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EYE ON THE MARKET - OUTLOOK 2012 Powered By Docstoc
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 A economia pós-estímulo
 O ano de 2012 marca uma transição de abandono do estímulo monetário e fiscal extremo em nível global, conforme ilustrado
 pelo pôr do sol. Em sua maior parte, a recuperação do setor privado terá de acontecer por conta própria a partir daqui. As
 notícias são melhores nos EUA do que na Europa ou no Japão. A Ásia está em expansão, mas o aperto nas taxas de juros está
 trazendo o crescimento de volta a patamares mais realistas. A altura de cada árvore mostra a recuperação em cada variável
 relativa a sua queda durante a recessão. Mais informações no interior da publicação.

 The post-stimulus economy
 2012 marks a transition away from extreme global monetary and fiscal stimulus, as illustrated by the setting sun. The
 private sector recovery will mostly have to make it on its own from here. The news is better in the US than in Europe
 or Japan. Asia is expanding, but tighter policy rates are bringing growth back to earth. The height of each tree shows
 the recovery in each variable relative to its decline during the recession. See inside cover for more details.
In the wake of the recession, a lot of stimulus was added to the global economy. The level of global policy
rates and fiscal deficits defines the trajectory of the sun. Fiscal tightening is scheduled almost everywhere
for 2012. On monetary policy, while inflation appears to be cresting, this more often prevents planned policy
rate increases, rather than ushering in another period of substantial easing. More monetary policy responses
in Europe are likely, but they are mostly intended to prevent a collapse of the Monetary Union as banks and
governments de-lever.

The height of each tree shows how much each variable has recovered, relative to its prior decline. For example,
S&P profits, high-end retail and German GDP have now recovered almost all of what they lost during the
recession, while US home prices and European peripheral employment are still close to their post-recession
lows. The three comparison points for computing the recovery are the pre-cycle peak; the lowest level of the last
four years; and the current value. One exception: US household balance sheet repair is computed as the decline
in real per household debt from the peak.

Commodity countries like Canada, Brazil and Australia, whose GDP in aggregate is much larger than Southern
Europe, recovered rapidly. The speedboat is Asia, whose production and output suffered only minor declines,
and which have long since eclipsed pre-recession levels. However, credit and policy rate tightening have caused
a slowdown to the Asian speedboat and the rest of the emerging world, compared to the booming growth rates
of 2010. The deflated volleyball is the European Economic and Monetary Union. See sources and definitions at
the end of this publication.
                            MARY CALLAHAN ERDOES
                                 Chief Executive Officer
                            J.P. Morgan Asset Management

As we turn the page and head that new year, it respects indefinable? reflect
How do you summarize a yearinto awas in many is important for us to On one
on the current landscape, and debt crisis, our best thinking on where the world
hand, the European sovereign to give you contracting housing markets and high
is heading.
unemployment weighed heavy on all of our minds. But at the same time, record
corporate profits and strong emerging markets growth left reason for optimism.
The past twelve months were filled with unprecedented events. We witnessed
Arab Spring uprisings and subsequent governmental changes, a devastating
So rather than look back, we’d like to look ahead. Because if there’s one thing that
earthquake and tsunami in few years, it’s ever downgrade of U.S. debt, a
we’ve learned from the pastJapan, the first that while we can’t predict the future,
continuously evolving European sovereign
we can certainly help you prepare for it. debt crisis, and the formal conclusion
of a near decade-long conflict in Iraq.
To help guide you in the coming year, our Chief Investment Officer Michael
Amidst such transformational events around the world, we recognize that
Cembalest has spent the past several months working with our investmentour job
of sifting through all of this and finding appropriate investment opportunities
leadership across Asset Management worldwide to build a comprehensive view
for the future is even more important. Our Chief Investment Officer potentially
of the macroeconomic landscape. In doing so, we’ve uncovered someMichael
Cembalest, in partnership with our investment teams across the world, has
exciting investment opportunities, as well as some areas where we see reason to
created with caution.
proceedan insightful framework for understanding and assessing the global
opportunities and risks that we can expect in the coming year.
Sharing these perspectives and opportunities is part of our deep commitment to
I hope you enjoy focus on cover picture day. We are grateful for your continued
you and what we the clevereach and everyMichael commissioned to capture
on one page the progress look forward made (or lack thereof) 2011.
trust and confidence, and that has been to working with you insince the global
recession of 2008–2009.
Most sincerely,
We wish you a healthy and happy new year. And most importantly, we thank you
for your continued trust and confidence in J.P. Morgan.

Most sincerely,
  Eye on the Market | OUTLOOK 2012
                                                      January 1, 2012
2012 Outlook
The Post-Stimulus Economy isn’t all bad (there are as many tall trees on the cover as short ones), but its risks and uncertainties
have not declined that much from a year ago. One historical frame of reference we have been using is shown in the first chart: a
prior period of monetary and fiscal uncertainty during which markets were volatile, and sideways. The bull market began in
1982 when there was a clear path forward, even though a lot of the prior mess hadn’t been completely dealt with. Where are we
this time in terms of monetary and fiscal uncertainty? While fiscal deficits are being reined in and household balance sheets are
healing, the long-term debt questions of the West remain mostly unanswered as of December 2011 (c2, c3).
 (c1) 1970s post-recovery equity                    (c2) OECD debt levels                                     (c3) OECD budget deficits
 market wilderness                                  Percent of GDP, gross                                     Percent of GDP
 S&P 500 level            Germany DAX level         110%                                                      46%
 180              Period of extreme           800   100%                                                                  Public expenditure
 160             monetary and fiscal
                     uncertainty              700        90%                                                  42%
                                                         80%                                                  40%
 120                                          600
                                                         70%                                                  38%
                                              500        60%                                                  36%
  80                                                                                                                                  Public revenues
  60                     Bull market                     50%                                                  34%
                              begins          400
  40                                                     40%                                                  32%
  20                                          300        30%                                                  30%
    1972 1974 1976 1978 1980 1982                           1970 1976 1982 1988 1994 2000 2006 2012              1970 1976 1982 1988 1994 2000 2006 2012

With fiscal stimulus coming to an end and with only modest monetary policy easing in the pipeline (see inside cover for more
details), the private sector will increasingly have to make it on its own. The US is showing some resilience (c4), while
Europe and Asia are showing more signs of a slowdown. The big issue for 2012 will be how deep the European recession turns
out to be. Prior sovereign debt crises were almost always solved by a combination of currency devaluation, higher growth and
aggressive monetary easing (c5). In contrast, Europe is taking the path of most resistance: no growth, no devaluation, lots of
austerity and the decision to turn the ECB into a Bad Bank repository.
 (c4) Global manufacturing surveys                  (c5) Fiscal adjustments, then & now                       (c6) Real S&P 500 earnings yield
 Purchasing Managers Index, sa                                                                     Prior      Trailing earnings yield less core CPI
                                                                    4.0%                         European      8%
 65                               US                                                                                                    As of
                                                                                                 and Latin     7%
 60                                                                 3.5%                        adjustments                             12/16/11
                                                    GDP Growth, %

                                                                                                 1975-2000     6%
 55              Asia                                               3.0%                                       5%
                                                                    2.5%                                       4%
 45                                                                 2.0%                                       2%
                                  Euro area                                 Europe
 40                                                                 1.5%                                       1%
 35                                                                 1.0%                                                            Assuming a 15%
                                                                                Currency Devaluation, %                           decline in earnings
 30                                                                 0.5%                                      -2%
  2007    2008    2009     2010        2011                                5%    35%      65%        95%         1956 1965 1974 1983 1992 2001 2010

Equity markets are aware of this, priced as cheaply as they have been in decades (c6). Even assuming a 15% earnings
decline*, the S&P 500 would still be priced at the cheap end of history. Factoring in valuation, volatility and the risks (both
known and unknown), our equity weightings are modestly lower than normal; the US is our largest regional position, and we
remain very underweight Europe. In this document, we walk through our views on Europe, the US and Asia, and our
investment priorities for 2012. It’s a narrative in pictures; when many things are at their widest extremes in decades (equity
valuations, government debt, central bank balance sheets, depressed labor incomes, housing inventory, etc.), pictures are better
than words. In the appendix, some thoughts on Iran, and a history of European austerity and its connection to social unrest.
On the December EU summit. The European debt bubble will be unwound more slowly given the decision by the ECB and
member central banks to finance just about every asset held by EU banks. Bilateral lending facilities for sovereigns may also be
expanded if necessary. The risk of a 2012 Europe meltdown may have melted, but what remains is a slow burn from a
recession, a credit contraction and investors possibly selling all they’ve got to the ECB and other non-economic buyers.
Michael Cembalest
Chief Investment Officer
 * In Q4 2011, the percent of negative S&P 500 earnings pre-announcements matched its 2001 and 2008 peak. Another sign:
companies reporting before Alcoa beat consensus earnings for the last 9 quarters, while in Q4, they trailed estimates by 2%.
     Eye on the Market | OUTLOOK 2012
                                        January 1, 2012
2012 Outlook
EUROPE: soul-searching into a recession
A year ago, we noted that Jacques Delors (a principal architect of the Euro) said that Europe needed “to find its soul”. As of the
time of this writing, they are still looking for it. In Delors’ latest interview, he conceded that the Euro was flawed from the start.
One of our most frequently used charts (c7) shows how: look at the gap in industrial production between Germany and Italy,
which began like clockwork with the European Monetary Union. In prior notes, we highlighted how European North-South
disparities in growth and employment have never been larger than they are now, even during the era of frequent devaluation and
inflation in Southern Europe. A project designed to foster integration has ended up jeopardizing it.
    (c7) Death in Venice                          (c8) Sovereign 10-year yields                 (c9) Maturing debt, interest due and
    Industrial Production Index, 1998 = 100, sa   Percent                                       primary deficits in 2012, Percent of GDP
140                                               7.5%                                          30%        Maturing debt and interest
                                 Germany                                                Italy
                                                                           Belgium                         Primary deficit
130                                                                                             25%                        €327bn
              Euro exchange
120                                                                    Spain                    20%                                               €203bn
                   rate fixed                                                                              €355bn
110                                               5.5%
100                                               4.5%
                                         Italy    3.5%
    80                                                                                           5%
    70                                       2.5%                                                0%
     1982 1986 1990 1994 1998 2002 2006 2010    Jan-10 Jun-10 Nov-10 Apr-11 Sep-11                          France                Italy              Spain

