J. P Morgan - EYE ON THE MARKET OUTLOOK 2013

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					EYE ON THE MARKET
OUTLOOK 2013
J.P. Morgan Private Bank




 “The Odyssey”
 This year’s cover art depicts the conflict between the world’s well-advertised challenges (the Squid), and its offsetting
 strengths (the Ship). The ship persevered in 2012, rewarding investors who maintained allocations to equities, credit
 and real estate with double-digit returns. The bar is a bit higher for 2013, as equity and credit valuations are no
 longer quite as cheap as they were. While politics may result in some volatility this year, we expect positive returns
 on financial assets by the time it’s over. See inside cover for more details.
There is a long history of European literature referring to seaborne battles with mythical sea creatures.
In Homer’s The Odyssey, Odysseus loses several men to the sea monster Scylla, while Icelandic and Norwegian
sagas refer to sea monsters that swallow men and ships. British poet Alfred Lord Tennyson wrote a sonnet
about a giant squid (“The Kraken”), and in 20,000 Leagues Under the Sea, French author Jules Verne describes
a giant squid attacking Captain Nemo’s vessel and devouring a crew member. On the cover, many of the squid’s
tentacles are European, a reminder that its debt/growth crisis still represents a large risk to the global economy.
                                                                                         Cover illustration by Anni Betts
                                  MARY CALLAHAN ERDOES
                                        Chief Executive Officer
                                   J.P. Morgan Asset Management




     How do you summarize a year that was in many respects indefinable? On one
In many respects, 2012 was a year of waiting: waiting for a path forward on the European debt
     hand, the European sovereign debt crisis, contracting housing markets and high
     unemployment results of a polarizing of our minds. But at the same time, record
crisis; waiting for theweighed heavy on all U.S. election; waiting for the Chinese leadership
     corporate profits and strong emerging markets issues; left reason for optimism.
transition; waiting for a resolution to the U.S. fiscal cliffgrowth waiting for the Middle East to
     peace; waiting look back, we’d global growth; and therefore, waiting one thing that
findSo rather than for a clear path tolike to look ahead. Because if there’sto invest additional
    we’ve learned from the past few years, it’s that while we can’t predict the future,
assets in the markets.
    we can certainly help you prepare for it.

     To help be a you in the coming year, our but it Investment Officer Michael
Waiting mayguidegood approach to many things,Chief is rarely a good idea in an investment
     Cembalest has spent the past several gathered over the with our investment
portfolio. The collective experience we have months working last 175 years of investing at
     leadership across Asset Management worldwide to build a comprehensive view
J.P. Morgan grounds us in the ability to see through temporary market disruptions and focus
     of the macroeconomic landscape. In doing so, we’ve uncovered some potentially
     exciting investment opportunities, as well as some areas where we see reason to
on keeping our clients invested for the long term, understanding that markets have a way of
     proceed with caution.
moving long before statistics and headlines say so. That was certainly the case in 2012, when
    Sharing these perspectives and value.
nearly every asset class appreciated in opportunities is part of our deep commitment to
    you and what we focus on each and every day. We are grateful for your continued
    trust and confidence, and look forward to working with you in 2011.
In this Outlook 2013, Michael Cembalest, our Chairman of Market and Investment Strategy, gives
us aMost sincerely,summary of the global factors at play, with a tone of optimism grounded in
    comprehensive
realism, and a path toward exciting new investment opportunities for future growth.


We appreciate the opportunity to share our thoughts with you.


More importantly, we thank you for your continued trust and confidence in J.P. Morgan.


Most sincerely,
  Eye on the Market | OUTLOOK 2013 January 2, 2013
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2013 Outlook
2013 Outlook
 The Odyssey. As we head into 2013, the global economy is treading water (c1 and c2), with better news in the US and China
The Odyssey. As we head into 2013, the global economy is treading water (c1 and c2), with better news in the US and China
 than in Europe, and with leading indicators pointing to more activity in services than in manufacturing. The cover art is meant
than in Europe, and with leading indicators pointing to more activity in services than in manufacturing. The cover art is meant
 to convey the conflict between the world’s well-advertised challenges (the Squid), and its offsetting strengths (the Ship). The
to convey the conflict between the world’s well-advertised challenges (the Squid), and its offsetting strengths (the Ship). The
 ship persevered in 2012, as the usual suspects that make up most portfolios (equities, credit and real estate) generated double-
ship persevered in 2012, as the usual suspects that make up most portfolios (equities, credit and real estate) generated double-
 digit returns despite low economic growth. The bar for 2013 is a bit higher since equity and credit valuations have risen.
digit returns despite low economic growth. The bar for 2013 is a bit higher since equity and credit valuations have risen.
 However, equity valuations are by no means stretched (c3), and still demonstrate skepticism about the future. While 2013 may
However, equity valuations are by no means stretched (c3), and still demonstrate skepticism about the future. While 2013 may
 be volatile for political reasons (see box), a portfolio of risky assets should generate modestly positive returns by the time the
be volatile for political reasons (see box), a portfolio of risky assets should generate modestly positive returns by the time the
 year is over. In all, 2013 looks to be another year of markets outperforming what economic growth conditions alone
year is over. In all, 2013 looks to be another year of markets outperforming what economic growth conditions alone
 would imply.
would imply.

 (c1) Global all-industry activity
  (c1) Global all-industry activity           (c2) Global air cargo traffic
                                             (c2) Global air cargo traffic                (c3) 2012 returns and valuation changes
                                                                                         (c3) 2012 returns and valuation changes
 Purchasing Managers Index, sa
 Purchasing Managers Index, sa               Freight-tonne kilometers, YoY % change
                                             Freight-tonne kilometers, YoY % change                        Jan '12 Dec '12
                                                                                                          Jan '12 Dec '12           2012
                                                                                                                                   2012
65
65                                           40%
                                             40%                                         Equity
                                                                                         Equity          P/E mult. P/E mult.
                                                                                                         P/E mult. P/E mult.      Return
                                                                                                                                  Return
                                                                                         S&P 500
                                                                                         S&P 500             11.7x
                                                                                                             11.7x      12.7x
                                                                                                                        12.7x       16.0%
                                                                                                                                    16.0%
                                             30%
                                             30%
                                                                                         MSCI Europe
                                                                                         MSCI Europe          9.6x
                                                                                                              9.6x      11.3x
                                                                                                                        11.3x       17.5%
                                                                                                                                    17.5%
60
60                                                                                       MSCI EM
                                                                                         MSCI EM              9.3x
                                                                                                              9.3x      10.6x
                                                                                                                        10.6x       18.5%
                                                                                                                                    18.5%
                                             20%
                                             20%
                                  US
                                  US
                                                                                         US REITs
                                                                                         US REITs            21.8x
                                                                                                             21.8x      21.4x
                                                                                                                        21.4x       19.6%
                                                                                                                                    19.6%
                                             10%
                                             10%
55
55                                                                                       Credit
                                                                                         Credit            Spread
                                                                                                           Spread     Spread
                                                                                                                      Spread      Return
                                                                                                                                  Return
                                              0%
                                              0%                                         US high yield
                                                                                         US high yield     724 bps
                                                                                                           724 bps     549 bps
                                                                                                                       549 bps      15.4%
                                                                                                                                    15.4%
                                                                                         EM $ debt
                                                                                         EM $ debt         426 bps
                                                                                                           426 bps     271 bps
                                                                                                                       271 bps      18.5%
                                                                                                                                    18.5%
50
50                                            -10%
                                             -10%
                                                                                         Bonds
                                                                                         Bonds                Yield
                                                                                                              Yield      Yield
                                                                                                                         Yield    Return
                                                                                                                                  Return
                                 China
                                 China        -20%
                                             -20%                                        10-year UST
                                                                                         10-year UST         1.88%
                                                                                                             1.88%      1.76%
                                                                                                                        1.76%        4.4%
                                                                                                                                     4.4%
              Euro area
              Euro area
45
45                                            -30%
                                             -30%                                        Returns through Dec. 31, 2012
                                                                                         Returns through Dec. 31, 2012
  2010
  2010        2011
              2011        2012
                          2012        2013
                                      2013       2003
                                                  2003   2005
                                                         2005   2007
                                                                2007   2009
                                                                       2009   2011
                                                                              2011       P/E multiples based on fw d. consensus earnings
                                                                                         P/E multiples based on fw d. consensus earnings


 It’s not an overstatement to say that we are living through the largest policy experiments of the last 300 years (c7, c13,
It’s not an overstatement to say that we are living through the largest policy experiments of the last 300 years (c7, c13,
 c82). In the US, Europe, Japan and the UK, governments account for 75% of all borrowing that is taking place, and central
c82). In the US, Europe, Japan and the UK, governments account for 75% of all borrowing that is taking place, and central
 banks account for 60% of all lending, both multiples higher than anything we have seen (or read about) before. As a sign of the
banks account for 60% of all lending, both multiples higher than anything we have seen (or read about) before. As a sign of the
 times, monetary policy was the primary issue in the recent election in Japan; voters gave a decisive victory to the party that
times, monetary policy was the primary issue in the recent election in Japan; voters gave a decisive victory to the party that
 campaigned on forcing its central bank to provide more of it. Central banks appear determined to reflate financial assets, hoping
campaigned on forcing its central bank to provide more of it. Central banks appear determined to reflate financial assets, hoping
 for whatever spillover they can get to economic growth.
for whatever spillover they can get to economic growth.
 On the following pages, we walk through a graphical depiction of the issues on the front cover; an economic review of the US,
On the following pages, we walk through a graphical depiction of the issues on the front cover; an economic review of the US,
 Europe and the emerging economies; and a summary of investment and market views. At the end, a look beyond 2013 at two
Europe and the emerging economies; and a summary of investment and market views. At the end, a look beyond 2013 at two
 litmus tests for America: entitlements and energy independence.
litmus tests for America: entitlements and energy independence.

