The Good The Bad and The Ugly Scenarios for World

The Good, The Bad and The Ugly - Scenarios for 2007 World Market Outlook Edmund Brandt, CFA Investment Director and Global Strategist April 2007 Reasons to be fearful – what is worrying investors  Mixed signals on economic outlook and earnings newsflow  Investors remain confused – stock market correction phase likely to last another 1-2 months  Market is seeking concrete reassurance that: – American economy doesn’t tip into recession – Earnings growth does not disappoint – Risk appetite does not implode  As a result, markets are likely to remain choppy 1 Agenda  Scenario analysis on the outlook for 2007  The outlook for Bonds  The outlook for Shares 2 Scenario 1: The Good…  Growth: US has economic "soft landing", with GDP growth re-accelerating in the second half of 2007 and in 2008. Europe has above trend growth, while Japan's recovery continues. Global growth slows but remains healthy  Inflation: Price pressures remain contained, with core inflation around 2% in all major economies. Labour markets ease in US, and unit labour costs remain subdued globally  Interest rates: US Federal Reserve eases in the second half of 2007, with 0.5% cut off rates. European Central Bank takes interest rates to 4%-4¼% and then pauses, while Bank of Japan increases interest rates to 1%. US bond yields preferred, while other bonds under-perform cash  Markets: Around 6% to 9% earnings growth expected. Shares outperform cash and bonds Source: JPMAM Global Multi Asset Group 3 Scenario 2: … The Bad…  Growth: US goes into technical recession in second half of 2007, which affects the rest of the world, especially Asia / emerging markets. European activity slows, while Japan suffers from weakness in its export markets  Inflation: Inflation falls everywhere, with Japan back in deflation. Unemployment rises. Energy prices fall due to slower global growth  Interest rates: Fed cuts rates aggressively to 3%, while other central banks follow suit. Bond prices rise. Bonds out-perform cash  Shares: shares hurt as earnings growth turns negative. Globally, Shares under-perform bonds and cash Source: JPMAM Global Multi Asset Group 4 Scenario 3: … and The Ugly  Growth: Growth softens but inflationary pressures rise. US GDP growth disappoints, while Europe and Japan have below average GDP growth  Inflation: Inflation proves sticky, driven by higher commodity prices and rising wages. Corporate margins under pressure  Interest rates: All main central banks forced to raise interest rates to keep a lid on inflation. Bond prices fall, driven by higher inflation expectations. Bond returns are negative and under-perform cash  Shares: Low earnings growth expected, with PER valuations under pressure due to higher interest rates. Shares struggle, registering negative returns but out-perform bonds, while under-performing cash Source: JPMAM Global Multi Asset Group 5 Global output – mid-cycle pause Purchasing manager data suggest that the global inventory slowdown is nearly over and that the industrial production cycle will accelerate into 2008 Global Industrial Production, % year on year 7.5% 5.0% 2.5% 0.0% -2.5% -5.0% -7.5% 00 01 02 03 04 05 06 07 Sources: MacData, JPMAM Global PMI, Jan 2000 = 50 64 60 56 52 48 44 40 Global Industrial Production Global PMI (RHS) 6 World Economic Scorecard Too early to look for falling interest rates globally, but the US will be the first to ease monetary policy US Growth Inflation Current Account Policy Rates Profitability Japan China Consolidating Rising Widening Surplus Up Decelerating Europe Peaking Stable Narrowing Deficit Up Decelerating UK Accelerating Rising Widening Deficit Up Decelerating Consolidating Accelerating Stable Narrowing Deficit Flat Decelerating Falling Widening Surplus Flat / Up Decelerating Source: JPMAM Global Multi Asset Group Note: Assessments are made on a 3-6 month horizon 7 US housing – a continuing worry Which picture fits the outlook for US housing in 2007/8? If housing problems increase, US consumption and GDP growth may suffer 8 Unit labour costs – inflationary pressures likely to be limited US unit labour costs are easing, while they are flat or falling in Europe and Japan – this is consistent with the Good and Bad scenarios Unit Labour