I will avoid the endless diagnoses of the problems, and skip to the endgame: a mid-flight redesign of the Euro since markets
have lost confidence in it (c8). While Greece, Ireland and Portugal are wards of the state, 2012 borrowing needs of larger
countries are in question as well (c9). In Q1 2012 alone, Italy must issue 112 billion in bills and bonds. The ECB balance sheet
(c10) may have to grow by 1 trillion to support sovereigns (c11) and under-capitalized, under-reserved banks (c12, c13), despite
opposition from Germany1. This is not just a sovereign/banking crisis, as noted by the rise in corporate debt, particularly in
Spain and Portugal (c14). Chart c5 shows that external devaluation is the road typically taken. Europe is taking the internal
devaluation route, but so far, Ireland is the only country that has made progress (c15). As for Ireland, we’d be more optimistic if
it weren’t for a crippling 140% debt to GNP ratio, a consequence of its decision to bail out EU depositors in Irish banks.
    (c10) Central bank balance sheets              (c11) Italian debt/GDP, Total gross           (c12) Europe: bigger banks, bigger
    Percent of GDP                                 general government debt/GDP, percent          problems, Liabilities, multiple of GDP
                                                  160%                                          7x
    35%               ECB plus €1 trillion                  WW I
                                                  140%                          WW II           6x         Foreign banks
    30%                                                                                                    Domestic banks
                                Japan             120%                                          5x
                                         ECB      100%                                          4x
    20%                                                                                         3x
    15%                                                                                         2x
                               US                  60%
                                            UK                                                  1x
    10%                                            40%
    5%                                             20%






      2007     2008    2009     2010     2011         1861 1886 1911 1936 1961 1986 2011                                                                       IRL
    (c13) Loan loss provisions on                 (c14) Change in non-financial corp.           (c15) Long road to convergence
    performing credit loans, Percent              debt from 2000-2010, Percent of GDP           Unit labor cost, index, Q1 2000 = 100, sa
    5%                                            60%                                           140
                                                                                                135                                   Ireland        Spain
    4%                                            40%                                           130
    3%                                                                                          120
                                                  20%                                                                                            France
    2%                                            10%                                           110
                                                   0%                                           105
    1%                                            -10%                                          100
                                                  -20%                                           95                                             Germany









         US banks             EU banks
                                                                                                   2000      2002      2004        2006         2009      2011

    The boy stamping his feet in the ECB chart is from Die Geschichte vom Suppen-Kaspar (Struwwelpeter).
     Eye on the Market | OUTLOOK 2012
                                              January 1, 2012
2012 Outlook
The irony of Italy in the eye of the storm is that since 1991, its primary budget has been in surplus (c16). However, Italy has no
choice given its debt burden of 1.9 trillion Euros (c11), a by-product of its 1980’s fiscal crises. Italy has paid a price for this
austerity (and its low productivity), generating almost the lowest growth rate in the OECD over the last 20 years, ahead of only
Japan (c17). It’s going to take a lot of work to convince markets that Italy is solvent, and that its debt is declining. We don’t
think it is: c18 shows an optimistic and pessimistic case, although neither represents possible extremes. We assume near-term
funding costs of ~6%, which as Italian debt matures, bring its overall average cost of debt from 3.9% to 4.4% by 2014.
    (c16) Italian primary balance                    (c17) 20-year growth rates, 1991-2011         (c18) Can Italy's debt stabilize?
    Surplus/deficit before interest, % of GDP        Percent                                       Government debt, percent of GDP
    8%                                                7%                                           134%
    6%                                                                                                        
                      Cyclically                      6%
                                                                                                   131%       
    4%                adjusted                        5%                                                      
    2%                                                                                             128%       
    0%                                                                                             125%
    -2%                               As reported                                          Italy
                                                      2%                                           122%
    -4%                                                                                                                 
                                                      1%                                           119%                  
                                                      0%                                                                
    -8%                                                                                            116%













       1970 1977 1984 1991 1998 2005 2012                                                              2009    2010    2011    2012     2013     2014

Will Maastricht 2.0 “work”, promising deficit limits that turn Italy and Spain into a Mediterranean Germany?
• Germany’s long-term plan appears to be: a heavy dose of austerity to reduce sovereign debt trajectories; commitments to run
   German fiscal policy; a Franco-German governance framework to enforce it; after all of that, a lot more help from the ECB; a
   lower Euro; and then, eventually, some kind of federalism (Eurobonds or other quasi-permanent transfers).
• It’s a risky strategy given the risk of a prolonged recession, superimposed on a region with 20 trillion in sovereign and
   financial sector debt outstanding (c19). Spain’s economy, for example, is in free fall. See Appendix A for charts on how bad
   things are in Spain, and a history of austerity and unrest in Europe over the last century.
• It’s not clear that the only difference between Germany and Italy/Spain is a slate of structural reforms. Even if reforms are
   put in motion, they have a short-term growth cost, particularly when applied to labor markets (c20). So far, Italy’s proposed
   adjustment is based more on higher taxes than lower spending; there has been less of a focus on addressing Italy’s yawning
   productivity gaps vs. Germany, which are also noticeable in France (c21). On the matter of France, it is difficult to believe that it
   will live by a 0.5% structural budget deficit limit; as shown a couple of weeks ago, it flies in the face of French budgetary history.
• Investors are unconvinced: in 2011, US money market funds cut exposure to EU banks in half, and dollar bond issuance by EU
   banks fell by 70%. Stress tests applied to EU banks, whose gross leverage is 26:1, are seen by many investors as unrealistic (e.g.,
   the latest round stressed sovereign debt, but not household or corporate debt). As the EFSF, the IMF and other non-economic
   buyers increase exposure, private investors may see this as an opportunity to exit (see Appendix C for some history).
• Europe will try to finance budget deficits through the use of bilateral and ECB facilities. But they don’t address the region’s large
   current account deficits which finance domestic consumption, particularly in France, Italy and Spain.
• A lot of master plans look good on paper; so did Maastricht 1.0. Our sense is that Germany and other AAA countries will not
   be able or willing to bear the ultimate cost2. If so, Mr. Delors will have to look for Europe’s soul someplace other than Berlin.
    (c19) Outstanding debt in Euro Area              (c20) Growth response to structural           (c21) Vive la difference!
    Trillions, EUR                                   reforms, Cumulative percent change in         Real exports, France as a percent of Germany
    14.0                 Financial                   real GDP per capita                           64%
                       corporations                   5%
                                                                        Trade Reform
                                                      3%       Tax Reform
                                        General       2%                                           54%
     9.5                              government      1%
                                                      0%                                           49%
     8.0                                                                            Financial
     6.5                                             -2%                             Reform        44%
                                                                         Labor Reform
     5.0                                                   0         3           6   9       12    39%
        2001   2003     2005   2007    2009   2011                         Years                      1970    1978    1986    1994    2002     2010

 Debt to GDP levels in France (85%) and Germany (81%) are already elevated. Based on estimates of growth and gov’t deficits, the
German ratio is projected to decline, while the French one peaks at 87% in 2014. After including pro rata shares of existing and future
bilateral guarantees, assumed guarantees of Central Bank SMP purchases and risk of deficit slippage, both ratios rise well over 90%.
     Eye on the Market | OUTLOOK 2012
                                               January 1, 2012
2012 Outlook
UNITED STATES: some decoupling from Europe and Asia, and the kindness of strangers
The US has generated better than expected news recently, including surveys of manufacturing (c22), light truck sales, consumer
spending, etc. Household balance sheets continue to heal, noted by the decline in credit card delinquency rates (c23). But the
strong spending data is a bit of a mystery. Some of it can be explained by the decline in debt service (rather than debt levels;
c24). But housing isn’t contributing much of a boost, given negative pricing trends and massive shadow inventory (c25).
There’s also the question of how much spending can rise when disposable income is weak (c26); the income measure below
includes government transfers, and would look much weaker without them (c57 vs. c58). Perhaps the fact that the wealthiest
10% account for 30%-40% of spending explains its resilience. It looks like parts of the labor market are recovering (c27); if job
losses in construction, government and finance stop getting worse, the jobs picture would look much better. Labor incomes are
at multi-decade lows relative to corporate sales and GDP, but prospects for the large number of unemployed may be getting
better on the margin, based on jobless claims, manpower surveys, the household survey, and a survey of small business (NFIB).
 (c22) Some better news from                          (c23) Credit card delinquencies                          (c24) Household debt and debt
 manufacturing surveys, Index, sa                     Percent, 90+ days delinquent                             service, Percent of disposable income
70                                                   3.5%                                                      140%                                        14.0%
                            New orders                                                                         130%                                        13.5%
60                                                   3.0%                                                                   Debt service
                                                                                                               120%           (RHS)                        13.0%
50                                                                                                             110%
                                                     2.5%                                                                                                  12.5%
                                          Total                                                                100%
40                                                                                                                                                         12.0%
                                                     2.0%                                                       90%
                                                                                                                                           Household       11.5%
30                                                   1.5%                                                                                  debt (LHS)
                                                                                                                70%                                        11.0%
20                                                   1.0%                                                       60%                                        10.5%
  2001     2003    2005     2007    2009    2011         2006      2007         2008   2009    2010    2011        1980          1990      2000     2010

 (c25) Shadow housing inventory                      (c26) Spending vs. income                                 (c27) Bipolar labor market
 Millions of units                                   Percent change, QoQ, real, annualized, sa                 Millions
 9           Current but underwater                                                                           39                                               100
 8                                                    10%                                     Consumption             Construction +
        Bank-owned real estate                                                                                                                                 99
                                                                                                              38      government +
 7                                                                                                                                                             98
              Foreclosed                                  6%                                                          finance (LHS)
 6                                                                                                            37                                               97
 5      90+ days                                          2%                                                                                                   96
        delinquent                                                                                            36
 4                                                                                                                                                             95
 3                                                    -2%                                                     35                                               94
 2                                                                                                                                                             93
                      Existing                        -6%              Disposable income,                     34      Total excluding construction +
 1                                                                                                                                                             92
                                                                       including govt. transfers                      government + finance (RHS)
 0                                                   -10%                                                     33                                               91
 2003      2005      2007      2009        2011          1990      1994     1998       2002   2006    2010     1998       2001     2004    2007    2010

This year’s 8% jump in capital spending (c28) was not a surprise. Since 2009 was the first year since 1932 in which the net
capital stock declined (c29), the rise was catch-up for a period of underinvestment. We have seen conflicting surveys regarding
capex intentions for 2012, with some higher (Citi) and some lower (ISM). We expect a positive contribution from the business
sector in 2012, and an economy-wide growth rate of ~2.25%. Commercial and industrial loan growth has been rising (c30),
offsetting continued weakness in residential loan demand, which supports some optimism on business spending for next year.
 (c28) Capital spending recovery                    (c29) Capital stock                                       (c30) C&I loan growth
 Billions of 2005 USD                               Percent change, YoY                                       Percent change, YoY
12                                                  10%                                                   25%
                                                                                     Estimate for 2011    20%
11                                                                                                        15%
                                                    6%                                                    10%
10                                                  4%
                                                    2%                                                    -5%
 9                                                                                                       -10%
 8                                                  -2%                                                  -20%
 2003       2005      2007         2009      2011         '50    '60      '70      '80   '90   '00   '10     2007         2008      2009    2010    2011