Michael Cembalest
Michael Cembalest
J.P. Morgan Asset Management
J.P. Morgan Asset Management


Fiscal cliff update. started writing about the disappearance of the political middle three years ago, when Congressional
Fiscal cliff update. II started writing about the disappearance of the political middle three years ago, when Congressional
polarization surpassed levels last seen during Reconstruction, a rancorous period following the Civil War. But even cynics like
polarization surpassed levels last seen during Reconstruction, a rancorous period following the Civil War. But even cynics like
me did not anticipate how difficult a fiscal cliff deal would be. It actually required the House Speaker to split the Republican
me did not anticipate how difficult a fiscal cliff deal would be. It actually required the House Speaker to split the Republican
caucus and introduce a bill that most of his members rejected. At the 11th hour, tax austerity scheduled for 2013 was cut by 2/3,
caucus and introduce a bill that most of his members rejected. At the 11th hour, tax austerity scheduled for 2013 was cut by 2/3,
as Congress unplugged most tax increases and spending cuts and agreed to raise taxes only on the wealthy. Defusing the cliff
as Congress unplugged most tax increases and spending cuts and agreed to raise taxes only on the wealthy. Defusing the cliff
removes barriers to growth in 2013, but upper bracket tax hikes make no more than a small dent in the deficit, and the Federal
removes barriers to growth in 2013, but upper bracket tax hikes make no more than a small dent in the deficit, and the Federal
debt is headed to levels exceeded only during WWII. As Walt Kelly (Pogo) once said, “we have met the enemy, and he is us.”
debt is headed to levels exceeded only during WWII. As Walt Kelly (Pogo) once said, “we have met the enemy, and he is us.”
 Looking ahead to the spring, debt ceiling and continuing budget resolutions may be even more contentious. What will the
Looking ahead to the spring, debt ceiling and continuing budget resolutions may be even more contentious. What will the
 sticking points be? There’s not much left to fight about on non-defense discretionary spending, scheduled to hit a 50-year low
sticking points be? There’s not much left to fight about on non-defense discretionary spending, scheduled to hit a 50-year low
 in 2017. As shown on page 14, outlays on things like energy R&D, education, worker retraining and infrastructure are
in 2017. As shown on page 14, outlays on things like energy R&D, education, worker retraining and infrastructure are
 increasingly crowded out by entitlements. The positions are clear: Democrats either simply do not believe that entitlement
increasingly crowded out by entitlements. The positions are clear: Democrats either simply do not believe that entitlement
 math is unsustainable, or search in vain for sufficient tax hikes to pay for them; while Republicans search for the political cover
math is unsustainable, or search in vain for sufficient tax hikes to pay for them; while Republicans search for the political cover
 to scale back social programs and still get elected. Of all the advice given by the country’s founders, perhaps none is more
to scale back social programs and still get elected. Of all the advice given by the country’s founders, perhaps none is more
 forgotten than the admonitions in George Washington’s farewell address: to cherish public credit, preserve it by using it as little
forgotten than the admonitions in George Washington’s farewell address: to cherish public credit, preserve it by using it as little
 as possible, and to “not ungenerously throw upon posterity the burden which we ourselves ought to bear".
as possible, and to “not ungenerously throw upon posterity the burden which we ourselves ought to bear".


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    Eye on the Market | OUTLOOK 2013 January 2, 2013
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2013 Outlook
The Squid. For 3,000 years, European authors (Homer, Verne, Tennyson and the Scandinavian sagas) have portrayed battles
with giant sea creatures, a reminder of which are the tentacles on the cover with European themes. Among our concerns: the
socio-economic and political implications of Europe’s employment crisis (c4); the continuing debt overhang of the Spanish
economy, even after help from the ECB (c5); the growing economic gap between France and Germany (c6); and the decline in
European imports (c64). The OECD’s fiscal situation is difficult (c7), and unless growth rebounds more rapidly, more austerity
will be imposed on the private sector at some point. The US fiscal cliff, deferred though it may be, cannot be made to disappear.
The political winds suggest that taxes will be raised to sustain entitlements, rather than constraining the latter to minimize the
former. The US private sector is showing signs of life, but US labor compensation is weak (c8), so too much austerity may
negatively affect consumption. In China, without continued expansion of credit and capital spending (c9), growth rates will
probably come down to 7%-8%. Japan is a mess (c10), grappling with the end of its current account surplus era which began in
1965, and a gazillion Yen of government debt. Central banks can be expected to keep the cost of money cheap, but the stimulus
benefit to manufacturing has been fading (c11). Finally, there’s the issue of Iran, where uranium enrichment marches on despite
crippling economic sanctions, a topic we addressed in more detail last November 19th. Henry Kissinger wrote recently that this
issue should be the President’s #1 foreign policy issue, and I can understand why: 2013 is the year in which Iran will have
enough enriched uranium to make a nuclear weapon (c12).

    (c4) Periphery employment crisis                 (c5) Spanish net foreign liabilities                  (c6) Growing Franco-German gap
    Unemployment, Periphery - Germany, %              Percent of GDP                                       Percent                            Billions, EUR
                                                     100%          ECB + EMU Central Banks                 4%                 Germany –                   800
    12%
               Euro exchange                                                                                                France, exports
    10%                                                                                                    3%                                             700
                    rate fixed
    8%                                               75%                                                   2%   France –
                                                                                                                Germany,                                  600
    6%                                                                                                     1% unemployment
    4%                                               50%                                                                                                  500
                                                                                                           0%
    2%                                                                                                                                                    400
                                                     25%              Foreign private sector               -1%
    0%
                                                                                                           -2%                                            300
    -2%
    -4%                                               0%                                                   -3%                                            200
       1980 1985 1990 1995 2000 2005 2010               1999        2002      2005       2008     2011        1999   2001    2004      2007    2010

    (c7) OECD fiscal situation                       (c8) Weak US labor compensation                       (c9) China capital spending/credit
    Percent of GDP                                   Qtrs. s ince profit trough, billions 2005 USD         overhang, Percent of GDP
    110%                                        0% 700                                                     50%                                        210%
               Fiscal balance                   -1% 600                                                               Total debt of
    100%                                                                   Past 5 recoveries
                                                -2% 500                                                    45%        non-financial sector
    90%                                                                                                                                               190%
                                                -3% 400
    80%                                              300                                                   40%    Gross fixed
                                                -4%
                                                     200                                                             capital                          170%
    70%                                         -5%
                                                     100                                                   35%     formation
                                                -6%                                Current recovery
    60%                                                0
                                                -7% -100                                                                                              150%
                    Gross debt                                                                             30%
    50%                                         -8% -200
    40%                                         -9% -300                                                   25%                              130%
       1980 1985 1990 1995 2000 2005 2010                  0    2     4       6      8    10     12   14      1980 1986 1992 1998 2004 2010

    (c10) Japan growth abyss, 1991-2011               (c11) Fading growth benefits from                     (c12) Iranian enrichment marches on
    Nominal GDP growth                                stimulus, Global Manufacturing PMI, index             despite crippling sanctions
    10%                                              60                                                     19.75% enriched uranium stockpile (kg)
                                                                                                           160
    8%                                               55                                                            Minimum required for
                                                                                                           140
                                                                                                                 nuclear weapon production
    6%                                               50                                                    120
    4%                                                                                                     100
                                 IMF Advanced        45
                                                                                                            80   Additional capacity
    2%                             Economies                                                                                                      Projected
                                                                                                            60   from Fordow on top
                                                     40
                                                                                                                 of Natanz
    0%                                                                                                      40
               Japan                                 35                                                                             Drawdown to
    -2%                                                                                                     20
                                                                                                                                replenish reactor fuel
          0%   1%    2% 3% 4% 5%          6%    7%   30                                                      0
                      Real GDP growth                 2007     2008    2009       2010    2011    2012       Feb-10 Nov-10 Aug-11 May-12 Feb-13




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  Eye on the Market | OUTLOOK 2013 January 2, 2013
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2013 Outlook
The Ship. Start with the ship’s foresail, central bank balance sheet expansion (c13). It has brought down the cost of credit, and
in the case of Europe, deferred sovereign and bank insolvency risk to another day. In the 1970’s, monetary policy was too easy
and caused an inflation problem, since there was little excess capacity. Looking at the “output gap”, there’s a lot of excess
capacity now (c14) and inflation is low (c81), allowing central banks to keep going. As a result, while government debt levels
are high (c7), the cost of servicing it is not (c15). The fore royal sail is the US housing recovery, which is not in dispute (c16);
we are debating the multiplier effect. The mizzen topsail, consumption in the emerging world, is holding up even as EM
manufacturing has slowed down, a reflection of rising household incomes (c17). The “death of equities” chatter seems odd,
given how well the mainsail of corporate cash flow is doing (c18); dividend growth rates are the highest in six decades. On
valuations (the fore topgallant sail), any approach using interest rates indicates that equities are still cheap (c19). Since 1960,
the S&P has not generated negative 1-year returns when the spread between S&P earnings yields and Treasury yields is this
high. The main royal sail is the natural gas boom (c20), which helps push out the “peak energy problem” to another day,
particularly in gas-abundant countries like the US (c90-c93). One of the most important drivers of the ship is the main
topgallant sail: walls of household and corporate cash (c21), which reflect caution about the future and lots of buying power. As
2012 came to a close, these cash balances were finally being drawn down and put to work in the form of consumer spending,
higher dividends and corporate acquisitions.
 (c13) To infinity...and beyond!!              (c14) Output gap of advanced                        (c15) OECD government net interest
 Central bank balance sheets, percent of GDP   economies, Percent of potential GDP                 expense, Percent of GDP
 45%                                            5%                                                 3.5%
         European Central Bank                             Positive output gap led
 40%     Bank of Japan                          4%
                                                                  to inflation                     3.0%
 35%     Federal Reserve                        3%
         Bank of England                        2%
 30%                                                                                               2.5%
                                                1%
 25%                                            0%                                                 2.0%
 20%                                           -1%
                                               -2%                                                 1.5%
 15%
                                               -3%                                                 1.0%
 10%                                                            Plenty of room to
                                               -4%
                                                           expand without inflation
  5%                                           -5%                                                 0.5%
    2008 2009 2010 2011 2012 2013                 1970     1980         1990     2000       2010       1970 1976 1982 1988 1994 2000 2006 2012

 (c16) "Shadow inventory" is steadily          (c17) Emerging markets retail sales                 (c18) Free cash flow to assets of US
 declining, Million units                      volume, Percent change, YoY                         large cap growth stocks, Percent
 7                                             14%
                 Real estate
 6               owned (REO)                   12%                                                 10%

 5                                             10%
                                                                                                   8%
 4                                             8%
                             Foreclosure                                                           6%
 3                                             6%
 2                                             4%
                             60+ days                                                              4%
 1                           delinquent        2%
 0                                             0%                                                  2%
 2000 2002 2004 2006 2008 2010 2012              2001    2003    2005    2007   2009    2011         1970       1980        1990     2000      2010

 (c19) S&P 500 trailing earnings yield         (c20) Natural gas boom                               (c21) The Walls of Cash
 less 10-year interest rates                   Global production index, 1970 = 100
 9%                                            350                                                 12%                                             12%
       Cheap                                                                                                                 Household
 7%
                                               300                                                                           cash to GDP           10%
                                                                                                   10%
 5%                                                                     Natural gas
 3%                                            250                                                                                                 8%
                                                                                                    8%
 1%                                            200                                                                                                 6%
-1%                                                                                                 6%
                                               150                                                                                                 4%
-3%                                                                             Crude oil                 Corporate
       Expensive
                                                                                                          cash to assets
-5%                                            100                                                  4%                                             2%
   1952 1962 1972 1982 1992 2002 2012             1970    1980      1990        2000     2010         1960    1970   1980    1990   2000    2010