Costs, % year on year 8 6 4 2 0 -2 -4 -6 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 Sources: Thomson Datastream, OECD, JPMAM US Germany Japan 9 Interest rates – markets expect cuts of 0.50% in US rates Forward markets in the US and Europe have priced in the peak in interest rates and the prospect of subsequent easing. This profile is consistent with a mid-cycle pause Per cent 5.50 5.00 4.50 4.00 3.50 3.00 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Source: Bloomberg Per cent 1.10 1.00 US 0.90 0.80 0.70 0.60 Europe Japan (RHS) 10 Earnings momentum – a retreat not a rout Earnings momentum has been trending lower for the US and Japan. Europe is the exception, where upgrades have been rising relative to downgrades Earnings Momentum Ratio* 3.0 2.5 2.0 1.5 1.0 0.5 0.0 97 98 99 00 01 02 03 04 05 06 07 US Europe ex UK Japan Sources: Thomson Datastream, JPMAM * Note: Momentum is defined as the number of upward revisions relative to the number of downward revisions, over a three month period . 11 Scenario verdict We stick with the Good scenario of a global soft landing, but note that the other two scenarios are realistic alternative outcomes. Given this uncertainty investors need to be sure they are being paid to take risk Good Global output Global leading economic indicators US recession indicator US housing US monetary conditions Spare capacity Unit labour costs Inflation Interest rates Earnings % Likelihood Source: JPMAM Global Multi Asset Group Bad Ugly           60%       30% 10% 12 Agenda  Scenario analysis on the outlook for 2007  The outlook for Bonds  The outlook for Shares 13 Global bonds - tactically overweight  Central banks will continue to withdraw liquidity in the next 3-6 months – US Federal Reserve to pause until mid- 2007 and then may have scope to cut interest rates by 0.5% thereafter – European Central Bank to raise interest rates to 4% by end-2007 and then go on “datawatch” – Bank of Japan to raise rates gradually to ¾%-1% by end-2007 – Bank of England to take base rates to a peak of 5¾%, but 6% remains possible  Bonds offer limited value in terms of real yields, but have benefits given the current macro uncertainties. We are tactically overweight, with a preference for the US over Europe. We remain cautious on Emerging Markets and High Yield bonds  Long duration: US, Japan  Neutral: UK  Short duration: Euro zone, Emerging Markets, High Yield 14 Bond spreads – compressed Spreads versus US Treasury bonds remain very narrow and close to all-time lows. A scenario of slower US and global growth could bring some modest widening. This would hurt existing investors Basis Points 1200 1000 800 600 400 200 0 2001 EMBI+ Spread over US Treasuries JP Morgan High Yield Spread over US Treasuries 2002 2003 2004 2005 2006 2007 Sources: MacData, JPMorgan, JPMAM We remain wary of both high yield and emerging market debt 15 Agenda  Scenario analysis on the outlook for 2007  The outlook for Bonds  The outlook for Shares 16 Global Shares - Neutral  Global Shares likely to generate a total of around 8% in 2007. This is vulnerable to any earnings disappointments  Tactically, while equity markets are no longer over-bought versus bonds, they have yet to deliver a strong buy signal  Earnings momentum is subdued in the short term for equity markets. This is causing investors to fret over how cheap valuations really are  However we still see good scope for positive earnings surprises in both Europe and Japan  On a one year view, we still see Shares as delivering a higher total return than either bonds or cash  We are overweight core markets and large caps, where value is most evident  Preferred markets: US large caps, Europe and UK. Underweight: Emerging markets US Small Caps 17 18 EPS Growth YoY (%) 12 10 8 6 4 2 0 12 10 8 6 4 2 0 USA Japan EPS Growth YoY (%) Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 6.0 2007 Consensus earnings forecasts – the key to equity performance in 2007 Source: JPMorgan Global Multi Asset Group The outlook for earnings growth Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 10.5 UK EPS Growth YoY (%) 12 10 8 6 4 2 0 EPS Growth YoY (%) 12 10 8 6 4 2 0 Europe ex UK Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 5.7 8.0 Historical valuations The recent correction