  Eye on the Market | OUTLOOK 2012
                                            January 1, 2012
2012 Outlook
The elephant in the room: US government debt
The failure of the Super Committee to agree to a deficit reduction plan cannot be dismissed by saying, “at least they will have
mandatory sequestered cuts instead”. The Super Committee was supposed to be the beginning of a process, not the end. If it
ends here, the government debt burden is not stabilized (c31), and another $5 trillion in deficit reduction over 10 years would
still be needed to reach the sustainable debt levels projected in the latest CBO estimate. The problem: almost all government
revenues are already spoken for through mandatory programs or interest (c32), and the 2012 budget deficit is still projected at
6%-8%. As a result, there is not that much “fiscal democracy” left, as described by Eugene Steuerle of Brookings, leaving most
members of Congress with little to do but fight over the scraps that remain. US gross debt to GDP passed 100% for only the
second time in its history last month (c33). The last time this happened, the US was fighting a two-front war and preparing a
land invasion of Japan (“Operation Downfall”). As Walt Kelly’s Pogo once said, “We have met the enemy, and he is us”.
An extension of the payroll tax cut that is not fully funded reduces the austerity burden next year (c34), and leaves the Federal
debt issue to be dealt with in the future. So far, the US Treasury has survived based on the kindness of strangers: foreign
central banks increasing their holdings (c35), and purchases by the Fed (c36). It pays to be the world’s reserve currency (c37),
which is helping prevent the kind of market revolt that sent European debt markets reeling. However, with the backdrop below,
I am reminded of the following remark from late MIT economist Rudiger Dornbusch: “Crisis takes a much longer time coming
than you think, and then it happens much faster than you would have thought.”

 (c31) Long-term debt scenarios                     (c32) Percent of gov't. revenue not                (c33) The US reaches its Pogo
 Net debt to GDP, percent                           committed to mandatory spending                    moment, Gross debt to GDP, percent
 110%                                               70%                                                120%
 100%              CBO June Alternative case        60%
                                                                                                       100%                                100%
  90%                                               50%
      Budget Control Act Phases 1 & 2                                                                  80%
  80%                                               40%
                            $5 trillion
  70%                              gap              30%                                                60%
  60%                                               20%
  50%                                               10%
                      CBO August Baseline                                                              20%
  40%                                                0%
  30%                                               -10%                                                 0%
     2004 2007 2010 2013 2016 2019                      1962 1971 1980 1989 1998 2007 2016                 1900   1922   1944     1966   1988    2010
 (c34) Fiscal adj. in 2012, Change in               (c35) Foreign holdings of US debt                  (c36) Fed holdings of US debt
 cyclically-adjusted fiscal deficit, % of GDP       Percent of total net debt outstanding              Percent of total net debt outstanding
 4%                                                 35%                                                18%
                                Fiscal tightening
 3%                                                                Official sector
                                                    30%                                                16%
 1%                                                 25%                                                14%
                                                    20%                                                12%
-2%                                                 15%                                                10%
            Assuming payroll tax cuts
            & unemployment insurance                10%                        Private sector          8%
-4%         benefits are extended
-5%                        Fiscal easing             5%                                                6%
   1963 1971 1979 1987 1995 2003 2011                  1994      1998      2002      2006   2010         1994     1998     2002     2006       2010

 (c37) Reserve currency status does                 (c38) Quarterly state tax revenue
 not last forever                                   growth, Percent change, YoY                         Some good news for municipal bond
                                                    18                                                  buyers: state tax revenues have picked
      US                                            14                                                  up after some tax rate increases, and
                                                    10                                                  states have also been shrinking their
                                                     6                                                  payrolls and capex plans to balance
 France                                              2                                                  budgets. This has a broader economic
 Netherl                                             -2                                                 cost, but in isolation, supports the
                                                     -6                                                 credit risk of many state and local
  Spain                                             -10                                                 issuers, particularly general obligation
Portugal                                            -14                                                 and essential service revenue bonds.
                             Year                   -18
            1400      1575   1750   1925    2100      1999          2003          2007          2011

  Eye on the Market | OUTLOOK 2012
                                       January 1, 2012
2012 Outlook
ASIA: finding out what growth looks like without all the stimulus
2011 should have been a good year for Asian financial assets; after all, Asia generated the best combination of real GDP growth
and corporate profits growth of the three major regions (c39). We had positioned for this, but were not rewarded for it, as Asian
equities underperformed. The first problem: Asia over-stimulated, bringing policy rates net of headline inflation to zero. While
the recovery in GDP growth was V-shaped, it also brought with it much higher inflation (c40). Blunt policy measures were then
needed to rein it in. China is one illustrative example: money supply growth had to fall by more than half (from 30% to 13%) in
order to bring inflation under control (c41). The good news is that inflation is now in retreat, with the latest reading close to 4%.
The rate of Chinese RMB appreciation will probably slow, as it did from July 2008 to July 2010 when growth slowed down.
 (c39) 2011 real GDP and earnings               (c40) Asia over-stimulated                          (c41) Chinese inflation comes down as
 growth, Percent change, YoY                    Percent change, YoY                                 money supply tightens
 16%                                             11%        Real GDP                           8% %, YoY, lagging 6 months            %, YoY
 14%                                             10%         (LHS)                             7% 30%                                       10%
                                                  9%                                           6%                                           8%
 12%                                                                                                                    (RHS)
                                                  8%                                                25%
 10%             Asia ex.                                                                      5%                                           6%
  8%              Japan                                                                        4%           M2
          Dev.                                    6%                                                20%   (LHS)                             4%
  6%      Europe                                                                               3%
                                                  5%                                                                                        2%
  4%                                              4%              Headline CPI                 2% 15%
          US                                                        (RHS)                      1%                                           0%
  0%                                              2%                                           0% 10%                              -2%
            Real GDP            Earnings            2001   2003    2005   2007   2009   2011         1998 2000 2003 2006 2009 2011

The second problem is European bank deleveraging, which runs the risk of a credit contraction in Asia, as the region was the
primary beneficiary of the expansion in EU and UK bank balance sheets (c42). While organic growth in Asia is real, in places
like China, growth has become more reliant on more and more credit (c43). The impact of monetary tightening, credit
tightening and slower growth in Europe can be seen in the decline in Chinese exports and manufacturing surveys (c44).
 (c42) Bankenstein's Monster                    (c43) Heavy reliance on credit, China's             (c44) Chinese exports & manufacturing
 Billions, USD                                  society-wide credit as % of nominal GDP             survey, Percent change, YoY   Index, sa
1,000                                            240%                                    60%                             PMI                    58
  900    European                                220%                                    50%
                                                                                                 (LHS)                  (RHS)                   56
  800 bank claims                                                                        40%                                                    54
        on Asia ex.                              200%                                    30%
  700                                                                                                                                           52
          Japan                                  180%                                    20%
  500                                            160%                                                                                           48
                    US bank claims on                                                     0%
  400                                                                                                                                           46
                      Asia ex. Japan             140%                                   -10%
  300                                                                                   -20%                                                    44
  200                                            120%                                                                                           42
  100                                            100%                                   -40%                                                    40
     2005 2006 2007 2008 2009 2010 2011              2002 2003 2005 2006 2008 2009 2011     2005     2007                2009      2011

We are still optimistic on the region for the long haul. Consumer spending in China is growing at a rapid pace: pay attention to
growth rates in spending, rather than its share of GDP (c45). The region has been running current account surpluses for years,
reducing sensitivity to external shocks (c46). Reduced financing from Europe will be felt, but can be made up by domestic
sources given high saving rates. We expect 2012 to be an improvement over 2011, even at lower projected growth rates (c47).
 (c45) Chinese consumer: watch the              (c46) Asia's current account balance                (c47) Asia ex. Japan real GDP growth
 level, not the share, % of GDP  Yuan           Percent of GDP                                      rates, Percent change, YoY
 50%                                   13,300   6%                                                  11%                             IMF
                     Annual retail
                    sales per capita                                                                10%            Historical       forecast
 47%                                   11,300
                        (RHS)                   4%                                                   9%
 44%                                   9,300                                                         8%
                                                                            Asia ex.                 7%
 41%      Household                    7,300    2%
       consumption/GDP                                                    China/Japan                6%
 38%        (LHS)                      5,300                                                         5%
                                                0%                                                                              forecast
 35%                                   3,300
 32%                                   1,300    -2%                                                  2%
    1993 1996 1999 2002 2005 2008                  1990 1993 1996 1999 2002 2005 2008 2011             1994 1997 2000 2003 2005 2008 2011

     Eye on the Market | OUTLOOK 2012
                                              January 1, 2012
2012 Outlook
Concerns about the world’s imbalances have resulted in more idle cash than I have seen in 25 years. The first 3 charts below
look at some of it, parked in US commercial bank retail deposit accounts, central bank and sovereign wealth funds, and
corporate balance sheets. A related example: $700 billion in unspent leveraged buyout, real estate and venture capital
commitments as of Q3 2011. Measures of short interest and market sentiment also show extreme levels of pessimism. Putting
some investment capital to work today seems reasonable; the investments described below are where we are focusing in 2012.
On a portfolio basis, our equity weightings are below normal, for all the reasons explained in the prior sections.
 (c48) US commercial bank excess                    (c49) Foreign exchange reserves                            (c50) US corporate cash balances
 deposits, Trillions, USD                           Trillions, USD                                             Cash and equivalents / tangible assets
 9                                                                                                             14%
 8                                                   7                    Emerging Markets
                                                     5                                                         10%
 6                                                   4
                                                     3                                                            8%
 5                                                                                Japan
 4                                                                                                                6%
 3                                                   0                                                            4%
  2000   2002    2004   2006   2008   2010               '70        '80     '90           '00       '10             1952 1960 1968 1976 1984 1992 2000 2008

Multinational equities, technology and equity income funds
The grids below show characteristics of select global and European multinational stocks. These companies have dividend yields
of 3%-5%, valuations at 10-11x 2012 earnings, and international revenue exposure. There are a lot of ways to gain exposure to
these companies, which we think should comprise a large part of any 2012 equity portfolio. On technology, the sector no longer
trades at any premium to the broad market. While growth expectations have come down in a world of deleveraging, the pricing
of technology stocks might be one of the cheapest options on a better outcome (c53). Stock selection is critical: over the last 4
years, return differentials between individual stocks have been greater in technology than healthcare, materials and financials.
(c51) Global Multinationals                    (c52) Oversold European Multinationals                     (c53) Forward P/E of S&P 500 and
Average characteristics                        Average characteristics                                    S&P 500 Tech Index, Multiples
Market Cap ($bn)                  131.5        Market Cap ($bn)                        93.3                                 S&P 500 Tech Index
Forward P/E                       11.0x        Forward P/E                             9.8x
Dividend Yield                    3.2%         Dividend Yield                          4.8%
Historical P/E                    13.7x        Return on Equity                        29%
% from 52-Week High               -13%         Net Debt to EBITDA                      0.7
% of Revenue Exposure                          % of Revenue Exposure                                                   S&P 500
                                  69%                                                  51%                10
outside Home Country                           outside Europe                                              1995     1998    2001   2004   2007   2010