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    Eye on the Market | OUTLOOK 2013 January 2, 2013
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2013 Outlook
United States: Consumer and housing recovering after a long hangover; eventually, fiscal ax will fall on some of them
The US consumer is showing signs of life: declining delinquencies (c22), improved balance sheets (c23; although this reflects
low rates more than debt reduction per se), the rise in the cyclical component of the job market (c24) and modestly rising
consumer sentiment (c25). As a result, real consumption growth of 2% seems achievable (c26) once hurricane effects fade.
Weakness in wages (c8) has been offset by large government transfers, so too much tax austerity in 2013 would bite.
    (c22) Delinquencies back to pre-            (c23) Household debt and debt                            (c24) Improving "cyclical" payrolls
    crisis levels, Percent                      service, Percent of disposable income                    Total payrolls excluding construction,
3.5%                                            140%                                            14.0%    government, & finance, millions
                                  Credit card                                                           100
3.0%                              delinquency   130%                                            13.5%
                                                                    Debt service                         99
                                   rate (90+    120%                                            13.0%    98
2.5%                                  days)     110%                                                     97
                                                                                                12.5%
2.0%                                            100%                                                     96
                                                                                                12.0%    95
1.5%                                             90%
                First-time                                                                      11.5%    94
                                                 80%                          Household                  93
1.0%            mortgage                                                        debt
                                                 70%                                            11.0%    92
               default rate
0.5%                                             60%                                            10.5%    91
    2007    2008    2009   2010   2011   2012       1980       1990           2000      2010              1998 2000 2002 2004 2006 2008 2010 2012

    (c25) U. Michigan consumer sentiment        (c26) US consumer trends                                (c27) Business caution
    Index                                       Percent change, YoY                  Millions, SAAR     USD, bn, non-defense ex-aircraft          Index
 110                                             5%                                               22 70                                               105
                                                                     Real personal                                         Durable
                                                 4%                                               20
 100                                                                 consumption                                            goods
                                                 3%                                                     65                                            100
                                                                                                  18                       orders
    90                                           2%
                                                 1%                                               16 60                                               95
    80
                                                 0%                                               14 55                                               90
    70                                          -1%
                                                                                                  12
                                                -2%                                                  50                                               85
    60                                                        Auto Sales                          10                            Small business
                                                -3%
                                                                                                                                   survey
    50                                          -4%                                               8     45                                            80
     2004    2006     2008    2010       2012      2004      2006      2008     2010     2012            2006       2008      2010       2012

The fly in the ointment is the slowdown in US business capital spending and sentiment (c27). This is a consequence of
weakness in Asia and Europe, but also of fiscal cliff concerns. Everyone knows by now that legislated austerity in the US is
large (c28), and will have to be reduced to avoid a recession. However, regardless of how the cliff is dealt with, the US will still
face challenging budget dynamics (c29 and c30) in the years ahead. Being the world’s reserve currency gives the US some
breathing room (c96), but the debates in DC reflect a recognition that something may have to be done soon. Around $4 trillion
in deficit reduction (higher taxes, lower spending) over 10 years is needed to get the debt down to 70% of GDP. In the 1950’s,
the US avoided that approach and mostly relied on a pro-growth agenda (see page 13), but political winds make this unlikely.
    (c28) Change in cyclically-adjusted          (c29) US tax policy and expenditures                   (c30) US long-term debt scenarios
    US federal deficit, % of potential GDP       Percent of GDP                                         Net debt to GDP, percent
  5                                                                                                     90%
       Fiscal stimulus                          24%                                                              CBO Alternative
  4                                                                       Expenditures
                                                                                                        80%          Case
  3
                                                22%
  2                                                                                                     70%
  1                                             20%       Receipts
                                                                                                        60%                   CBO Baseline
  0
 -1                                             18%                                                     50%
 -2                     2013 estimate                                                                                     Tax hikes, AGI>$250k
                           assuming             16%                                                     40%                      Obama budget
 -3
       Fiscal drag        current law                                                                                 Obama budget + Sequester
 -4                                             14%                                                     30%
   1963 1970 1977 1984 1991 1998 2005 2012             50's 60's 70's 80's 90's 00's 2012E                 2004 2007 2010 2013 2016 2019 2022

Putting it all together, our best guess is a reduction of the fiscal cliff to 1.5% of GDP in 2013, payroll growth of 200k per
month, a rebound in business investment, and GDP growth of ~2.5% by the fall (this is not a Herculean achievement; most
countries should grow by 2.5% with a 7% budget deficit and 0% interest rates to pull forward future consumption). Note that the
growth estimate reflects a multiplier effect of payroll tax and upper bracket income tax rate increases of less than 1.0.

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  Eye on the Market | OUTLOOK 2013 January 2, 2013
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2013 Outlook
Close-up: What will the growth contribution be from the US housing recovery?
Pent-up demand (c31), easier financing conditions, and the extent to which buying is cheaper than renting (c32) have prompted
consumers to start looking for mortgage credit (c33), and to buy homes again (c34). The results: The homebuilder survey is
soaring, as are housing permits and starts (c35). As further confirmation, the residential component of the Architecture Billings
Index hit a 5-year high in November. The very strong rebound in the “sand” states is particularly telling (c36). However,
housing’s share of GDP and employment is lower after the collapse (c37), so its contribution is growing from a low base. We
also don’t expect a recurrence of massive home equity borrowing that reached $1 trillion per year in early 2006. So far, the
housing recovery has not been reliant on credit, shown by the lack of a pick-up in mortgage applications (c38). As a result,
housing should contribute roughly 0.75% to growth in 2013. That’s pretty good, but less than in the late 1940’s, less than
the housing recovery of 1982 (c39), and less than some forecasts we have seen (e.g., Roger Altman’s 1%-2%). There should be
positive multiplier effects in the rest of the economy, which gets us to around 2.5% GDP growth in 2013 after accounting for the
drag from the fiscal austerity that is not legislated away.
One last point: The rise in average FICO scores for mortgage originations (c38) is mostly a reflection of tighter criteria applied
to refinancing. As per data made available by the Home Mortgage Disclosure Act, in terms of purchase loans, almost half the
volume from 2009 to 2011 was underwritten by the Federal Housing Administration, Veterans Affairs and the Department of
Agriculture with average down-payments of just 3%. A problem for another day?
 (c31) An estimate of pent-up                  (c32) Where buying is cheaper than                 (c33) % of banks reporting more (less)
 demand for housing, Millions of units         renting, Percent of metropol. stat. areas          demand for residential mortgages
 1.5                                           60%                                                  80%
 1.0                                                                                                60%
                                               50%
                                                                                                    40%
 0.5
                                               40%                                                  20%
 0.0                                                                                                 0%
                                               30%
-0.5                                                                                               -20%
                                               20%                                                 -40%
-1.0
                                                                                                   -60%
-1.5                                           10%
                                                                                                   -80%
-2.0                                            0%                                                -100%
    2004    2006    2008     2010    2012         2000 2002 2004 2006 2008 2010 2012                   1991 1994 1997 2000 2003 2006 2009 2012

 (c34) % of consumers planning to              (c35) Demand for housing has                       (c36) Sand states (AZ, NV, FL & CA)
 buy a home within six months                  improved, Index   Percent of households            Percent change, YoY
10%                                            70               Avg. of housing starts     2.5%    80%                                          20%
       6-month moving average                                                                                         Real estate related
 9%                                            60                    and permits                   60%                                          15%
                                                                                                                        employment
                                                                                           2.0%                                                 10%
 8%                                            50                                                  40%
                                                                                                                                                5%
                                                                                           1.5%    20%
 7%                                            40                                                                                               0%
                                                                                                    0%
 6%                                            30                                                                                               -5%
                                                                                           1.0%   -20%
                                                                                                                       Building                 -10%
 5%                                            20                                                 -40%
                                                          Traffic of                       0.5%                        permits                  -15%
 4%                                            10    prospective buyers                           -60%                                          -20%
 3%                                             0                                          0.0%   -80%                                          -25%
   1980     1988     1996     2004      2012    1985 1990 1995 2000 2005 2010                         1991    1996    2001   2006   2011

 (c37) Share of housing in GDP and             (c38) Credit expansion not playing a                (c39) Residential investment
 employment, Percent                           role yet, Score                  Index              contribution to real GDP growth, ppts
 8%                                            760                                          600    2.5%
                                                         Mortgage applications
 7%         Construction share of              750                                          550    2.0%
                                                             for purchase
               employment                      740                                          500    1.5%
 6%
                                                                                            450    1.0%
 5%                                            730
                                                                                            400    0.5%
 4%                                            720
                                                                                            350    0.0%
 3%            Residential investment          710
                                                                                            300   -0.5%
 2%                share of GDP                700                                          250   -1.0%
 1%                                            690                                          200   -1.5%
                                                           Avg. FICO score
 0%                                            680                                          150   -2.0%
   1939 1949 1959 1969 1979 1989 1999 2009        2001      2003   2006      2009   2012               1930    1950      1970     1990      2010


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    Eye on the Market | OUTLOOK 2013 January 2, 2013
                           

2013 Outlook
Europe: Capital markets rescue in full swing, but fewer signs of improvement on the ground
Take a road trip across Europe on behalf of Chancellor Merkel to assess economic conditions. Start in Berlin1:
• German growth is fading to +1% (c40). This is not catastrophic and the latest data releases are not declining any more, but
  Germany is the backstop for Europe and its debt is already over 80% of GDP. Take A2 and head southwest to Paris.
• France has stalled (c41) and its employment/export gap with Germany is widening (c6), making it harder to pay for its
  worker utopia (c42). Businesses are more pessimistic about Hollande than consumers so far. Head south on A10 to Madrid.
• Since 1850, Spanish growth over 5 years has only been weaker during its civil war (c43). Its current account improvement is
  a false signal, since unemployment is 25% and Spain is in recession (c44); look at the cyclically-adjusted one instead. Bank
  non-performing loans are still rising and home prices are still falling. Head east on A8 to Rome.
• Italy didn’t have a housing crisis and its banks are in decent shape, but government debt is close to post-1861 unification
  peaks (c45) and requires constant primary budget surpluses. If it weren’t for Japan, Italy would be the poster child for an
  aging, over-indebted low-growth economy. Take the Brindisi ferry to Igoumenitsa, then take E90 southeast to Athens.
• Greece’s GDP decline is among the worst of the post-war era, exceeded only by the collapse of Soviet communism, and
  foreign/civil wars (c46). Greece’s debt ratio is 170% after private sector debt relief (the 120% target is for 2022); similar
  exercises in Argentina and Mexico yielded 40%-60%. Head north to Berlin on E75 and report back to Merkel.
    Road trip                                   (c40) Decline in German business                      (c41) French growth stalls, business
                                                surveys and manufacturing orders                      confidence even worse
    Google maps
                                                Percent change, YoY                        Index      % change, YoY                 Index, L-T average = 100
                                                30%                                           115      4%                               Real GDP          120
                                                20%                                           110                                       growth
                                                                                                       2%                                                              110
                                                10%
                                                                                              105                                                                      100
                                                 0%                                                    0%
                                                                                              100                                                                      90
                                               -10%                                                  -2%
                                                        German
                                                                                              95                                                                       80
                                               -20%   manufacturing       IFO survey of
                                                         orders           non-financial              -4%                                                               70
                                               -30%                                           90                 Business climate
                                                                           businesses                            survey
                                               -40%                                           85     -6%                                                               60
                                                   2005    2007    2009       2011                      2003          2005      2007     2009       2011

(c42) France: A worker's utopia                                       (c43) Spain's economic decline
Average dispersion above or below the mean, across 9 factors          Percent change in 5-year real Spanish GDP, since 1850
 1.5                                                                  60%
          Most favorable to workers
 1.0                                                                  50%
                                                                      40%
 0.5
                                                                      30%
 0.0                                                                  20%

