believe that eventually, the constituency of the European Monetary Union will have to change. However, my colleagues in
J.P. Morgan Securities’ economics group disagree. They believe that the EMU will survive intact, and believe that Europe is
moving towards Federalism, with this crisis as the basis for putting it in place. I have been a skeptic of this idea; how can a
region use the structural failures of its current model as an excuse for expanding it, particularly when popular support for
the European project is at such low levels 7 ? The history of Europe does show that revolutions are often imposed from above
(e.g., Peter the Great, Otto von Bismarck, Napoleon) rather than below, so anything is possible. If my colleagues are right,
losses suffered by holders of Greek, Irish and Portuguese debt may be a lot less than what’s priced in right now. I don’t have
the conviction to make that kind of call, at least not yet; geopolitical investing is a very hard thing to do. We remain cautious
on Europe; are underinvested in government debt, corporate credit and equities across the region; and expect a Greek
sovereign debt restructuring within the next 18 months (see chart from “Five Stages of Greece”, June 30, 2011 ).
Michael Cembalest
Chief Investment Officer
50%
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
Source: International Monetary Fund.
6 JP Morgan’s Prime Money Market Fund is indicative of industry concerns about a liquidity squeeze. The fund holds no Greece, Portugal,
Ireland or Spain. Its Italy holdings are less than 2% of the fund, and the portfolio manager does not expect to roll them when they mature.
7 A 2010 Eurobarometer Poll showed very low readings on whether “Membership in the EU is a good thing”. More recently, the centre-left
Foundation for European Progressive Studies polled EU civil servants (a pro-EU constituency if there ever was one) and found that a
majority believe that “the European model has entered into a lasting crisis”. Only a quarter of respondents saw the EU as having evolved
positively over the last decade, or believe that the December 2009 Lisbon Treaty has had a positive effect.
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July 11, 2011
Topics: Portfolios, US corporate profits and the Twilight of the Gods (in the US, Europe, China and the IEA)
The material contained herein is intended as a general market commentary. Opinions expressed herein are those of Michael Cembalest and may differ from those of other J.P.
Morgan employees and affiliates. This information in no way constitutes J.P. Morgan research and should not be treated as such. Further, the views expressed herein may
differ from that contained in J.P. Morgan research reports. The above summary/prices/quotes/statistics have been obtained from sources deemed to be reliable, but we do not
guarantee their accuracy or completeness, any yield referenced is indicative and subject to change. Past performance is not a guarantee of future results. References to the
performance or character of our portfolios generally refer to our Balanced Model Portfolios constructed by J.P. Morgan. It is a proxy for client performance and may not
represent actual transactions or investments in client accounts. The model portfolio can be implemented across brokerage or managed accounts depending on the unique
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