Another part of our equity portfolio includes equity income funds. Dividend stocks have to be chosen carefully, since their P/Es
are high relative to history, particularly in the US utility and consumer staples sectors. The scope for dividend increases is rising
given corporate cash balances (c54). One preferred strategy focuses on companies with high dividend yields, but low dividend
payout ratios (c55); these companies have outperformed, perhaps due to the ability to reinvest in their core businesses.
 (c54) Scope for dividend increases                 (c55) Companies that can afford high
 Percent                                            dividends outperform, Total return
 70%                                          13%
                   Cash to tangible           12% 350%               High dividend
 60%                assets (RHS)              11%                  yield, low payout
                                                    250%                                   S&P 500
 50%                                          10%
 40%                                          8%
                                              7%    50%                      High dividend yield,
 30%                                                                            high payout
                 Payout ratio (LHS)
 20%                                          5%    -50%
    1988 1992 1996 2000 2004 2008                       1990       1994   1998     2002      2006    2010

          Eye on the Market | OUTLOOK 2012
                                                                              January 1, 2012
2012 Outlook
Equity valuations: low and likely to stay that way in 2012
Valuation multiples have fallen sharply from their historical averages (c56), on both a price-to-book and price-to-earnings basis.
However, we are not optimistic about multiple expansion until the imbalances of this cycle are reduced. One example of why:
consider where profitability has come from in the US. In contrast to prior cycles (c57), current cycle profits have been boosted
by very low labor compensation (c58). Given the fiscal, social and political issues this creates, it’s hard to pay a very high
multiple for this kind of profits boom. A resolution of the US long-term budget deficit would be very bullish for P/E multiples.
    (c56) The men who fell to earth                                               (c57) Past 5 recoveries                                                                                                                   (c58) Current recovery
    P/E and P/B ratios vs. long-term averages                                     Billions of 2005 USD                                                                                                                      Billions of 2005 USD
                           16x                                                    900                                                                                                                                        900
                                                                                                                                                                                   Sales                                                                                   Profits
    Price to forward earnings

                                                                                  700                                                                                                                                        700
                           14x                HK
                                                                                                                                                                            Labor                                            500                                             Sales
                                                                                  500                                                                                 compensation
                           12x                                                                                                                                                                                               300
                                      JPN                      US                 300
                                              AU                                                                                                                                                                             100
                           10x                UK                  LT average                                                                                                                   Profits
                                       FR                                         100                                                                                                                                                                    Labor compensation
                                           KOR                    Current                                                                                                                                                   -100
                                       SP GER    CHN
                                8x                                                -100                                                                                                                                      -300
                                     0.8       1.3       1.8      2.3       2.8          0           1            2            3          4          5          6         7        8            9 10 11                            0    1   2    3   4    5    6   7   8   9 10 11
                                              Price to book value                                            Quarters since trough                                                                                                          Quarters since trough
Europe: no appetite yet for a contrarian call, and looking for bank loan sales instead
A warning to skeptics like us: markets are underweight Europe, valuations are low (particularly banks, c59), and the larger
toolkit announced at the EU summit will slow the rate of deleveraging. However, our view is that while buying equities and
credit in the middle of a recession has proved fruitful for forward-looking investors (see October 21, 2009 EoTM for more
details), investing at the beginning of a recession rarely is. Secondly, while European bank valuations are low, they are not that
different from levels reached in prior banking crises (c60). A contrarian call for 2012 would be an overweight to European
equities. This is not a call we are ready to make (yet), and remain underweight Europe, and overweight the US.
Here’s what we are focused on instead: purchases of loans from deleveraging European banks, which rely way more on volatile,
wholesale funding3 than their counterparts in the US or Japan (c61). Here are some recent transactions from our managers:
•                               Spain: performing consumer loans at a discount of 50%
•                               Netherlands: 7,200 performing consumer loans at 64 cents on the Euro, sold by a failing bank
•                               2 billion Euros in non-performing commercial mortgage loans in the UK, Germany and 6 other countries at a 58% discount
•                               UK: performing residential mortgage loans at a 36% discount to par
    (c59) European banks                                                          (c60) How bad can banks get in a                                                                                                           (c61) G-3 banking sector loan to
    Price-to-book ratio, Eurostoxx Banks Index                                    crisis? Trough price to tangible book                                                                                                      deposit ratios
2.1                                                                               1.0                                                                                                                                       1.8
1.9                                                                               0.8                                                                                                                                       1.6
1.7                                                                                                                                                                                                                                                           Median
                                                                                  0.6                                                                                                                                       1.4
1.5                                                                                                                                                                                                                                                           Weighted average
1.3                                                                                                                                                                                                                         1.2
1.1                                                                               0.2
0.9                                                                               0.0
                                                                                                                      Thailand '97
                                                                                                                                     Finland '91


                                                                                                                                                                                       Malaysia '97
                                                                                         Korea '97

                                                                                                                                                   Europe '09

                                                                                                                                                                                                      Norway '87
                                                                                                     Sweden '91

                                                                                                                                                                          US '09

                                                                                                                                                                                                                   US '89

0.5                                                                                                                                                                                                                         0.6
0.3                                                                                                                                                                                                                                    Western                US            Japan
  2007                                     2008    2009    2010      2011                                                                                                                                                              Europe

To be clear, we do not have a view on when/if the constituency of the Eurozone might change. It is not clear that
anyone would have enough inside knowledge of Germany’s real breaking point to know; or even if Germany itself has
figured this out. Nor do we have a very strong view on the bilateral $-Euro pair for 2012. Our concerns are focused on
European equities and sovereign credit, which we believe may suffer more underperformance vs. other regions.

 A recent Bridgewater Associates report estimated that European banks own around $4 trillion in dollar-denominated assets, and that
90% of these assets are funded on a wholesale basis (compared to their domestic Euro-denominated assets, which are funded 30% with
wholesale money). While the Fed recently lowered the cost of a dollar liquidity facility made available to EU banks, eventually, many
of these assets will probably migrate to other private sector owners.
  Eye on the Market | OUTLOOK 2012
                                       January 1, 2012
2012 Outlook
Private mezzanine debt, US high yield and leveraged loans
Investment grade and high yield spreads rallied sharply from 2009 to 2011. However, these spreads masked the reality that
many companies did not have the same kind of access they did before the credit bubble burst. As a result, some issuers have
had to look to private credit markets for financing, particularly newer issuers finding it more difficult to issue in public markets.
As shown below (c62), private credit lending through “mezzanine” (subordinated) debt may offer substantial yields, cash
coupons, substantial debt service coverage, call protection and equity beneath the mezzanine positions. However, these returns
come at a price: private lending portfolios are illiquid, can be concentrated by sector, and are usually less diversified (20-30
positions) than high yield mutual funds.
US high yield bond prices fell sharply in the wake of the US downgrade by S&P in August (c63). Current prices imply default
rates of around 40% over a 5-year period. These implied default rates are above the losses experienced during the prior two
recessions (c64), but lower than what was priced in during March 2009. We see value in the high yield market for unleveraged
investors who can ride out the volatility. Leveraged loans, currently priced at a spread of around 6.5% over 3-month Libor, are
another area of focus, given the implicit (and admittedly remote) inflation hedge.
(c62) Private credit fund characteristics       (c63) High yield vs. US government                 (c64) Market implied 5-year cumulative
Equal-weighted averages                         bonds, Total return index , Q4 2010 =100           default rates, Percent, assuming 30%
                   Corporate Comm. R/E          112                                                recovery and 0% break-even return
                                                                        5-7 year
Yield to call    15.2% - 18.8% 12.7%            110                    Treasuries                  80%
Yield to maturity 13.1% - 14.2%       12.6%     108                                                70%                     Worst default rate for
                                                                                                   60%                       entire HY universe
Cash coupon         8.6% - 10.4%      10.1%     106
                                                                                                                           (1989-94 and 1999-04)
Years to maturity   4.7 - 6.5 yrs    4.9 yrs    104                                                50%
Debt / EBITDA        5.0x - 6.1x       n/a      102
Estimated equity                                100
                                                                       US High Yield
                    23% - 42%         33%                                                          20%
cushion                                          98                                                10%
Debt service                                     96
                     2.3x - 2.5x      1.2x                                                          0%
coverage                                          Jan-11      Apr-11      Jul-11       Oct-11                 March 2009               Current

Two caveats on credit. First, while the supply/demand dynamic in credit looks good for 2012 and 2013 (when credit demand
from portfolio buyers is expected to substantially exceed credit supply), maturities pick up substantially in 2014 and beyond
(c65). Second, credit volatility and bid/offer ratios are higher now, as dealer inventories have declined (c66), a function of
regulatory and other industry changes.
 (c65) High yield loan and bond                (c66) Primary dealer corporate bond                (c67) US commercial real estate
 maturities, Billions, USD High yield          positions, Billions, USD                           Percent of decline since peak
 300                                bonds      250                                                 5%
       Leveraged loans
 250                                                                                               -5%
                                                                                                                      Major properties
                                               200                                                -15%
 200                                                                                                                  in major markets
 150                                           150                                                                                   Overall
                                               100                                                -45%
                                                                                                  -55%   properties
   0                                           50                                                 -65%
       '12 '13 '14 '15 '16 '17 '18 '19 '20+      2003      2005   2006    2008      2009   2011      Oct-07     Jan-09        Apr-10        Jul-11

Commercial real estate
The search for yield resulted in a recovery in “core” real estate prices, shown above as “major properties in major markets”
(c67). As a result, we have seen better value in the distressed sector, assuming of course that it can be priced right, and
diversified. Usually, distressed transactions require motivated sellers, such as undercapitalized regional US banks; healthy
banks looking to sell foreclosed real estate; sub-investment grade companies looking to raise cash by selling wholly owned real
estate; and REITs looking to scale back their geographical or sector footprint. One example: a portfolio of 60 suburban office
properties sold at roughly $108 psf (a 40% discount to replacement cost), for a 9.3% cap rate based on 84% occupancy.
Another example of distress (not for the faint of heart): a neglected Boston-area office building that’s only 48% occupied, sold
at $176 psf; that’s around 50% of replacement cost. The benefit of acquiring buildings at steep discounts to replacement cost:
there’s limited risk of new supply, and property owners can bid aggressively to attract tenants from other buildings.