-0.5                                                                  10%
                                                                       0%
-1.0
                                                                      -10%     Revolution/    Pan-European                                                 Euro
                                      Least favorable to workers                              banking crisis/                                              boom-
-1.5                                                                  -20%     exile Queen
                                                                               Isabella       Phylloxera                  Civil war                        bust
            IRL
          FRA




          CZE




          CHL
             UK




           IND


           IDN


             HK
          SWE




          COL
          HUN




          BRA



          MAL
          USA


          CHN
          PRT
           BEL
          AUT




          RUS



          NZL
          CHE
          GRC
          NLD
          NOR




          MEX




          PHL
          VEN

          ARG
          TUR




          PER
            ITA
          ESP




          POL
          JPN




          ECU



          CAN


          THA


           SIN
          GER




          KOR




                                                                      -30%
                                                                             1855   1872     1889   1906       1923      1940   1957     1974      1991      2008

    (c44) Spain isn't more competitive,         (c45) Italy's debt/GDP: highest since               (c46) Largest post-war GDP declines
    just in recession, Percent of GDP           unification other than wartime, Gross                           5 yrs Real GDP
    2%                                          general government debt/GDP                                    ending decline Proximate cause
                             Actual           160%                                                  Ukraine     Mar-97     -50.8%   USSR collapse
    0%
                            current           140%
                                                                                                    Bulgaria    Jun-94     -37.1%   Chaotic transition to capitalism
    -2%                     account                       WW I                WW II                 Venezuela Mar-03       -31.5%   Failed PDVSA strike to oust Chavez
                                              120%                                                  Romania Dec-92         -30.6%   Chaotic transition to capitalism
    -4%
                                              100%                                                  Peru       Sep-92      -27.8%   Shining Path civil war, hyper-inflation,
    -6%                                                                                                                             nationalization
                                               80%                                                  Russia      Mar-97     -26.4%   USSR collapse
    -8%                                        60%                                                           Mar-97
                                                                                                    Kazakhstan             -25.4%   USSR collapse
          Cyclically-adjusted
                                                                                                    Iran       Sep-88      -20.8%   Isolation after '79 revolution, 1980-
-10%       current account                     40%                                                                                  1988 Iran-Iraq war
-12%                                        20%                                                     Greece     Dec-13      -20.8%   Eur. Mon. Union boom-bust
    1990 1993 1996 1999 2002 2006 2009 2012    1861 1886 1911 1936 1961 1986 2011                   Latvia      Mar-97     -19.2%   USSR collapse


1
    Messerschmitt Kabinenroller (Ger), Citroën DS (Fr), SEAT 600 (Sp), Alfa Romeo Giulia Spider (It), and Namco Pony (Greek).
                                                                                                                                                                 6
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  Eye on the Market | OUTLOOK 2013 January 2, 2013
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2013 Outlook
Explain to Merkel that Europe may grow at 0% in 2013 after a mild recession in 2012, that periphery unemployment is 18% and
rising (c4), and that tensions are resulting in higher polling results for some extremists (c55). At least fiscal austerity peaked in
2012 (c47), allowing easier conditions in 2013. The jovial Chancellor is not happy! These risks are understood in Berlin, which
explains the capitulations Germany made (ECB expansion, bilateral loans, relaxed fiscal targets, etc.). The expanded safety
net has paid dividends: not economic ones, but in markets. To see how, start with Europe’s balance of payments crisis,
shown by the collapse in French and German bank claims on the periphery (c48). In response, Germany has allowed the ECB to
finance governments, banks and bank recapitalizations (c13). There are few specifics, but the mere suggestion of a couple of
trillion Euros of unconditional support (c49) has calmed markets. Since Draghi’s July “bumblebee” speech, Eurozone equities
are up 12%, credit spreads plummeted (c50), bank deposits and private foreign ownership of Spanish and Italian bonds
stabilized (c51, c52), peripheral banks can issue debt again (c53), and Spain made a small reduction in assets financed at the
ECB (c54). Compared to Draghi, only the Three Witches from Macbeth ever cast a wider and more powerful spell.
 (c47) Fiscal thrust in Europe                  (c48) Bank claims on Portugal, Greece,         (c49) Euro public support: potential
 Percent of potential GDP                       Ireland, Spain, Italy, Billions, USD           uses and capacity, Billions, EUR
 0.0%                                           1000                                           2,500
                                                                                   French
 -0.5%
                                                                                    banks      2,000                                       ECB
 -1.0%                                           800                                                                   Bank recap
 -1.5%                                                                                         1,500
                                                 600                                                                   Sovereign    Uncommitted
 -2.0%                                                                                                                                 ESM
                                                                                               1,000
                                                                                                                                    levered 3:1
 -2.5%                                           400
             Germany                                                             German         500
 -3.0%       Italy                                                                banks                                                 IMF
                                                 200                                                                                   EFSF
 -3.5%       Spain                                                                                   0
                                                                                                         Committed      Further       Potential
 -4.0%                                                0                                                                 needs          funding
            2011        2012            2013           2000 2002 2004 2006 2008 2010 2012                                             capacity

 (c50) Spanish credit spreads                   (c51) Peripheral European deposits              (c52) Private foreign holdings of
  5-year CDS, basis points                      Index, June 2009 = 100                          Spanish & Italian gov't debt, bn, EUR
 650                Draghi's                    130                                            240                                                 850
                                                       Portuguese          Italian banks
                  bumblebee                     120      banks                                                                         Italy
 550                                                                                           220                                                 800
                    speech
                                                110
 450                                                                                           200                                                 750
                                                100
 350                                                                                           180                                                 700
                                                90                        Spanish banks
 250                                                                                           160                          Spain                  650
                                                80
 150                                            70                                             140                                                 600
                                                                           Greek banks
  50                                            60                                             120                                                 550
   2010          2011          2012              Jun-09        Jun-10     Jun-11      Jun-12      2006        2008          2010      2012

 (c53) Periphery bank net debt                  (c54) Spain: ECB net lending to banks          (c55) Election results of extremist
 issuance, bn, EUR, 3-month average             Percent of total bank liabilities              right-wing parties, Percent
 8                                              12%                                            30%
                                                                                                                                       AUT
 6                                              10%                                            25%

 4                                               8%                                            20%                                           NOR
                            Secured
 2                                               6%                                            15%                    FRA

 0                                               4%                                            10%
                                                                                                                            DEN
-2                                               2%                                             5%
                             Unsecured                                                                       NED
                                                                                                                                           GRE
-4                                               0%                                             0%
 2007     2008   2009   2010     2011    2012      1999         2003      2007       2011            1984   1989     1994    1999   2004    2009

Now what? Europe has created a safety net for domestic and foreign depositors, bondholders and lenders, which reduces
the impact of Europe on global markets. However, the decline in Spanish employment is 4x higher for people under 25
(compared to the population at large), and worse in Italy, Portugal and Greece. If the social fabric can withstand it, Europe may
get through this, but it could take additional relative wage declines/productivity improvements of 30% in France and Spain to
eliminate competitiveness gaps with Germany. By primarily relying on unemployment and wages to restore competitiveness,
Europe is taking the road less traveled and remains an economic and social experiment of the highest order.
                                                                                                                                             7
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    Eye on the Market | OUTLOOK 2013 January 2, 2013
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2013 Outlook
Emerging Markets: Chinese growth a positive in 2013, with the rest of Asia rebounding as well
Consensus Chinese growth forecasts are around 8% (c56). Based on our read of high-frequency indicators (c57), this seems
achievable, particularly given China’s ability to spend without worrying about excessive debt or deficits (c58). The same goes
for the rest of EM Asia, compared to developed economies. We can debate the quality of Chinese growth; capital spending, for
example, appears driven increasingly by government stimulus rather than the private sector (c59). And as shown earlier,
Chinese growth has also become increasingly dependent on credit (c9). However, given the indicators below, China’s
economic momentum should be a positive in 2013 rather than a negative, as production, demand and housing (floor
space, prices, real estate investment) are all showing signs of improvement. If there is a concern, it’s the rest of emerging
Asia, where manufacturing has been stagnant for the last 2 years as China’s keeps rising (c60). Korean, Singaporean and
Taiwanese exports have picked up recently, but not by much (c61).
                                                        (c57) High-frequency complements to
    (c56) Chinese real GDP growth                                 Chinese GDP data
                                                                                                                         (c58) EM Asia has more room to spend
    Percent change, YoY                             Data                Latest read                                      Estimate for calendar year 2012
14%                                                 Cement production         Steady trend growth                                               8%
                                                                                                                                                      EM Asia




                                                                                                                 General gov't fiscal balance
                                                    Container throughput      Steady trend growth
13%                                                 Electricity consumption   Strong rebound                                                    4%
12%                                       2013
                                                    Exports                   Weak after steady growth                                                            China
                                                    Floor space started       Rebound after fall in Oct/Sept




                                                                                                                        as % of GDP
11%                                    consensus                                                                                                0%
                                                    Highway freight           Strong rebound
10%                                     forecast    HK Luxury sales           Flat vs. large gains in '09-'11                                                             Developed
                                                    HSBC Manuf. survey
                                                                                                                                            -4%
    9%
                                                                              Moderately improving                                                                        markets
                                                    Macau gaming revenue      Flat vs. large gains in '09 -'11
    8%                                              Passenger car sales       Moderately improving                                          -8%
                                                    Rail freight              Strong rebound after summer
    7%
                                                                              collapse                                                -12%
    6%                                              Steel production          Strong rebound                                                         0%       100%          200%
      2005     2007      2009     2011     2013     Waterway freight          Strong rebound                                                          Government debt as % of GDP

    (c59) Chinese fixed asset investment            (c60) EM Asia manufacturing output                              (c61) Korea, Taiwan and Singapore:
    Percent change, YoY, 3m moving average          Index; Jan 2011 = 100                                           exports stabilizing, Percent change, YoY
    60%                                                                                                               50%
                 From                               120                                   China
    50%      manufacturing                                                                                            40%
                sector                              115
    40%                                                                                                               30%
                                                    110                                                               20%
    30%
                                                    105                                     EM Asia                   10%
    20%
                                                                                            ex-China                         0%
    10%                                             100
                                                                                                                  -10%
     0%                                              95                                                           -20%
                      From infrastructure
-10%                                                 90                                                           -30%
    2005 2006 2007 2008 2009 2010 2011 2012           Jan-11     Jul-11       Jan-12       Jul-12                     2005                               2007     2009      2011

    (c62) EM interest rate swap curve               (c63) BRIC hits the wall in Brazil                              (c64) Euro area imports from LatAm
    Percent, 1-year rate, avg. of EM countries      Percent change, YoY                                             and Asia, Percent change, YoY
7%                                                  20%      Production
                Spot rate        Forward rate
                                                    15%                                                  40%          30%
                                 starting 6/30/11
6%                                                  10%
                                                                                                         20%          20%
                                                     5%
5%                                Forward            0%
                                  rate starting                                                          0%           10%
                                                    -5%
                                  12/20/12
4%                                                  -10%                               Exports           -20%                0%
                                                    -15%
3%                                                  -20%                                                 -40% -10%
  2007        2009     2011     2013     2015           2007 2008 2009 2010 2011 2012                            Jan-11                                  Jul-11    Jan-12     Jul-12

We expect better data in emerging Asia in 2013, in part a consequence of declining interest rate expectations (c62). The same
holds for Brazil, where the Central Bank continues to reduce policy rates. Both Brazilian exports and industrial production are
finally stabilizing (c63). We do not, however, see much improvement in European demand for Asian or Latin American
exports, which have fallen recently (c64). As in 2011 and 2012, a risk for the region would be a rise in inflation that forces
Central Banks to start raising policy rates again. This is something we will have to watch, since Asia ex-Japan’s output gap has
turned positive, unlike the large negative one in the advanced economies (c14).