has refreshed market valuations, but “Greater China” still looks pricey. Note that Asian currencies look undervalued EXPENSIVE MARKET / CHEAP CURRENCY HK Sth Africa 2.0 Japan 1.5 CHEAP CURRENCY US CHEAP MARKET / Currency Valuation Taiwan 1.0 Canada 0.5 0.0 -0.5 India Singapore China EXPENSIVE MARKET / EXPENSIVE CURRENCY Australia Korea Europe Brazil Russia -1.5 UK Zone of Indifference -1.0 Turkey -1.5 CHEAP MARKET / 0.5 EXPENSIVE CURRENCY -3.0 -2.5 -2.0 -2.0 -1.0 -0.5 0.0 Market Valuation 1.0 Sources: Thomson Datastream, JPMAM Global Multi Asset Group Note: The Market Valuation measure comprises four standardised metrics (P/E ratio, price-to-cash flow, dividend yield and price-to-book) as a composite measure of value. The currency valuation measure gauges possible over/under-valuation of currencies by looking at current real exchange rate levels compared with recent trends. Both series are standardised against a three-year history 19 Liquidity – supportive of stock markets Global liquidity is growing at the fastest annualised rate since January 2004. This should support markets and help underpin risk appetite Global Liquidity, 13 week change, annualised 35% 28% 21% 14% 7% 0% -7% -14% 98 99 00 01 02 03 04 05 06 07 Sources: Thomson Datastream, JPMAM Note: Global Liquidity is defined as the sum of the US monetary base and Holdings of Agency and Treasury securities held at the Federal Reserve 20 Investor risk appetite – will remain under pressure Risk Appetite Index 8 6 4 2 0 -2 Low risk tolerance High risk tolerance Credit Suisse Risk Appetite Index -4 -6 81 83 85 87 89 91 93 95 97 99 01 03 05 07 Source: Credit Suisse If investor risk appetite falls, emerging markets, smaller companies and high yield bonds tend to do badly 21 Volatility of returns set rise due to increased economic uncertainty Vix index of implied volatility Price Index 50 40 30 20 10 0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 Source: JPMAM If volatility of returns rises, larger companies and bluechips in the core stock markets of Europe and the USA tend to do better 22 European shares - Overweight  European shares remain our top asset allocation choice  Economic data remains positive and looks set to exceed forecasts for 2007. A modest recovery in domestic demand is now discernible, which should be boosted by falling unemployment  In the short term, European shares may see a correction, due to profittaking  The 1 year outlook for European stocks is attractive, with strong earnings growth, which is supported by ongoing corporate restructuring. There is further scope for positive earnings surprises  Even on current earnings forecasts, European shares look attractively cheap, on 13.2x forward PER  The return of M&A fever will boost investor sentiment and will help to lift share prices 23 Healthy bank lending is a strong positive for the future growth Eurozone mortgage lending rose 9.4% in February 24 European Mergers and Acquisition is good for share prices We expect M&A fever to remain strong through-out 2007 25 American shares - Overweight  US interest rates seem to have peaked. Combined with a forecast soft landing in GDP growth during 2007, this is traditionally positive for US shares. Lower interest rates normally boost share prices  Most global investors are materially underweight US Shares: assuming no recession, the pressure to increase exposure to US shares will grow  US large caps are looking attractively cheap, both versus small caps and versus history. Due to the uncertain risk outlook, we expect investors to prioritise earnings quality  We do not forecast a collapse in earnings for 2007. Rather we expect slower, but still healthy profit growth of around 6%. US shares are now valued at 15.0x forward PER  US corporate Free Cash Flow is currently very high and is likely to positively impact US shares in 2007 via continued mergers and acquisitions (M&A) fever, which will help lift share prices 26 The US economy will be a rough ride in 2007 US shares: stay on the horse! 