  Eye on the Market | OUTLOOK 2012
                                    January 1, 2012
2012 Outlook
Oil and Gas investments
In November, we wrote our annual Thanksgiving piece on the outlook for conventional and renewable energy sources, and
related investments. It’s worth a read if you are interested in the subject matter; it was based on a day we spent with Vaclav
Smil and his 2010 book, “Energy Myths and Realities”. One trend we noted towards the end of the piece is that projections for
global liquids production and US dry gas production both assume substantial contributions from non-conventional sources (c69,
c70). This creates opportunities across the entire value chain, including exploration and production, distribution and services.
On natural gas, new finds have been rewarding, even with natural gas prices at current low levels (c68), since large major oil
and gas companies aggregate proven reserves, and are willing to pay a premium for them given their long-term horizons. On
crude oil, many of our investments focus on so-called “renaissance” plays, which entail older, mostly depleted fields which
majors sell as they reshuffle their reserve mix to higher-growth assets. Service companies include firms providing enhanced oil
recovery, fracking and waste-water management. Other servicing investments are related to deep-sea fields recently discovered
off the coast of Brazil. We have discussed these projects before (EoTM September 2009). The sub-salt fields in Brazil lie 7
kilometers below the surface of the ocean, beneath a thick salt canopy in the Lower Tertiary region. Oil extraction can be quite
complicated due to the low permeability and porosity of the salt canopy, and tar pockets. Our investments in this region are
linked to providing services, rather than owning exploration and production assets themselves.
 (c68) Natural gas spot price                (c69) Global liquids production             (c70) US dry gas production
 USD/mmBtu                                   Million barrels per day                     Trillion cubic feet per year
16                                          120                                         30
                                                     History       Projections                  History                 Projections
                                            100                                         25
12                                                                         OPEC                                 Net imports
                                             80                                         20
10                                                                      Conventional                            Shale gas
 8                                           60                        Unconventional   15 Non-associated
 6                                                                                                      Non-associated onshore
                                             40                                         10
 4                                                                      Non-OPEC                            Tight gas
                                             20                        Conventional      5
 2                                                                                                          Coalbed methane
 0                                            0                                          0                  Associated with oil
 1999 2001 2003 2005 2007 2009 2011           1990      2000    2010      2020   2030    1990      2000     2010        2020    2030

Gold, macro hedge funds and oil
Gold has been correlated to lots of things (c71): credit spreads on European sovereigns (directly); the yield on inflation
protected bonds (inversely) and the highly liquid money supply (directly). Gold markets are volatile, have attracted a lot of hot
money that needs to book profits from time to time, and are always at risk of Central Banks unloading supply. However, until
the variables mentioned (sovereign spreads, the monetary base and inflation fears) move back to where they started, we would
not sell gold here. Last year we wrote that we expected gold to be volatile in 2011, but end the year higher than it began. We
have the same view for 2012.
We generally use hedge funds as a           (c71) Gold is correlated to everything         (c72) Macro hedge funds require
                                                                  Highly liquid            diversification, 5-yr annualized return
complement to underweight positions                            money supply ($)
in equities. One of the more successful                                                   40%
strategies involves macro hedge                           10y TIPS yield
                                                          (Inverted, %)
funds. As shown (c72), individual             Gold price
macro hedge funds generate a lot of           ($ / ounce)
volatility. When grouped (even                                                            10%
randomly) into pods of 5 funds, low                                      Western Europe    0%
correlation tends to reduce return, but                                 Sovereign 5y CDS
reduce volatility even more. That’s a                                      spread (Bps)  -10%                         Indiv. funds
                                                                                                                  5 random funds
tradeoff we see as sensible. As for oil                                                  -20%    Volatility
                                             Jan-09      Dec-09      Nov-10       Oct-11
markets, we are expecting below-trend                                                         0%           25%       50%          75%
oil demand growth in 2012 given the
recession in Europe and slower GDP growth in Asia in the first half of the year, but still an increase in oil demand overall. As
inflation comes off the boil in Asia, we expect oil demand to pick up later in the year. Any supply increases from Libya and
Iraq might be offset by Gulf countries returning to pre-Libyan war production levels; since July 2010, Kuwait, Saudi Arabia and
the UAE increased production by 2 million barrels per day. The wild card for oil markets in 2012 is Iran and its continuing
quest to enrich uranium (see Appendix B). Bottom line: any 10%+ declines in oil prices would represent good value.

     Eye on the Market | OUTLOOK 2012
                                        January 1, 2012
2012 Outlook
[Appendix A] The pain in Spain, and a history of European austerity and social unrest
Other than exports (c78), the news in Spain is very downbeat. If there are socioeconomic limits to how much austerity a country
can take in order to remain in a currency union, we are likely to find out in Spain, where unemployment is 23%, youth
unemployment is over 40%, and there are large budget deficit and current account deficit adjustments still to come.
    (c73) Spanish services activity survey       (c74) Spanish unemployment rate                 (c75) Spanish industrial production
    Purchasing Managers Index, sa                Percent                                         Index, January 2007=100
65                                                                                               105
60                                                                                               100
55                                               19%
                                                 16%                                             90
40                                               13%
35                                                                                               80
30                                                                                               75
25                                                7%                                             70
 2000       2002     2004   2006   2008   2010      1983   1988     1993   1998   2003   2008     2007       2008    2009       2010      2011

    (c76) Spanish cement consumption             (c77) Spanish retail sales                      (c78) Spanish exports
    Millions, tons                               Index, January 2003 =100                        Percent change, YoY
    60                                           115                                             16%
    55                                                                                           12%
    50                                                                                               8%
    45                                           105
                                                 100                                                 0%
    30                                           95
    25                                                                                               -8%
    20                                                                                           -12%
    15                                           85                                              -16%
     1973 1978 1983 1988 1993 1998 2003 2008      2003       2005      2007       2009    2011       2000     2002   2004      2006    2008    2010

Austerity and Unrest. Austerity sounds straightforward as a policy, until the consequences bite. It remains unclear that the road
Europe is taking is less costly in the long run, in economic, political and social terms. The history of Europe over the last 100
years shows that austerity can have severe consequences and outcomes. A paper from the Centre for Economic Policy Research
looks at the unrest that resulted from austerity in 32 European countries since 19194. They found a very clear pattern of
rising demonstrations, riots and strikes (and worse) after expenditure cuts took place (c79). The authors tested to see if
results varied with ethnic fragmentation, inflation, penetration of mass media and the quality of government institutions; they
did not. Results are also consistent across time, covering interwar and postwar periods. The independent variable that did
result in more unrest: higher levels of government debt in the first place.
Compounding the problem is the way some decisions are                      (c79) Austerity and unrest in Europe, 1919 - 2008
                                                                           Number of incidents per country per year
being taken, which may reinforce perceptions of a “democratic
deficit” at the EU level, an issue highlighted by Germany’s                1.5
                                                                                                                            Expenditure increases
Constitutional Court. It remains to be seen if Europe can                                                                   Expenditure reduction >1%
sustain cohesion around its path of most resistance. One sign                                                               Expenditure reduction >2%
of rising tensions: the following (staggering) comment by the                 1                                             Expenditure reduction >3%
head of the Bank of France: "A downgrade does not appear to                                                                 Expenditure reduction >5%
me to be justified when considering economic fundamentals,"
Noyer said. "Otherwise, they should start by downgrading                   0.5
Britain which has more deficits, as much debt, more inflation,
less growth than us and where credit is slumping." At a time
of increasing budgetary pressures and declining growth, I
suppose there are limits to European solidarity.                                    Demonstrations           Riots                    General strikes
                                                                                                     Measures of instability
 “Austerity and Anarchy: Budget Cuts and Social Unrest in Europe, 1919-2008”, Ponticelli and Voth, International Macroeconomics
and Economic History Initiative, CEPR, December 2011.
     Eye on the Market | OUTLOOK 2012
                                             January 1, 2012
2012 Outlook
[Appendix B] Learning to live with a nuclear Iran
Investors have to factor in more than just finance and economics. As we head into 2012, oil markets are at risk from ongoing
issues surrounding Iran’s quest to enrich uranium. Here are a few things to keep in mind regarding this issue:
•      The International Atomic Energy Agency now believes that Iran has undertaken most steps necessary to design,
       manufacture, test and deliver a nuclear weapon, including the modification of a ballistic missile to accommodate a
       nuclear payload, and computer modeling of the process to compress and detonate enriched uranium. Joschka Fischer,
       Germany’s foreign minister and vice chancellor from 1998 to 2005, noted in a November article that Iran only has one
       civilian nuclear reactor (fuel rods supplied by Russia), and that the Iranian technology being developed cannot be used in it.
•      Iran may be motivated by what happened elsewhere in the Gulf. After the NATO intervention in Libya, Ayatollah
       Khamenei gave a speech saying that Ghaddafi’s mistake was giving up his nuclear program, as it made him vulnerable to
       outside intervention. This reduces the chances of a deal whereby Iran agrees to meaningful compromises.
•      Nevertheless, the likelihood of a US military strike appears low. Last month, Secretary of Defense Panetta reiterated
       the position of prior Defense Secretary Gates that an attack on Iran would be difficult, citing “unintended consequences”.
       Capitol Hill has been more hawkish, but there appears to be considerable resistance in the intelligence and military
       establishments against an Iranian attack. For more context around the Iran hawks and doves within the US political and
       military establishment, and the history of National Intelligence Estimates which claim that Iran has not yet moved towards
       weaponization, see “The domestic politics of America’s response to Iran’s nuclear programme”, Cambridge Review of
       International Affairs, Ido Oren, December 2011. According to sources we spoke with, the world might only have a few
       weeks to respond if Iran moves towards weaponization, a process that could be signaled by banning IAEA inspectors, or
       changes in inventory levels of uranium enriched to 3.5% or 20% (90% is needed for weapons). The time required to enrich
       uranium from 20% to 90% is much shorter than the time required to enrich uranium from 0% to 20%5; it is not linear.
•      There have been some successes through unattributed covert operations to slow down Iran’s progress. David
       Albright at the Institute for Science and International Security walked me through the nuances of the Stuxnet computer virus
       that apparently wreaked havoc with vibration sensors, pressure gauges and frequency converters at one of Iran’s centrifuge
       facilities. A more recent virus (Duqu) appears designed to gather intelligence, perhaps in preparation for a future operation.
       However, there may be limits to what can be accomplished, as supply chains and security procedures are tightened.
•      If there were circumstances that resulted in Iran deciding to cease oil exports to the OECD, some combination of
       Libyan, Iraqi and other Gulf production might be able to take up the slack. However, given tight conditions in oil
       markets, prices would probably spike. Here are some of the numbers. Rising Libyan and Iraqi production could provide
       a supply cushion in case Iranian exports to the OECD were cut off (c80). There is also reason to believe that other Gulf
       countries could increase production as well; over the last few months, Saudi, Kuwaiti and UAE production rose around
       2 million barrels per day above prior estimates, as they responded to the situation in Libya (c81). However, oil markets
       overall are pretty tight. OPEC countries are running at very high levels of production, and the IEA decision to release
       strategic reserves during the Libya crisis is an indication that they see limits to OPEC production increases. As a result, we
       believe that oil prices will remain well bid in 2012, despite declining expectations for global GDP growth. If a crisis
       occurred in Iran, oil prices would likely head sharply higher.