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8
 Eye on the Market | OUTLOOK 2013 January 2, 2013
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                        

2013 Outlook
2013 Outlook
Investments
US equities. Slow economic growth doesn’t always mean low equity returns; there are times when equities do well anyway
US equities. Slow economic growth doesn’t always mean low equity returns; there are times when equities do well anyway
(c65). This typically happens after a recession ends, when valuations are low and pessimism is high. That was the case in 2012,
(c65). This typically happens after a recession ends, when valuations are low and pessimism is high. That was the case in 2012,
when US equities began the year at a forward multiple of less than 12x due to concerns about Europe. Multiples have since
when US equities began the year at a forward multiple of less than 12x due to concerns about Europe. Multiples have since
risen to 12.7x, and still look reasonable. Not everyone agrees; I don’t think I have ever had more debates about US equity
risen to 12.7x, and still look reasonable. Not everyone agrees; I don’t think I have ever had more debates about US equity
valuations than during the last year. One side of the debate: the Graham-Dodd/Shiller approach, which looks at trailing reported
valuations than during the last year. One side of the debate: the Graham-Dodd/Shiller approach, which looks at trailing reported
earnings over the last ten years. This approach makes equities look expensive to history (c66), but we have reservations about
earnings over the last ten years. This approach makes equities look expensive to history (c66), but we have reservations about
this model (see box). The other end of the spectrum: the S&P earnings yield less 10-year interest rates, under the notion that the
this model (see box). The other end of the spectrum: the S&P earnings yield less 10-year interest rates, under the notion that the
purpose of investing in stocks is to earn more than on bonds. Under this logic, equities look very cheap (c67), an epiphany the
purpose of investing in stocks is to earn more than on bonds. Under this logic, equities look very cheap (c67), an epiphany the
Fed is hoping investors will come to and drive up financial asset prices. I am not a huge fan of this logic, and over the long run,
Fed is hoping investors will come to and drive up financial asset prices. I am not a huge fan of this logic, and over the long run,
neither are markets: The volatility of stocks since the Greenspan-Bernanke era of low real interest rates began is even higher
neither are markets: The volatility of stocks since the Greenspan-Bernanke era of low real interest rates began is even higher
than before the creation of the Fed in 1913, when the US was beset by frequent recessions and depressions. Looking at history
than before the creation of the Fed in 1913, when the US was beset by frequent recessions and depressions. Looking at history
and at the future, US equities seem fairly valued at current multiples of 12-13 times 2013 earnings estimates.
and at the future, US equities seem fairly valued at current multiples of 12-13 times 2013 earnings estimates.

 (c65) Global equity returns vs. GDP
 (c65) Global equity returns vs. GDP                               (c66) Graham-Dodd/Shiller valuation
                                                                   (c66) Graham-Dodd/Shiller valuation           (c67) S&P 500 trailing earnings yield
                                                                                                                 (c67) S&P 500 trailing earnings yield
 growth, 1970-2012
 growth, 1970-2012                                                 approach, S&P 500 price to 10-year trailing
                                                                   approach, S&P 500 price to 10-year trailing   less 10-year interest rates
                                                                                                                 less 10-year interest rates
                      45%
                      45%                                          average reported earnings
                                                                   average reported earnings                     15%
                                                                                                                 15%
                                                                                                                              Cheap
                                                                                                                              Cheap
 Annual Global equity returns




                      35%
                      35%                                          35x
                                                                   35x   Expensive
                                                                         Expensive
                      25%
                      25%                                          30x
                                                                   30x                                           10%
                                                                                                                 10%
                      15%
                      15%                                          25x
                                                                   25x
                                     2012
                                     2012
                        5%
                        5%
                       -5%
                      -5%                                          20x
                                                                   20x                                           5%
                                                                                                                 5%
                     -15%
                     -15%                                          15x
                                                                   15x
                     -25%
                     -25%                                          10x
                                                                   10x
                                       Box: Low growth and
                                       Box: Low growth and                                                       0%
                                                                                                                 0%
                     -35%
                     -35%
                                       positive equity returns
                                       positive equity returns     5x
                                                                   5x                                                       Expensive
                                                                                                                            Expensive
                     -45%
                     -45%                                                 Cheap
                                                                          Cheap
                           -2% -1% 0% 1% 2% 3% 4% 5% 6%
                          -2% -1% 0% 1% 2% 3% 4% 5% 6%             0x
                                                                   0x                                            -5%
                                                                                                                 -5%
                                 Annual Global GDP growth
                                 Annual Global GDP growth            1901 1921 1941 1961 1981 2001
                                                                     1901 1921 1941 1961 1981 2001                  1901 1921 1941 1961 1981 2001
                                                                                                                    1901 1921 1941 1961 1981 2001

Profit margins are in good shape (c68), defying expectations of a decline. While manufacturing is only 15% of US GDP, its
Profit margins are in good shape (c68), defying expectations of a decline. While manufacturing is only 15% of US GDP, its
contribution to S&P profits is closer to 60%. US manufacturers have benefited from globalization and productivity gains in
contribution to S&P profits is closer to 60%. US manufacturers have benefited from globalization and productivity gains in
labor and technology (an example: Manufacturing output is roughly the same as in 2000 and there are 30% fewer manufacturing
labor and technology (an example: Manufacturing output is roughly the same as in 2000 and there are 30% fewer manufacturing
workers). Recently, as the rest of the world has slowed down, US earnings growth has re-converged to nominal GDP growth
workers). Recently, as the rest of the world has slowed down, US earnings growth has re-converged to nominal GDP growth
(c69). Consensus 2013 earnings estimates show 10% growth (c70), a number which stabilized after declining in the fall.
(c69). Consensus 2013 earnings estimates show 10% growth (c70), a number which stabilized after declining in the fall.
Dividend payout ratios are near all-time lows and have room to rise. Currently, dividend growth rates are the highest in six
Dividend payout ratios are near all-time lows and have room to rise. Currently, dividend growth rates are the highest in six
decades. S&P 500 returns of 8%-10% seem achievable in 2013, particularly with a “grand bargain” in DC that drives
decades. S&P 500 returns of 8%-10% seem achievable in 2013, particularly with a “grand bargain” in DC that drives
P/E multiples higher. Deferring the cliff and doing nothing about the long run will probably not have the same impact.
P/E multiples higher. Deferring the cliff and doing nothing about the long run will probably not have the same impact.
 (c68) S&P 500 ex-financials net profit
 (c68) S&P 500 ex-financials net profit                            (c69) Ratio of earnings growth to
                                                                   (c69) Ratio of earnings growth to              (c70) S&P 500 earnings growth
                                                                                                                  (c70) S&P 500 earnings growth
 margin, Percent
 margin, Percent                                                   nominal GDP growth
                                                                   nominal GDP growth                             estimates, Percent change, YoY
                                                                                                                  estimates, Percent change, YoY
 10%
 10%                                                               15x
                                                                   15x                                           14%
                                                                                                                 14%
    9%
    9%                                                                                                 16.6x
                                                                                                       16.6x     13%
                                                                                                                 13%
                                                                   10x
                                                                   10x                                                                           2013
                                                                                                                                                 2013
                                                                                                                 12%
                                                                                                                 12%
    8%
    8%                                                                                        Average
                                                                                              Average
                                                                                                                 11%
                                                                                                                 11%
    7%
    7%                                                              5x
                                                                    5x    Average peak: 2.1x peak: 4.2x
                                                                          Average peak: 2.1x peak: 4.2x
                                                                                                                 10%
                                                                                                                 10%
    6%
    6%                                                                                                            9%
                                                                                                                  9%
                                                                    0x
                                                                    0x
                                                                                                                  8%
                                                                                                                  8%
    5%
    5%                                                                                                                                           2012
                                                                                                                                                 2012
                                                                   -5x
                                                                   -5x                                            7%
                                                                                                                  7%
    4%
    4%                                                                                                            6%
                                                                                                                  6%
    3%
    3%                                                             -10x
                                                                   -10x                                           5%
                                                                                                                  5%
      1977
      1977                      1984
                                1984   1991
                                       1991   1998
                                              1998   2005
                                                     2005   2012
                                                            2012       1952 1961 1970 1979 1988 1997 2006
                                                                      1952 1961 1970 1979 1988 1997 2006           Jan-12
                                                                                                                   Jan-12     Apr-12
                                                                                                                              Apr-12    Jul-12
                                                                                                                                        Jul-12   Oct-12
                                                                                                                                                 Oct-12

Reservations on Graham-Dodd. By using ten years of trailing reported earnings, Graham-Dodd effectively assumes that the mayhem of
Reservations on Graham-Dodd. By using ten years of trailing reported earnings, Graham-Dodd effectively assumes that the mayhem of
the prior decade is indicative of the future. While earnings are volatile, the magnitude of the 2008 collapse hadn’t been seen in over 100
the prior decade is indicative of the future. While earnings are volatile, the magnitude of the 2008 collapse hadn’t been seen in over 100
years. Given the compositional shift in the S&P 500 since 2000 (240 of the 500 companies in the S&P have changed), I’m not sure the
years. Given the compositional shift in the S&P 500 since 2000 (240 of the 500 companies in the S&P have changed), I’m not sure the
last ten years are a good proxy for future earnings. The use of reported earnings instead of operating earnings also has an impact, given
last ten years are a good proxy for future earnings. The use of reported earnings instead of operating earnings also has an impact, given
the abnormally large decline in reported earnings during the financial crisis. If the model (a) incorporated the earnings history of the
the abnormally large decline in reported earnings during the financial crisis. If the model (a) incorporated the earnings history of the
companies now in the index and not its prior constituents; (b) assumed that reported earnings rise back to their average level relative to
companies now in the index and not its prior constituents; (b) assumed that reported earnings rise back to their average level relative to
operating earnings of 88%; and (c) assumed that earnings declines during recessions are 20%-30% and not 70%; it would show valuations
operating earnings of 88%; and (c) assumed that earnings declines during recessions are 20%-30% and not 70%; it would show valuations
much closer to average. In short, anchoring expectations in the immediate past is a problem with the Graham-Dodd/Shiller approach.
much closer to average. In short, anchoring expectations in the immediate past is a problem with the Graham-Dodd/Shiller approach.
                                                                                                                                                          9
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  Eye on the Market | OUTLOOK 2013 January 2, 2013
                         