27 Japanese shares - Neutral  The recovery in the Japanese economy is being driven by strong domestic demand growth. While leading indicators and earnings momentum have both slowed in the short term, domestic recovery is a sustainable and attractive medium term investment theme  Any signs of accelerating economic and earnings growth will be positive for Japanese shares  Japan is the only G7 economy that might see GDP growth accelerate in 2007  The Yen is at a 20 year low versus other major currencies  Japan’s recent underperformance has left the market looking technically attractive. The market is cheap by historical standards, on 18.5x forward PER 28 After being stuck at a red signal for 2006, the Japanese bullet train is starting to pick up speed! 29 Emerging Market shares - Underweight Eastern Europe – Underweight, Latin America – Overweight, Asia – Neutral, EMEA – Underweight  We expect volatility to continue within emerging markets as investors absorb the full implications of tighter global money and ebbing liquidity  Emerging market valuations still seem vulnerable to bad news. Valuations are still not cheap. On a price-to-book ratio of around 2.5x, emerging market Shares are above the usual valuation range  As a group, Emerging Markets still look expensive relative to core G7 Shares  We see Latin American countries (notably Brazil) as still under-valued. We also continue to favour domestic demand oriented Asian shares  We are wary on Russia and Hungary 30 Emerging Market Valuations Emerging markets were about 15% overvalued at the end of February. History suggests corrections tend to end leaving emerging markets undervalued. The pull-back may therefore have further to go Composite Valuation Index, 1995-2005 Average = 100 140 130 120 110 100 90 80 70 60 96 97 98 99 00 01 02 03 04 05 06 07 Index 1000 900 800 700 600 500 400 300 200 Composite Valuation Index MSCI Emerging Markets (RHS) 31 Sources: Thomson Datastream, JPMAM Note: The Composite Valuation Indicator comprises four valuation metrics (P/E ratio, price-to-cash flow, dividend yield and price-to-book) in an index which is rebased to the average of the 10 years to end-2005. Latest observation is a mid-month estimate Conclusions  Escalating fears over the US sub-prime mortgage market have led to increased uncertainty about the US economic outlook  Our scenario based analysis reaffirms our belief in a soft landing for the global economy that will be followed by renewed re-acceleration in 2007/08  The most likely outlook entails four quarters of sub-trend US growth, interest rate cuts in the second half of 2007 and single-digit global earnings growth. We expect modest shares upside in 2007/08  We believe that Shares offer a reasonable but not compelling risk premium over bonds, given present uncertainties. Our strategy is to be Neutral in Shares vs bonds for the time being, until valuations become more appealing.  Bonds: We are overweight, with a preference for the US over Europe and the UK  Shares: Preferred markets are US large caps, Europe and UK. Underweight: US small cap and Emerging Markets Conclusions 32 Asset allocation summary We are tactically underweight Shares. While our scenario-based analysis favours Shares, we would like to see further valuation improvements before recommitting to the asset class Underweight Shares (Neutral) Neutral Japan Asia ex Japan UK Overweight US Small Cap Global Emerging Markets Europe Ex-UK US Large Cap Underweight Bonds (Long duration) Neutral UK Other dollar bloc Overweight US Japan Europe ex UK High Yield Emerging Markets Source: JPMAM Global Multi Asset Group 33 Any forecasts or opinions expressed are JPMorgan’s own at the date of this document and may be subject to change. The value of investments and the income from them may fluctuate and your investment is not guaranteed and investors may not get back the full amount invested. Past performance is not a guide to future performance. Exchange rates may cause the value of underlying overseas investments to go down or up. Investments in smaller companies may involve a higher degree of risk as they are usually more sensitive to market movements. Investments in emerging markets may be more volatile than other markets and the risk to your capital is therefore greater. Also, the economic and political situations may be more volatile than in established economies and these may adversely influence the value of investments made. Telephone lines are recorded and may be monitored for security and training purposes 34