    (c80) Possible offsets to an Iranian supply shock                           (c81) Increased production vs. mid-2010 output
    Millions of barrels per day, as of October 2011                             Millions of barrels per day
                                                      YE2012                    2.2
                           Domestic                           Change in
             Production               Exports         Exports                                   Saudi Arabia
                          Consumption                          Exports          1.8
                                                       (Est.)                                   United Arab Emirates
    Iraq         2.7           0.8          1.9         2.6          0.7        1.4             Kuwait

    Libya        0.3           0.1          0.2         1.1          0.9
                                                         Total:      1.6
                                     Iranian Exports to OECD:        1.2

                                                                                       Jul-10       Oct-10     Jan-11   Apr-11   Jul-11   Oct-11

    See “The New IAEA Report: Beyond Weaponization”, U.S. Bipartisan Policy Center, November 10, 2011.
    Eye on the Market | OUTLOOK 2012
                                    January 1, 2012
2012 Outlook
Hopes that Iranians will effect regime change appear overstated. There is conflicting evidence on conditions in Iran:
     o   IMF data on real per capita income growth show that Iran has the 2nd best results in the region since 1990, behind only
         Qatar (which spreads its natural gas riches over 1.7 million people). Other factors that might contribute to cohesion:
         “freedom shares”, handed out as part of a $100 bn privatization program; and the recognition of progress in human
         development. Since 1990, of the 94 countries in the United Nations Human Development Report ranked as “high” or
         “very high”, Iran recorded the single largest improvement, reflecting progress in life expectancy and education.
     o   On the other hand, a recent Gallup poll shows that 26% of Iranians are economically “suffering”, compared to 14% in
         2008, in part a reflection of the removal of domestic energy subsidies. IMF data rely on official Iranian statistics, which
         may understate actual inflation; there are reports that capital flight is rampant. Economists inside and outside of Iran,
         and European governments, have questioned the accuracy of the IMF's data. According to Karim Sadjadpour at the
         Carnegie Endowment for International Peace, Iran ranks higher than Egypt and Tunisia in terms of economic malaise
         (inflation and unemployment) and corruption. Household incomes have fallen versus prior generations, and people
         under the age of 30 now account for 70% of all unemployed persons; youth unemployment itself is around 23%. As for
         sanctions, recent ones are aimed at Iran’s gas, oil and petrochemical industries (the US Government Accountability
         Office reports that only 16 firms are currently active in Iran, down from 43 in 2010). Other sanctions are aimed at its
         banks, and potentially at its Central Bank. The sanctions have impeded the modernization of its natural gas industry, led
         to shortages in construction materials affecting small and medium sized businesses, and reduced available trade finance.
The bottom line is that it does not appear that regime change from within is something to be expected in Iran. Investors don’t
necessarily need another reason to hold gold, but this appears to be another issue with no resolution in 2012.

[Appendix C] Sovereign defaults, preferred creditors, and what “pari-passu” means (not that much) 6
Every sovereign default is like a snowflake, with a story all its own. But there are often common factors: high levels of
hard currency sovereign debt, a monetary anchor of some kind, and a balance of payments problem. Some Southern
European countries have aspects of all three. While EU 2011 debt levels are above those associated with most prior debt
crises (c82), the help these countries might get from outside lenders (and the ECB) is also larger; it’s premature to know
how deep those latter pockets are. When thinking about where we go from here, I remind our investors of the following:
1. In prior debt crises, IMF and other bilateral facilities did not prevent (c82) Sovereign debt levels in prior crises vs.
   a subsequent decline in securities prices (c83-c86)                       Europe 2011, Debt to GDP, percent, by country and year
2. The lack of a legal framework around sovereign debt restructurings       140%
   can increase the risks for bondholders when things go wrong              120%
On the latter point, there have been thousands of pages of legalese            100%
written on the topic. Here are some observations on sovereign                   80%
defaults, preferred creditors and risks to bondholders:                         60%
• Most sovereign bonds contain a clause referring to their pari-passu          20%
  (equal) treatment vs. other indebtedness of the same issuer. Such              0%
  clauses tend to work well in a corporate setting, where bankruptcy
                                                                                       IRL '11
                                                                                      PRT '11

                                                                                      COS '89

                                                                                      ARG '82
                                                                                      ARG '00

                                                                                      MEX '82
                                                                                      ARG '90
                                                                                      MEX '89
                                                                                         IT '11

                                                                                      PAN '83

                                                                                      VEN '89

                                                                                       PHI '83

                                                                                      BRA '83

                                                                                      VEN '82

                                                                                      BRA '93
                                                                                       GR '11

                                                                                        BE '11

                                                                                        SP '11
                                                                                      ECU '00

                                                                                      ECU '84

                                                                                      RUS '97

                                                                                      ECU '08
                                                                                      RUS '91
  courts in a given country enforce clauses across creditor classes.
• However, sovereign issuers are not subject to a bankruptcy
  code, their own, or anyone else’s. They have the freedom to discriminate amongst creditors, and often do. Sovereign
  entities in distress rarely pay all creditors on a “ratable” basis, where “ratable” signifies equal treatment in terms of
  priority, magnitude and timing of payment.
• The pari-passu clause does not prevent issuers, as a matter of practice, from discriminating in favor of institutions such
  as the IMF and World Bank. As a result, should an eventual writedown of debt be needed, it might have to be
  absorbed by a smaller universe of private sector creditors. In this regard, increased commitments by official
  sector lenders may not change the risk equation for bondholders in the long run7.

  This section draws on “The Pari-Passu Debt Clause in Sovereign Debt Instruments”, Buchheit and Pam, Emory Law Journal, 2004.
Lee Buchheit is with Cleary Gottlieb Steen & Hamilton, which represents many sovereign issuers in distress/default. I have a lot of
respect for Lee’s judgment and decades of experience, but also believe that such commentary should be considered in light of what
sovereign counsel normally does: seek maximum flexibility for sovereign issuers, sometimes at the expense of private creditors.
  On a related matter, I wouldn’t put too much importance on the decision by EU governments to remove “private sector involvement”
language as a pre-condition for lending via the ESM (European Stability Mechanism). Just because they removed it from the ESM
doesn’t mean investors won’t be required to share the pain in the future.
2012 Outlook
• The IMF and World Bank are not the only ones given preferred treatment. In the proposed Greek debt exchange,
   Greek the Market OUTLOOK its sovereign debt were
  Eye onSocial Security Funds holding2012 January 1, 2012 reportedly not scheduled to participate. And in prior
   sovereign debt restructurings, t-bills were excluded, further concentrating losses on the remaining bondholders.
2012 Outlook of corporate credit, lenders have a wide variety of remedies they can use when seeking to ensure equal
• In the world
   treatment: sharing clauses, the use of a trustee to distribute payments ratably, inter-creditor agreements debt exchange,
• The IMF and World Bank are not the only ones given preferred treatment. In the proposed Greekamong lenders
   to share payments and losses equally, and subordination agreements. These remedies to generally not used prior
   Greek Social Security Funds holding its sovereign debt were reportedly not scheduled areparticipate. And in by lenders
   to governments, most likely because were excluded, further concentrating losses on the them.
   sovereign debt restructurings, t-bills it would be difficult (if not impossible) to enforce remaining bondholders.
   A the world of corporate credit, lenders have wide variety of remedies they can use when seeking bonds, since Peru
• In notable exception: in the year 2000, a hedgeafund sought to block Peruvian payments on its Brady to ensure equal
   didn’t pay interest on the fund’s Peruvian loans distribute payments participate in the Brady bond exchange). The
   treatment: sharing clauses, the use of a trustee to(the fund opted not toratably, inter-creditor agreements among lenders
   hedge fund’s injunction was equally, and subordination agreements. These remedies are Appeals, and the by lenders
   to share payments and lossesgranted by a New York Federal Court and a Belgian Court ofgenerally not usedhedge fund
   was fully paid. most investor, I have would sympathy (if not impossible) actually them.
   to governments, As an likely because it a lot of be difficultfor creditors that areto enforceable to get their contracts
   enforced. In recent years, year 2000, a hedge fund sought to block Peruvian payments Peru Brady getting the phrase
• A notable exception: in theother creditors have not been as successful in the wake of the on itscase in bonds, since Peru
   “pari-passu” to mean the fund’s Peruvian loans (the fund opted not to participate in the Brady bond anything.
   didn’t pay interest on what markets often assume it to mean . The reality: it may mean very little, if exchange). The
   hedge fund’s injunction was granted by a New York Federal Court and a Belgian Court of Appeals, and the hedge fund
    things considered, the history have a lot of investors seek a very large potential able to before contracts
Allwas fully paid. As an investor, I suggests thatsympathy for creditors that are actually rewardget theirtaking risk on
   enforced. In once crisis hits. Here are the charts referenced above on how official sector case facilities the phrase
sovereign debt, recentayears, other creditors have not been as successful in the wake of the Perucreditin getting did not
   “pari-passu” to mean what markets often assume the mean8. The reality: it Argentina very little, these declines
prevent further deterioration in securities markets of it tocountries involved. In may mean and Russia if anything. were
permanent. In Mexico and Indonesia, the declines were temporary; after 50%-70% currency devaluations eventually re-
established a more stable equilibrium, their sovereign bond seek very large
All things considered, the history suggests that investors pricesarecovered. potential reward before taking risk on
sovereign debt, once a crisis hits. Here are the charts referenced above on how official sector credit facilities did not
prevent further deterioration in securities markets of the countries involved. In Argentina and Russia these declines were
 (c83) Argentina                                                        (c84) Mexico
 Sovereign debt price: 113/8and Indonesia, the declines were temporary; afterBrady Bond debt price: devaluations eventually
permanent. In Mexico                                                    Sovereign 50%-70% currency 6 1/4 2019
 120                                                                    85
re-established a more stable equilibrium, the IMF, IADB and Spain prices recovered.
                                              their sovereign
                                       promise $40 bn in aid. “Thisbond         80
                                              should improve the investment                                                            Creation of $20 bn
    100                                                                         75
                                              climate, and together with                                                               Exchange
    (c83) Argentina
     90                                       enhanced domestic and external    (c84) Mexico
                                                                                70                                                     Stabilization Fund
    Sovereign debt price: 113/8 2017          confidence, lay the ground for    Sovereign Brady Bond debt price: 61/4 2019
    120                                                                         85                                                     [2/95]
                                              Banks, the IMF, IADB and Spain
                                              sustained economic Argentine      65
    110                                       promise $40 bn in aid. “This
                                              growth” – IMF Managing            80
                                              should improve
                                              Director [12/00] the investment   60                                                      Creation of $20 bn
    100                                                                         75
                                              climate, and together with        55                                                      Exchange
     90                                       enhanced domestic and external                Creation of permanent                       Stabilization Fund
     40                                       confidence, lay the ground for    50         $6.7 bn line of credit for                   [2/95]
                                              sustained economic Argentine      65
                                                                                45         Mexico from the United
     70                                       growth” – IMF Managing                        States and Canada [4/94]
                                              Director [12/00]                  60
      Jan-98        Jul-99           Jan-01       Jul-02         Jan-04          Dec-93
                                                                                55          Mar-94          Jun-94          Sep-94       Dec-94      Mar-95
     50                                                                                     Creation of permanent
    (c85) Russia
     40                                                                         (c86) Indonesiabn line of credit for
                                                                                50          $6.7
    Sovereign debt price: GKO (T-Bill) 3/10/1999                                            Mexico from the United
                                                                                Sovereign debt price: 73/4 2006
     30                                                                         120         States and Canada [4/94]
    90     The IMF Executive Board completed the review of the
     20    Extended Fund Facility, and agreed to disburse a $700                40
                                                                                 Dec-93     Mar-94          Jun-94     IMF likely to resume lending
                                                                                                                         Sep-94        Dec-94     Mar-95
      Jan-98          Jul-99        Jan-01         Jul-02        Jan-04
           million tranche, thus bringing the program back on track.
    80                                                                                                                 under $40 bn package [04/98]
    (c85) Russia                                                                (c86) Indonesia
    Sovereign debt price: GKO (T-Bill) 3/10/1999                                Sovereign debt price: 7   3/4
    90    The this point, the Board completed the
        "Up to IMF Executiveoptimists on Russia review of the                   120
        have been more right thanand pessimists.
          Extended Fund Facility, the agreed to disburse a $700                  80                                    IMF likely to resume lending
          million tranche, thus bringing the
    60 There is good reason to believethe program back on track.
    80 optimists will continue to be right." Stanley                             70                                    under $40 bn package [04/98]
        Fischer, IMF Managing Director [01/98]                                   60                                    “We’ve been very impressed
    50                       Russia stocks and bonds soared after the            90                                    by the negotiations with the
    70 "Up to this point, the optimists on Russia
                             promise of $22.6 bn in loans led by the IMF         50                                    new Cabinet” – IMF [04/98]
        have been more right than the pessimists.                                80
                             – Bloomberg [07/98]
    60 There is good reason to believe the                                       40
        optimists will continue to Apr-98 Stanley
                   Feb-98          be right."   May-98          Jul-98           70
                                                                                  Jul-96       Jan-97              Jul-97            Jan-98       Jul-98
        Fischer, IMF Managing Director [01/98]                                   60                                    “We’ve been very impressed
    50                       Russia stocks and bonds soared after the                                                  by the negotiations with the
                             promise of $22.6 bn in loans led by the IMF         50                                    new Cabinet” – IMF [04/98]
                             – Bloomberg [07/98]
    40                                                                           40
     Jan-98        Feb-98          Apr-98       May-98          Jul-98            Jul-96       Jan-97              Jul-97            Jan-98       Jul-98