2013 Outlook
Within US equity markets, cyclical stocks trade at a large discount to defensives (c71) after the demand for dividend-payers in
the last 4 years. Consumers and businesses have pent-up demand for durable goods (c72) that makes some cyclical stocks
interesting. On financials, banks have been recapitalized (c73), reducing the risk of a relapse in 2013. Net interest margins are
still under pressure, and since March 2010, released loan loss provisions account for ~100% of the improvement in bank
earnings (provisions are now close to pre-crisis levels). However, large cap money center bank valuations of 1.1 times tangible
book value are only 30% of pre-crisis levels, and the housing recovery shown on page 5 has not fully impacted results yet.
Greater capital needs reduce returns on bank equity, but valuations appear to have accounted for this; large cap banks are trading
at ~7.5x long-run normalized earnings. The deepest value sector: Healthcare, which trades at the lowest multiple relative to
consumer staples since 1980, and which has more cash flow and higher cash reserves.
 (c71) Cyclicals trading cheaply vs.             (c72) Durable goods spending by          (c73) US bank Tier 1 capital ratio
 Defensives, Cyclicals/Defensives trailing P/E   consumers and businesses, % of GDP       Percent
 1.8                                             19%                                     16%
                                                                                                Banks with assets of 1B-10B
 1.6                                                                                     15%
                                                 18%
                                                                                         14%
 1.4
                                                 17%
                                                                                         13%
 1.2
                                                 16%                                     12%
 1.0
                                                                                         11%
                                                 15%
 0.8                                                                                     10%
 0.6                                             14%
                                                                                          9%
                                                                                                        Banks with assets >10B
 0.4                                             13%                                      8%
    1974 1980 1986 1992 1998 2004 2010              1947 1957 1967 1977 1987 1997 2007      2000     2003      2006       2009    2012

The Sick Men of Europe. Last summer, European equities traded at their largest discount to the US in 40 years, driven mostly
by declines in Southern Europe. Europe-bears must concede that a lot of news is in the price. At a 30% discount (c74), things
need to get increasingly bad to cause relative valuations to decline further (EU utilities and telecoms in particular trade at much
lower multiples). With the larger safety net discussed on page 7, Europe moved out of intensive care into long term care. Since
the July ECB speech, European equities have outperformed the US, recapturing just one-third of Europe’s underperformance
since January 2010. I don’t think the valuation gap shown will close rapidly, in part since ROEs in Europe are 60%-70% of US
levels. Bottom line: For the first time in 3 years, there is no longer as strong an argument to hold radically underweight
EU equity positions. However, with no viable growth future for countries like Spain in the Eurozone, the big questions remain
unanswered. In a reflationary world, EU equities may drift up with the rest until the next inflection point in the crisis.
 (c74) European equity discount to US            (c75) EM earnings revisions              (c76) Chinese equity valuations
 Composite of P/E, P/B and P/Dividend            6-month percent change                   Price to trailing earnings
 10%                                             20%                                     60x

                                  Premium        10%                                     50x                           Shanghai
     0%
                                  Discount                                                                             Composite Index
                                                  0%                                     40x
-10%
                                                 -10%                                    30x
-20%
                                                 -20%                                    20x
-30%                                             -30%                                    10x
                                                                                                H-shares:
-40%                                             -40%                                     0x    Hang Seng China Enterprises Index
    1975 1980 1985 1990 1995 2000 2005 2010          1995   1999   2003   2007   2011       2001 2003 2005 2007 2009 2012

Emerging market equities kept pace with the US and Europe in 2012 (c3), with much better performance in Asia ex-Japan
than Latin America. Earnings revisions are now declining (c75), reflecting slowing profits growth in China, Taiwan, Brazil,
Chile and Indonesia. Part of the reason is the global manufacturing slowdown (c11), which affects commodity and goods
exporters. In China, there has been a structural decline in valuations (c76). Multiples have come down everywhere since 2007,
so part of this is global. Reliance on credit and government spending (c9) and lower growth also argue for lower multiples.
Finally, in 2011, China raised rates to deal with inflation, and its equities often rise and fall with monetary policy. All things
considered, the veneer has been stripped from Chinese stocks, leaving investors skeptical about growth and data quality.
H-shares (Chinese companies listing in Hong Kong) look interesting at forward P/E multiples less than 10x, although Asia is
admittedly a strange place to make “value” investments. The rest of Asia ex-Japan trades at slightly higher multiples of
12x-15x but doesn’t have as many structural issues, and may be a better place to be in 2013. Within China, private equity
is interesting given the ability to focus on consumption and the service sector (see page 12).
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  Eye on the Market | OUTLOOK 2013 January 2, 2013
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2013 Outlook
Credit: The best evidence of the Fed’s portfolio rebalancing channel at work
Spreads have rallied but are not (yet) back to the levels of the late 1980’s, 1990’s or 2007 (c77). Underwriting standards have
loosened, shown below by the increase in US high yield issues rated at or below B-, and the rise in senior debt-to-cash flow
multiples for leveraged buyouts (c78). However, recessions are typically the biggest problem for credit, and we do not expect
one in 2013. Corporate defaults (c79) are low and expected to rise by only ~0.5% next year, and low interest rates have helped
debt service coverage. Supply conditions are favorable: The net supply of credit in 2013 is projected to be the lowest in a
decade, other than 2008. The era of capital gains from credit is probably over for this cycle, but we expect credit to
contribute income to portfolios in 2013. Distressed debt managers may find it harder, given the decline of cheaply priced
loans and bonds (c80); in 2012, they generally did well and ranked near the top of hedge fund return tables.
 (c77) Global USD high yield spreads           (c78) Underwriting standards                        (c79) Corporate default rates
 Spread to worst, basis points                 % of total HY issuance          Debt/cash flow Issuer-weighted, last 12 months
2,000                                         70%     HY B- and lower           LBO sr.     6x 14%
1,800                                                                           debt                  US HY Global HY bonds
                                              60%     issuance                                 12%
1,600                                                                           multiple              bonds
                                              50%                                             5x 10%
1,400
1,200                                         40%                                                  8%
                                                                                              4x
1,000                                         30%                                                  6%
  800
                                              20%                                                  4%
  600                                                                                         3x
                                              10%                                                  2%
  400
                                                                                                                      US lev. loans
  200                                          0%                                             2x   0%
     1987 1991 1995 1999 2003 2007 2011          1997     2000   2003   2006   2009    2012          1981 1985 1989 1993 1997 2001 2005 2009

 (c80) US HY bonds and loans trading            (c81) Core CPI                                      (c82) Excess reserves held at major
 <= 80% of face value, Percent                  Percent change, YoY                                 central banks, Billions, USD
50%                                            4.5%                               Emerging         3,500
        Peak levels (Nov. '08)
45%    Bonds: 77% / Loans: 81%                 4.0%                                Markets         3,000
40%
                                               3.5%
35%                                                                                                2,500
30%                                            3.0%
        Bonds                                                                                      2,000
25%                                            2.5%                                     Global
20%                                                                                                1,500
                                               2.0%
15%                                                                                                1,000
                                               1.5%
10%
                                               1.0%                                                  500
 5%
               Loans                                         Developed Markets
 0%                                            0.5%                                                     0
   1994 1997 2000 2003 2006         2009           2004      2006       2008    2010     2012            1999 2001 2003 2005 2007 2009 2011

Commodities: The interesting question is what happens to precious metals (we don’t expect that much from industrial metals or
energy given low global growth). Even though inflation is currently low (c81), precious metals had another good year in 2012,
and have generated 15%-16% annualized returns since Q4 2007. Precious metals prices are responding to the explosion in base
money that is currently inert (c82); over $3 trillion is held globally by private sector banks at central banks. If deployed,
this could fuel inflation when the output gap (c14) eventually closes. Precious metals markets are betting that when it does
close, central bankers will let growth run and allow inflation to rise above presumed targets. I agree, and expect another positive
year for precious metals in 2013. Also, don’t underestimate the pressure that a White House can put on a Fed that wants to
raise rates (see EoTM 5/7/2009 on the admittedly extreme case of the Nixon administration’s response to the Fed in the 1970’s).
Japan: One emerging view on Japan: Investors should add Japanese equities, short                   (c83) US vs Japan corporate profits
the Yen and short JGBs. Why? Japan is allegedly in such dire straits that the only                 Billions, USD                    Trillions, JPY
option left is unlimited Yen-printing and an inflation target of 2%. Things are                    2,000                                       18
certainly gloomy: Japan is the poster child for low growth (c10); its current                                                  US
                                                                                                                                               16
account surplus is close to zero; its trade account is in sustained deficit for the first
                                                                                                                                               14
time since 1965; and its corporate profits are at 2004 levels while US corporate                   1,500
profits are 60% higher (c83). Corporations blame a Yen which has risen by 20% in                                                               12
real terms since the crisis, and Japan’s energy policy is shifting to offshore wind                                                            10
from nuclear, which is like trading a motorcycle for a unicycle (EoTM 10/22/2012).                 1,000                              Japan
                                                                                                                                               8
However, as a cautionary note, a lot of money has been lost over the last 20 years                                                             6
betting on a reflationary Japocalypse that never happened. Even if the government
                                                                                                    500                                        4
forces the central bank to inflate, Japan will compete with other central banks doing                 1999    2002   2005   2008      2011

                                                                                                                                         11
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    Eye on the Market | OUTLOOK 2013 January 2, 2013
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2013 Outlook
the same (c13). Money-printing may create short-term gains on Japanese stocks and pressure the Yen, but I’d be surprised if
Japan stuck with it long enough for such gains to be sustained. Japanese bank JGB holdings are 9x their capital, which creates
problems if reflation is accompanied by higher interest rates. On fundamentals, the ROE on Japanese stocks is less than 1/3 of
the US and Europe. As a result, positioning for reflation may be a good short-term trade, but be prepared to leave the
party early. Since 1993, Japanese equities have generated a -1.5% annualized return, with large booms/busts in between.
Alternatives: The best ones are often investments that cannot be replicated in public markets
Millions of middle-class households continue to form in China2, where urban household consumption is growing by 10-12% per
year. This has created a large service sector which now represents 50%+ of Chinese GDP; the same is true in Brazil. However,
China’s non-financial service sector represents a much smaller share of its equity markets, which are dominated by
banks, energy, industrials and basic materials. In China, these sectors are 81% of the Shanghai Composite. The situation in
Brazil is similar; non-financial service sector companies, telecoms and transports only make up 15% of the Bovespa, but a much
larger share of GDP. As a result, private equity can be a better way to invest in emerging economy consumption (retailing,
healthcare, food certification and distribution, etc). There is some evidence that private equity has delivered: Both Asian and
Latin American private equity indices from Cambridge Associates outperformed public equity over the last 5 years (c84).
    (c84) Public and private equity investing in Asia and                           (c85) Debt issuance by mid-market firms (EBITDA
    LatAm, 5-year annualized return through Q1 2012, percent                        <=$50mm), Number of deals, quarterly
    12%                                                                             140

     9%                                                                             120

     6%                                                                             100

                                                                                    80
     3%
                                                                                    60
     0%
                                                                                    40
     -3%
              MSCI      MSCI Asia Asia PE &   Asia EM    MSCI EM LatAm &            20
             Pacific    ex-Japan VC Index     PE & VC     Latin  Caribbean
                                               Index     America PE & VC             0
     PE and VC returns are net of fees.                            Index                  '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12