    See “Debt Defaults and Lessons from a Decade of Crises”, Sturzenegger and Zettelmeyer, MIT Press, 2006, p. 71 and table 3.1.

    See “Debt Defaults and Lessons from a Decade of Crises”, Sturzenegger and Zettelmeyer, MIT Press, 2006, p. 71 and table 3.1.                                14
 Eye on the Market | OUTLOOK 2012 January 1, 2012

2012 Outlook
Chart sources
 (c1)    Bloomberg, December 1983                                          (c44)   China Customs, J.P. Morgan Securities LLC, Markit, November 2011
 (c2)    OECD, December 2011                                               (c45)   IMF, China State Statistical Bureau, China National Bureau of
                                                                                   Statistics, Q4 2010
 (c3)    OECD, December 2011                                               (c46)   IMF, Q4 2011
 (c4)    Markit, Institute for Supply Management, J.P. Morgan              (c47)   IMF, Bloomberg, J.P. Morgan Private Bank, September 2011
         Securities LLC, November 2011
 (c5)    IMF, OECD, Barclay's Capital, Bloomberg                           (c48)   FRB, December 2011
 (c6)    Bloomberg, Bureau of Labor Statistics, Empirical Research         (c49)   Ministry of Finance Japan, IMF, J.P. Morgan Securities LLC, October
         Partners, December 2011                                                   2011
 (c7)    Statistisches Bundesamt/Deutsche Bundesbank and Istituto          (c50)   FRB, Q3 2011
         Nazionale di Statistica, October 2011
 (c8)    Bloomberg, December 2011                                          (c51)   J.P. Morgan Private Bank, Bloomberg, Company filings, December
 (c9)    European Commission, Bloomberg, September 2011                    (c52)   J.P. Morgan Private Bank, Bloomberg, Company filings, December
 (c10)   FRB, BEA, ECB, Eurostat, Bank of England, UK Office for           (c53)   Factset, December 2011
         National Statistics, Bank of Japan, Japan Cabinet Office,
         Heinrich Hoffmann, November 2011
 (c11)   Reinhart, Carmen M. and Kenneth S. Rogoff, “From Financial        (c54)   FRB, Standard & Poor’s, Q3 2011
         Crash to Debt Crisis,” NBER Working Paper 15795, March
 (c12)   FRB, ECB, J.P. Morgan Private Bank, Q4 2010                       (c55)   Credit Suisse quantitative equity research, November 2011
 (c13)   European Banking Authority, US 10-Ks, December 2010               (c56)   J.P. Morgan Securities LLC, December 2011
 (c14)   OECD, Bank for International Settlements, "The real effects of    (c57)   BEA, J.P. Morgan Private Bank, Q3 2011
         debt", Cecchetti, Mohanty and Zampolli, Sept. 2011
 (c15)   OECD, Q1 2011                                                     (c58)   BEA, J.P. Morgan Private Bank, Q3 2011
 (c16)   OECD, December 2011                                               (c59)   Bloomberg, December 2011
 (c17)   IMF, September 2011                                               (c60)   Estimates based on Thomson Reuters, Credit Suisse HOLT,
                                                                                   Credit Suisse research, September 2011
 (c18)   IMF, National Inst. of Statistics, J.P. Morgan Private Bank, Q3   (c61)   J.P. Morgan Securities LLC, Bloomberg, November 2011
 (c19)   Statistical Office of the European Communities, Haver             (c62)   J.P. Morgan Private Bank, November 2011
         Analytics, Q2 2011
 (c20)   IMF, November 2011                                                (c63)   Bloomberg, J.P. Morgan Securities LLC, Barclays Capital, iBoxx,
                                                                                   December 2011
 (c21)   OECD, Q2 2011                                                     (c64)   Bloomberg, J.P. Morgan Securities LLC, December 2011
 (c22)   Institute for Supply Management, November 2011                    (c65)   J.P. Morgan Securities LLC, December 2011
 (c23)   Bloomberg, November 2011                                          (c66)   FRB, November 2011
 (c24)   FRB, BEA, Q3 2011                                                 (c67)   Moody’s Commercial Property Price Indices, August 2011
 (c25)   National Association of Realtors, J.P. Morgan Securities LLC,     (c68)   Bloomberg, December 2011
         Amherst Securities, Mortgage Bankers Association, Dec. 2011
 (c26)   BEA, Q3 2011                                                      (c69)   U.S. Energy Information Administration, December 2010
 (c27)   Bureau of Labor Statistics, November 2011                         (c70)   U.S. Energy Information Administration, September 2011
 (c28)   BEA, Q3 2011                                                      (c71)   Federal Reserve Bank of St. Louis, Markit, Bloomberg, J.P. Morgan
                                                                                   Securities LLC, December 2011
 (c29)   BEA, J.P. Morgan Private Bank, August 2011                        (c72)   Hedge Fund Research, J.P. Morgan Private Bank, September 2011
 (c30)   FRB, November 2011                                                (c73)   Markit, J.P. Morgan Securities LLC, November 2011
 (c31)   CBO, J.P. Morgan Private Bank, December 2011                      (c74)   Eurostat, October 2011
 (c32)   CBO, J.P. Morgan Private Bank, August 2011                        (c75)   Instituto Nacional de Estadística, Haver Analytics, October 2011
 (c33)   US Treasury, BEA, December 2011                                   (c76)   Oficemen, October 2011
 (c34)   J.P. Morgan Securities LLC, CBO, September 2011                   (c77)   Eurostat, J.P. Morgan Securities LLC, October 2011
 (c35)   FRB, US Treasury, November 2011                                   (c78)   Instituto Nacional de Estadistica, Haver Analytics, Q3 2011
 (c36)   FRB, US Treasury, November 2011                                   (c79)   Austerity and Anarchy: Budget Cuts and Social Unrest In Europe,
                                                                                   1919-2008, Jacopo Ponticelli and Hans-Joachim Voth, Centre for
                                                                                   Economic Policy Research, August 2011
 (c37)   Hong Kong Monetary Authority, December 2011                       (c80)   J.P. Morgan Securities LLC, Government Agencies, News
                                                                                   Reports, October 2011
 (c38)   Census Bureau, Bureau of Economic Analysis, Rockefeller           (c81)   J.P. Morgan Securities LLC, Government Agencies, News Reports,
         Institute, Q3 2011                                                        October 2011
 (c39)   J.P. Morgan Securities LLC, December 2011                         (c82)   Gramercy Capital, OECD, December 2011
 (c40)   J.P. Morgan Securities LLC, October 2011                          (c83)   Bloomberg, December 2011
 (c41)   China National Bureau of Statistics, People’s Bank of China,      (c84)   Bloomberg, December 2011
         November 2011
 (c42)   Bank for International Settlements, Q2 2011                       (c85)   Bloomberg, IMF, December 2011
 (c43)   China National Bureau of Statistics, People’s Bank of China,      (c86)   Bloomberg, December 2011
         J.P. Morgan Private Bank, Q3 2011
                                                                                                                                               15      15
   Eye on the Market | OUTLOOK 2012 January 1, 2012
2012 Outlook
2012 Outlook
Cover art data sources
Cover art data sources
Banco de España, Bank for International Settlements, Bloomberg, Bureau of Economic Analysis, Bureau of Labor Statistics, Case-Shiller,
Banco de España, Bank for International Settlements, Bloomberg, Bureau of Economic Analysis, Bureau of Labor Gallup, Inc., Instituto
China National Bureau of Statistics, Dealogic, Deutsche Börse, Eurostat, Federal Reserve Board, G7 Governments,Statistics, Case-Shiller,
China National Bureau International Monetary Fund, Intervención General de la Administración del Estado, J.P. Morgan Private Bank,
Nacional de Estadística,of Statistics, Dealogic, Deutsche Börse, Eurostat, Federal Reserve Board, G7 Governments, Gallup, Inc., Instituto
Nacional de Securities LLC, Ministère de l'Economie Intervención General de la Administración del Estado, J.P. Morgan Private Bank,
J.P. Morgan Estadística, International Monetary Fund, des Finances et de l'Industrie, Ministero dell'Economia e delle Finanze, MSCI, The
J.P. Morgan Securities LLC, Ministère de l'Economiefor Economic Co-operation and Development, Standard e delle Finanze, MSCI, The
National Institute for Statistics of Italy, Organization des Finances et de l'Industrie, Ministero dell'Economia & Poor’s, US Census Bureau,
US Treasury. Periphery includes Italy, Organization for Spain and Co-operation end retail proxied Standard & Poor’s, US Census Bureau,
National Institute for Statistics ofPortugal, Ireland, Italy, Economic Greece. High and Development,by the Deutsche Börse World Luxury
US Treasury. Periphery includes the S&P Ireland, Italy, Spain and Greece. High end retail proxied as of Deutsche 30, 2011, except the
Index. Low end retail proxied by Portugal, Department Stores Index. All data are the latest available by theNovember Börse World Luxury
Index. Low end retail proxied by the S&P Department as of June 30, 2011.
global policy rates and global fiscal deficits, which are Stores Index. All data are the latest available as of November 30, 2011, except the
global policy rates and global fiscal deficits, which are as of June 30, 2011.
Acronyms Bureau of Economic Analysis
CBO           Bureau of Economic Analysis
              Congressional Budget Office
CDS           Congressional Swaps
              Credit Default Budget Office
EBITDA        Credit Default Swaps taxes, depreciation, and amortization
              Earnings before interest,
ECB           Earnings Central Bank
              Europeanbefore interest, taxes, depreciation, and amortization
EU            European Central Bank
EMU                      Union
              European Economic and Monetary Union
EBA                      Economic and Monetary Union
              European Banking Authority
EFSF                     Banking Stability
              European FinancialAuthority Facility
FRB           European Financial Stability Facility
              Federal Reserve Board
GDP           Federal Reserve Board
              Gross Domestic Product
GNP                  Domestic Product
              Gross National Product
IAEA          Gross National Product
              International Atomic Energy Agency
IEA                          Atomic Energy
              International Energy Agency Agency
IMF                          Energy Agency
              International Monetary Fund
ISM           Institute for Monetary Fund
              InternationalSupply Management
NATO          Institute for Supply Management
              North Atlantic Treaty Organization
NFIB          North Atlantic Treaty Independent
              National Federation ofOrganization Business
OECD          National Federation of Independent Business Development
              Organization for Economic Co-operation and
OPEC                         for Economic Co-operation and Development
              Organization of Petroleum Exporting Countries
PMI           Organization of Petroleum Exporting Countries
              Purchasing Managers Index
REIT          Purchasing Managers Index
              Real Estate Investment Trust
RMB           Real Estate
              Renminbi Investment Trust
PSF           Renminbi
              Per square foot
SMP           Per square foot
              Securities Markets Program
TIPS          Treasury Markets Program
              SecuritiesInflation Protected Securities
UAE           Treasury Inflation Protected Securities
              United Arab Emirates
UAE           United Arab Emirates
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
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equity and hedge funds), in which
Monetary Authority of Singapore.
Cover illustration © Dan Williams, 2012
© 2012 JPMorgan ChaseWilliams, 2012 reserved.
Cover illustration © Dan & Co. All rights
© 2012 JPMorgan Chase & Co. All rights reserved.

                                                                                                                                                                      16          16
MICHAEL CEMBALEST is Global Head of Investment Strategy for J.P. Morgan’s Asset Management
business. In that role, he leads Asset Management’s analyses of global markets for $1.8 trillion of client
assets worldwide. In addition, as Chief Investment Officer for global private banking at J.P. Morgan,
Mr. Cembalest is responsible for the day-to-day strategic and tactical asset allocation for $700 billion
in client assets.
Mr. Cembalest is also a member of the J.P. Morgan Asset Management Investment Committee and
a member of the Investment Committee for the J.P. Morgan Retirement Plan for the firm’s 240,000
Mr. Cembalest was formerly head of a fixed income division of J.P. Morgan Investment Management with
responsibility for high grade, high yield, emerging markets and municipal bonds.
Prior to 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.


RICHARD MADIGAN is Managing Director, Chief Investment Officer and Head of the Investment
Team managing the Global Access Portfolios and Access Funds at J.P. Morgan. With over 20 years
of experience in portfolio management and international capital markets, he is a senior member of
the J.P. Morgan Private Bank Global Strategy Team, where he is responsible for the development of
investment strategy, including tactical and strategic asset allocation. He is also responsible for the
Private Bank’s Global Portfolio Construction effort. In addition, Mr. Madigan is Chairman of the Hedge
Fund Advisory Council and an officer of J.P. Morgan Private Investments, Inc. Prior to his current role
with J.P. Morgan, Mr. Madigan served as Managing Director, Head of Emerging Markets Investments
and Senior Portfolio Manager at Offitbank, a New-York-based wealth management boutique, where
he managed the firm’s emerging markets assets and investment team, including the firm’s flagship
emerging markets mutual fund. Mr. Madigan’s commentaries have appeared in the Financial Times,
The New York Times, The Wall Street Journal, Bloomberg and Reuters. He has been a guest speaker
on CNBC, CNN and Bloomberg News, as well as at various industry conferences. Mr. Madigan holds a
master’s degree from New York University, where he majored in Finance and International Business.
MICHAEL VAKNIN serves as Chief Economist for J.P. Morgan Private Bank. In this role, he is
responsible for the global, macroeconomic and market research that underpins the firm’s long-term
views and, by extension, how client portfolios are positioned. Mr. Vaknin is also a member of the
Private Bank Investment Team, which guides asset allocation and market strategy decision-making for
J.P. Morgan private clients across the globe.
Prior to joining J.P. Morgan, Mr. Vaknin was a Senior Global Markets Economist at Goldman
Sachs International in London, where he supported global economic research and macro-based
rates strategy and analysis. With extensive expertise in interest rates, credit, currencies and
macroeconomics, his views were published regularly in various communications.
Previous to Goldman, Mr. Vaknin worked as an economist at the Falk Institute for Economic Research
and lectured on international finance and monetary economics at Columbia University. While earning
an M.A. and Ph.D. in Economics and Finance from Columbia University, he worked as a research
assistant to Nobel Laureates Joseph Stiglitz and Edmund Phelps as well as for Richard Clarida, former
Assistant Secretary of the U.S. Treasury.

IVAN LEUNG is a Managing Director and the Chief Investment Strategist for J.P. Morgan Private
Bank in Asia. Mr. Leung is responsible for setting the regional investment strategy as well as
managing the model portfolio that is implemented for discretionary portfolios. He is a member of the
Global Private Bank Investment Team and chairs the Asia Local Investment Committee.
Before joining J.P. Morgan in 2007, Mr. Leung served at UBS Wealth Management for six years and
was the regional head of portfolio specialists. There, he created and managed customized portfolio
solutions for ultra-high-net-worth and institutional clients. Prior to that, Mr. Leung worked for
Deutsche Bank and Dresdner Bank in portfolio manager roles.
Mr. Leung speaks frequently to the financial media. His articles and interviews have appeared in
newspapers and newswires, including the Financial Times, Business Times, The Edge Singapore and
Bloomberg. He holds a Bachelor of Applied Science degree from the University of Toronto and an
M.B.A. from the Schulich School of Business.

CÉSAR PÉREZ is Chief Investment Strategist for EMEA. He was most recently at Al Rajhi
Capital Bank in Riyadh, Saudi Arabia, where he was responsible for investment strategy, portfolio
construction and risk management. Mr. Pérez has worked in the investment management business
for the past 17 years, including two years at Credit Suisse Asset Management, where he was head
of equities, five years at M&G Investments in London and nine years at J.P. Morgan Investment
Management in Madrid, London and New York. Throughout his career, Mr. Pérez has worked across
all asset classes and regions for both institutional and private clients, serving in roles ranging from
portfolio management to sales and relationship management.
PHIL GUARCO is Chief Investment Strategist for J.P. Morgan Private Bank, Latin America. He is part
of the team responsible for Global Investments and Portfolio Strategy for J.P. Morgan international
client relationships. Mr. Guarco began his career with Citibank as a financial institutions banker in New
York. He subsequently served as a corporate and investment banker for Citibank in Mexico between
1992 and 1995. Additionally, Mr. Guarco worked for Citicorp in New York in its political risk insurance
subsidiary as a Senior Underwriter. He was also a Senior Credit Officer for Latin American financial
institutions at Moody’s from 1997 to 2006. His commentaries have been frequently covered in the local
Latin American press, as well as in the international press, such as the Financial Times, The New York
Times, and The Wall Street Journal. He has also been a guest speaker on Bloomberg and Reuters News
and has been cited frequently in World Bank and IMF publications. Mr. Guarco obtained his B.A. degree
in Economics and Spanish from Grinnell College, and a master’s degree in International Affairs and
Economics from the Johns Hopkins School of Advanced International Studies.
ANTHONY CHAN currently serves as the Chief Economist for Private Wealth Management. His
responsibilities include economic analysis and research supporting J.P. Morgan’s Wealth Management
businesses and the Private Bank’s strategy group. Mr. Chan has also served on the Economic Advisory
Committee of the American Banker’s Association. After completing his doctoral studies, Mr. Chan was
a Professor of Economics at the University of Dayton after which he was an Economist at the Federal
Reserve Bank of New York and a Senior Economist at Barclays de Zoete Wedd Government Securities.
He has been quoted in many media outlets, including The Wall Street Journal, Barron’s, The New
York Times, The Washington Post, the Chicago Tribune, the Los Angeles Times and Investor’s Daily. He
periodically appears on CNBC, Bloomberg TV and public television’s Nightly Business Report. Mr. Chan
received his B.B.A. in Finance and Investments from Baruch College and his Masters and Ph.D. in
Economics from the University of Maryland.

Hong Kong   United States   France         Dubai         270 Park Avenue
Singapore   Brazil          Germany                      New York, NY 10017
            Chile           Italy
            Mexico          Spain
            Peru            Switzerland
            Venezuela       United Kingdom

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Description: 2012 marks a transition away from extreme global monetary and fiscal stimulus, as illustrated by the setting sun. The private sector recovery will mostly have to make it on its own from here. The news is better in the US than in Europeor Japan. Asia is expanding, but tighter policy rates are bringing growth back to earth. The height of each tree showsthe recovery in each variable relative to its decline during the recession. See inside cover for more details.