While credit markets have healed, many smaller companies have less access to debt capital markets (c85). Terms and
conditions in private credit generally offer higher coupons and more covenants (change in control provisions, prepayment
restrictions, etc.); the trade-off is less liquidity. On US commercial real estate, low interest rates have generated interest in
well-leased, prime locations, but non-prime locations (suburban property or cities outside the six major markets) still trade at
larger discounts (c86). The supply story is favorable: US fixed investment in office, retail and multifamily is at multi-
decade lows, and the CMBS financing market has begun to recover. On oil & gas, investments in exploration, production
and distribution of traditional energy are more compelling than renewable energy. One reason why: substantially higher
levelized costs for renewable energy, which means that politically volatile (and costly) subsidies remain a large part of the
equation. The levelized costs shown below are for Germany (c87), but are not much different in other parts of the world.
    (c86) Prime vs. non-prime real estate               (c87) Levelized cost of electricity                   (c88) Global M&A volume by month
    Index, Q4 2000 = 100                                production in Germany, USD/MWh                        Billions, USD
225                                                 440                                                       350
                                          Major
           Non-major market
200                                       market    390                                                       300
              CBD office
                                           CBD      340
175                                       office                                                              250
                                                    290
           Major market                                                                                       200
150                                                 240
            suburban                                190                                                       150
125           office
                                                    140                                                       100
100                                                     90                                                     50
                        Non-maj. mkt. sub. office       40
    75                                                       Nuclear   Coal   Nat    Onshore Offshore Solar     0
      2001    2003     2005   2007   2009   2011                              Gas     Wind    Wind              Oct-10   Apr-11    Oct-11   Apr-12   Oct-12


2
 According to the International Labor Organization, wage increases over the last decade have completely closed China’s wage gap vs.
Mexico. The Brookings Institute expects Chinese middle class consumption to surpass the US by 2020.
                                                                                                                                                     12
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  Eye on the Market | OUTLOOK 2013 January 2, 2013
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2013 Outlook
On hedge funds, we see managers positioning around (a) event-driven and activist strategies that seek to generate returns from
an increase in buybacks, dividends, capital expenditures and M&A (c88); (b) long/short strategies based on fundamental
research now that intra-stock correlations have finally fallen back to pre-crisis levels; (c) less liquid credit instruments in select
emerging markets and Europe; and (d) markets where a scarcity of capital has created opportunities, such as reinsurance.
Looking beyond 2013: Further progress on entitlements and energy independence would be bullish signals for America
The US debt was 80% of GDP only once before, in the 1950’s (c89). The solution was not austerity (outlays were stable), large
tax increases (receipts were stable), inflation (which was 2%) or negative real interest rates (they were positive). The solution
was growth (over 4% in real terms, compounded for the entire decade). Times and circumstances are different, but the question
of whether the US will adopt a more aggressive pro-growth agenda is a fair one to ask (e.g., the NFIB survey indicates that
“government red tape” has now caught up to “poor sales” as the largest problem for small business). Of the many factors
affecting the long-term growth outlook, there are two that deserve special attention: energy independence, and entitlements.
(c89) 1950's Federal debt reduction relied on growth, not                    (c90) What US energy independence might look like
austerity, inflation, taxation or artificially low interest rates            US net crude oil imports, million barrels per day
         Net debt/ Net debt Nominal    Real  Outlays % Receipts Real 10 year 10
           GDP       (bn)   GDP bn    GDP bn  of GDP   % of GDP  UST rate     9                                  
  1950    80%      $219      $273      $273     16%      14%       1.3%      8                                   
  1951    67%      $214      $320      $302     14%      16%       -5.3%                                         
                                                                             7                                   
  1952    62%      $215      $349      $322     19%      19%       0.5%
                                                                             6                                   
  1953    59%      $218      $373      $341     21%      19%       2.0%
  1954    60%      $224      $377      $343     19%      19%       2.1%      5
                                                                             4         Net
  1955    57%      $227      $396      $354     17%      17%       3.1%
                                                                                     Imports                                                  Col/Brazil
  1956    52%      $222      $427      $368     17%      18%       1.7%      3                         Net                                     Mexico
  1957    49%      $219      $451      $377     17%      18%       0.3%      2                       Imports
  1958    49%      $226      $460      $377     18%      17%       0.6%      1                                                                     Canada
  1959    48%      $235      $490      $398     19%      16%       3.3%
                                                                             0
  1960    46%      $237      $519      $415     18%      18%       2.7%                                                                       Current US
                                                                                      2012            2025
Comp. ann'l gr:    0.8%      6.6%     4.3%                                                          Projection                                 imports

As reviewed last October, US energy independence within the next 10-15 years is a possibility, assuming that you define it as:
• the US only having to rely on the Western Hemisphere ex-Venezuela for its crude oil import needs, and
• the US maintaining its electricity cost advantage (US electricity costs are currently 50% of the global rate)
On the first point, recent gains in domestic crude oil production would need to be sustained, with the largest gains coming from
“tight oil” extracted from Bakken and Eagle Ford formations and the Permian Basin. Increased production is the largest
component of the energy independence equation as we see it (c90). On electricity, there is perhaps no issue being addressed
so divergently as future supply. In Germany and Japan, nuclear is being phased out in favor of offshore wind and other
renewable sources, whereas in the US, there is a move towards cheaper natural gas-powered electricity. As shown in c87
on the prior page, energy transitions in Germany and Japan are extremely costly. One example from our October paper: The
cost of building connections between European offshore wind farms and the electricity grid (excluding the cost of the wind
turbine itself) can be greater than the cost of building a new combined cycle natural gas plant.
The US electricity advantage is substantial (c91) and growing as natural gas rises as a share of generation (c92), and as natural
gas prices remain low (c93). To maintain this edge, real-world solutions will be needed on fracking. The topic is complex, but
according to my friend Vaclav Smil, “Hydraulic fracking is not that different from secondary enhanced recovery techniques which use
huge volumes of water mixed with chemicals, pressurized natural gas and/or carbon dioxide to recover oil from wells that have ceased
 (c91) Wholesale electricity prices                     (c92) US electricity from natural gas            (c93) Global natural gas prices
 USD/MWh                                                Percent of net electricity generation            USD/MMBtu
 105                                                                                                     15.0
  95                                                   24%                                               12.5
  85                                      China                                                          10.0
                                                       20%
  75                                                                                                      7.5
  65                                   Europe          16%                                                5.0
  55                                                                                                      2.5
                                                       12%
  45                      US                                                                              0.0
                                                                                                                                                                     JAP
                                                                                                                                             BRA


                                                                                                                                                         CHN
                                                                                                                                                               KOR
                                                                                                                      BEL




                                                                                                                                                   ARG
                                                                                                                 US


                                                                                                                            UK


                                                                                                                                       IND
                                                                                                                                 ESP




  35                                                    8%
   2006           2008         2010           2012        1965 1972 1979 1986 1993 2000 2007
                                                                                                                                                           13
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     Eye on the Market | OUTLOOK 2013 January 2, 2013
                            

2013 Outlook
flowing naturally. As long as the wells are properly cemented when they go through water tables and deeper aquifers, there should be no
contamination of ground water, assuming strict protocols for proper tank and pond storage of processing water and its requisite on-site
cleansing. Fracking is orders of magnitude less complex than nuclear power and deepwater oil extraction (e.g., Macondo at 1.2 km below
the sea surface), and in the case of fracking accidents, they should be rare, brief and more easily contained.”
The other issue is entitlements, the third rail of American politics. Before getting into the charts, recall for a moment a 2012
Republican Presidential debate in which some candidates suggested dismantling or seriously curtailing the Environmental
Protection Agency. This extreme3 idea is indicative of how little non-defense discretionary spending is left to fight about.
After the Budget Control Act, non-defense discretionary spending relative to GDP will be at the lowest level in decades (c95).
If that’s the case, why isn’t overall spending coming down? Because of the boiling frog problem of US entitlement spending
(c94), which is crowding out the energy, education, worker retraining and infrastructure spending that helps shape the future.
When Medicare was introduced in the 1960’s, it was described as “brazen socialism” in the Senate. When Truman proposed a
national healthcare program in the 1940’s, the plan was called a Communist plot by a House subcommittee. And when President
Roosevelt introduced Social Security in the 1930’s, he was branded as a Communist sympathizer by Republican Senators from
Ohio, Pennsylvania and Minnesota, publisher William Randolph Hearst and Alf Landon (Roosevelt’s opponent in the 1936
election). So in 1969, when one-quarter of Americans over the age of 65 lived in poverty, politicians showed courage in
creating a larger social safety net. However, the formulas, approaches and incentives used have become unmanageable
geometric equations. In 1967, the US House Ways and Means Committee estimated that Medicare expenses would grow by a
factor of 7 by 1990, and they grew by a factor of 61 instead4. As a result, it will take even greater political courage to alter
what is now seen as permanent, since entitlements are no longer sustainably linked to national income. The 10-year
horizon shown below does not even show the truly explosive entitlement dynamics which begin around 2025.
If handled the right way, energy independence and entitlement policy could prolong the status of the US$ as the world’s reserve
currency. When fiscal, military and political issues are mismanaged, reserve currency eras often come to an end (c96).
Michael Cembalest
J.P. Morgan Asset Management
     (c94) The Boiling Frog
     Percent of GDP, historical and CBO alternative case 2013-2022
25%                    Other mandatory spending                                 The crowding out of discretionary spending
                                                                                                               Estimated 2017 level
20%                         Interest                                            Category                         vs. historical peak
                                                           Gov't                Energy                                          33%
15%
                                                           Receipts             Education                                       69%
               Social Security, Medicare, Medicaid
10%                                                                             Teacher and worker retraining                   86%
                                                                                Transportation infrastructure:
 5%                                                  Discretionary
                       Defense                                                    Ground transportation                          4%
                                                                                  Air transportation                             9%
 0%
   1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 2020

     (c95) Non-defense discretionary spending: already low                   (c96) Dominant reserve currency/superpower since
     after BCA kicks in, Percent of GDP                                      1400 AD
5.5%
                                                                                 US
5.0%
                                                                              Britain
4.5%

4.0%                                                                          France

3.5%                                                                          Netherl

3.0%                                     Assuming spending caps from
                                         the Budget Control Act but            Spain
2.5%                                     without the sequester
                                                                             Portugal
2.0%
        1962         1973         1984       1995         2006        2017              1400        1575          1750           1925   2100

 3
   The US ranks around median according to the OECD’s air pollution measure (sulphates, nitrates, carbon matter, sodium, ammonium
 ions) and 49th out of 132 on the Columbia/Yale Environmental Performance Index. Let’s not eliminate the EPA just yet.
 4
   Source: Senate Joint Economic Committee Report, July 2009, and the behemoth “USA Inc.” from Kleiner Perkins.
                                                                                                                                        14
14
 Eye on the Market | OUTLOOK 2013 January 2, 2013
                        

2013 Outlook
Chart sources
 (c1)    ISM, Markit, December 2012                                      (c47)   OECD, J.P. Morgan Securities LLC, June 2012
 (c2)    International Air Transport Association, October 2012           (c48)   Bank of International Settlements, Q2 2012
 (c3)    Bloomberg, ISI, December 31, 2012                               (c49)   Bridgewater Daily Observations, November 9, 2012
 (c4)    Bank of Spain, Bank of Portugal, OECD, CSO, NSS, IMF,           (c50)   Bloomberg, December 2012
         EuroStat, JPMAM, October 2012                                   (c51)   ECB, JPMAM, October 2012
 (c5)    Banco de España, Instituto Nacional de Estadística, Q2 2012     (c52)   Banca d'Italia , Tesoro Público, Barclays, September 2012
 (c6)    Deutsche Bundesbank, EuroStat, OECD, Q4 2012                    (c53)   J.P. Morgan Securities LLC, November 2011
 (c7)    OECD, December 2012                                             (c54)   Banco de Espana, November 2012
 (c8)    BEA, JPMAM, Q3 2012                                             (c55)   Friedrich Ebert Foundation, 2011 (See 10/15/2012 EOTM)
 (c9)    China National Bureau of Statistics, Gavekal Research,                  Updated by JPMAM through December 2012
         JPMAM, December 2012                                            (c56)   China National Bureau of Statistics, Bloomberg, Q3 2012
 (c10)   IMF, December 2011                                              (c57)   JPMAM, ISI, November 2012
 (c11)   J.P. Morgan Securities LLC, November 2012                       (c58)   IMF, Gavekal Research, October 2012
 (c12)   IAEA, November 2012, see 11/19/2012 EOTM                        (c59)   Gavekal Research, Chinese National Bureau of Statistics,
 (c13)   FRB, BEA, ECB, Eurostat, BoE, UK Office for National                    November 2012
         Statistics, BoJ, Japan Cabinet Office, J.P. Morgan Securities   (c60)   J.P. Morgan Securities LLC, November 2012
         LLC, December 2012                                              (c61)   Bank of Korea, Taiwan Ministry of Finance, Trade Develop-
 (c14)   IMF, OECD, ECB, Eurostat, FRB, JPMAM, 2011                              ment Board, J.P. Morgan Securities LLC, November 2012.
 (c15)   OECD, 2011                                                      (c62)   Bloomberg, JPMAM, December 2012
 (c16)   J.P. Morgan Securities LLC, LoanPerformance, MBA, Q3            (c63)   Instituto Brasileiro de Geografia e Estatística, Banco Central
         2012                                                                    do Brasil, October 2012
 (c17)   J.P. Morgan Securities LLC, October 2012                        (c64)   Eurostat, October 2012
 (c18)   Empirical Research Partners, November 2012                      (c65)   Bloomberg, OECD, J.P. Morgan Securities LLC, JPMAM,
 (c19)   Robert J. Shiller data set, Standard & Poor's, December 2012            December 2012. For 2012, Equity return is from 12/31 to
 (c20)   BP Statistical Review of World Energy, 2011                             12/20; GDP is Q3 annualized.
 (c21)   FRB, BEA, Q3 2012                                               (c66)   Robert J. Shiller data set, Standard & Poor’s, December 2012
 (c22)   Bloomberg, J.P. Morgan Securities LLC, LoanPerformance,         (c67)   Robert J. Shiller data set, Standard & Poor’s, December 2012
         October 2012                                                    (c68)   Empirical Research Partners, December 2012
 (c23)   FRB, BEA, Q3 2012                                               (c69)   Standard & Poor’s, JPMAM, Q3 2012
 (c24)   BLS, November 2012                                              (c70)   FactSet, December 2012
 (c25)   University of Michigan, December 2012                           (c71)   J.P. Morgan Securities LLC, December 2012
 (c26)   BEA, Q3 2012                                                    (c72)   Bureau of Economic Analysis, Q3 2012
 (c27)   US Census Bureau, NFIB, November 2012                           (c73)   FDIC, Bloomberg, Q3 2012
 (c28)   CBO, IMF, JPMAM, July 2011                                      (c74)   MSCI, J.P. Morgan Securities LLC, December 2012
 (c29)   OMB, December 2012                                              (c75)   IBES, November 2012
 (c30)   CBO, JPMAM, August 2012 (See 11/07/2012 EOTM)                   (c76)   Bloomberg, December 2012
 (c31)   US Census Bureau, JPMAM, September 2012                         (c77)   J.P. Morgan Securities LLC, December 2012
 (c32)   J.P. Morgan Securities LLC, AxioMetrics (rents), CoreLogic      (c78)   Standard & Poor’s, Capital IQ, October 2012
         (home prices), Freddie Mac (rates), Q2 2012                     (c79)   J.P. Morgan Securities LLC, S&P, November 2012
 (c33)   Federal Reserve Board, Q4 2012                                  (c80)   J.P. Morgan Securities LLC, S&P/LSTA Leveraged Loan
 (c34)   The Conference Board, November 2012                                     Index, November 2012
 (c35)   NAHB, US Census Bureau, December 2012                           (c81)   J.P. Morgan Securities LLC, November 2012
 (c36)   BLS, US Census Bureau, Empirical Research Partners, October     (c82)   FRB, ECB, BoJ, BoE, October 2012
         2012                                                            (c83)   BEA, Japan Ministry of Finance, Q3 2012
 (c37)   BLS, BEA, October 2012                                          (c84)   Cambridge Associates LLC, Bloomberg, Q1 2012
 (c38)   J.P. Morgan Securities LLC, MBA, McDash Online,                 (c85)   Standard & Poor's Leveraged Commentary & Data, Q3 2012
         December 2012                                                   (c86)   Moody's, Real Capital Analytics, Q3 2012
 (c39)   BEA, JPMAM, July 2012                                           (c87)   IEA, Nuclear Energy Agency and OECD, 2010, see
 (c40)   Institut für Wirtschaftsforschung, Bundesministerium fur                10/22/2012 EOTM
         Wirtschaft und Arbeit, December 2012                            (c88)   Executive M&A Summary, Citigroup Inc, October 2012
 (c41)   Banque de France, Markit, INSEE, Ministere du Travail et de     (c89)   OMB, BEA, Robert Shiller data set, BLS, December 2012
         l’Emploi, November 2012                                         (c90)   US Energy Information Administration, JPMAM, October
 (c42)   IMF, World Bank, WEF, OECD, ILO, Mercer, US Social                      2012, see 10/22/2012 EOTM
         Security Administration, see 11/07/2012 EOTM                    (c91)   Bridgewater Daily Observations, November 21, 2012
 (c43)   "Statistics on World Population, GDP and Per Capita GDP",       (c92)   US Energy Information Administration, September 2011
         University of Groningen; Standard & Poor's; Conference          (c93)   Federal Energy Regulatory Commission, November 2012
         Board; Universidad Carlos III de Madrid, Departamento de        (c94)   CBO, OMB, JPMAM, August 2012
         Historia Económica e Instituciones, December 2012               (c95)   CBO, OMB, August 2012
 (c44)   Banco de Espana, JPMAM, Q3 2012                                 (c96)   From a speech by Joseph Yam, Chief Executive of the Hong
 (c45)   Reinhart, Carmen M. and Kenneth S. Rogoff, “From Financial              Kong Monetary Authority, January 2005
         Crash to Debt Crisis,” NBER Working Paper 15795, March          SEAT 600: photo by Joost J. Bakker from IJmuiden
         2010                                                            Alfa Romeo Giulia Spider: photo by Marvin Raaijmakers
 (c46)   IMF, OECD, Country sources, September 2012                      Namco Pony: photo by Craig Howell


                                                                                                                                                  15
                                                                                                                                          15
  Eye on the Market | OUTLOOK 2013 January 2, 2013
                         

2013 Outlook
Additional sources and acronyms
“Federal Financial Institutions Examination Council Announces Availability of 2011 Data on Mortgage Lending”, FFIEC, Sep 2012
“Dividend growth: good groupthink”, Empirical Research Partners, Michael Goldstein, December 10, 2012
“Reassessing banks; downgrading insurance”, Credit Suisse Equity Research, Andrew Garthwaite, October 2, 2012
“Restructuring Europe”, Goldman Sachs Equity Research, Huw Pill, November 30, 2012
A conversation with Vaclav Smil on hydraulic fracking (http://www.vaclavsmil.com/)

AGI: Adjusted Gross Income; AZ, NV, FL & CA: Arizona, Nevada, Florida, and California; BCA: Budget Control Act; BEA: Bureau of Economic
Analysis; BLS: Bureau of Labor Statistics; BoE: Bank of England; BoJ: Bank of Japan; BRIC: Brazil, Russia, India, China; CAFE: Corporate
Average Fuel Economy; CBD: Central Business District; CBO: Congressional Budget Office; CDS: Credit Default Swaps; CMBS: Commercial
Mortgage-Backed Securities; CPI: Consumer Price Index; DC: District of Columbia; EBITDA: Earnings Before Interest, Taxes, Depreciation, and
Amortization; ECB: European Central Bank; EFSF: European Financial Stability Facility; EM: Emerging Markets; EPA: Environmental Protection
Agency; ESM: European Stability Mechanism; EU: European Union; EUR: Euro; FICO: a credit scoring model named after the Fair Isaac
Corporation; FRB: Federal Reserve Board; GDP: Gross Domestic Product; HK: Hong Kong; HY: High Yield; IAEA: International Atomic Energy
Agency; IBES: Institutional Brokers’ Estimate System; IEA: International Energy Agency; ILO: International Labour Organization; IMF:
International Monetary Fund; ISI: International Strategy and Investment Group; ISM: Institute for Supply Management; JPMAM: J.P. Morgan Asset
Management; KG: Kilogram; L-T: long term; LSTA: Loan Syndications and Trading Association; MBA: Mortgage Bankers Association;
M&A: Mergers and Acquisitions; MMBtu: millions of British thermal units; MPG: Miles per Gallon; MSCI: Morgan Stanley Capital International;
MWh: Megawatt hour; NAHB: National Association of Home Builders; NFIB: National Federation of Independent Business; OECD: Organization
for Economic Co-operation and Development; OMB: Office of Management and Budget; P/B: Price to Book; P/E: Price to Earnings; PE: Private
Equity; PMI: Purchasing Managers Index; PDVSA: Petróleos de Venezuela, S.A.; REIT: Real Estate Investment Trust; RMB: Renminbi; ROE:
Return on Equity; S&P: Standard & Poor’s; SAAR: Seasonally Adjusted Annual Rate; USD: United States Dollar; USSR: Union of Soviet Socialist
Republics; UST: United States Treasury; VC: Venture Capital; WEF: World Economic Forum; YoY: Year-over-year

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                                                                                                                                                                            16
16                                                                                                                                                                            1212-0713-04
MICHAEL CEMBALEST is Chairman of Market and Investment Strategy for J.P. Morgan Asset
Management, a global leader in investment management and private banking with $2.0 trillion of
client assets worldwide. He is responsible for leading the strategic market and investment insights
across the firm’s Institutional, Funds and Private Banking businesses.

Mr. Cembalest is also a member of the J.P. Morgan Asset Management Investment Committee and
a member of the Investment Committee for the J.P. Morgan Retirement Plan for the firm’s 260,000
employees.

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

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

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




                                                                                                       17
ASIA        AMERICAS        EUROPE         MIDDLE EAST   WORLD HEADQUARTERS
Hong Kong   United States   France         Dubai         270 Park Avenue
Singapore   Brazil          Germany                      New York, NY 10017
            Chile           Italy
            Colombia        Spain
            Mexico          Switzerland
            Peru            United Kingdom

				
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