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					                                                                                      Global Asset Allocation
                                                                                      Mar 4, 2011




Flows & Liquidity

Low hedge fund leverage contrasts with elevated
bank leverage
                                                                                       Nikolaos PanigirtzoglouAC
                                                                                       (44-20) 7777-0386
• While hedge fund leverage has been declining since the Lehman                        nikolaos.panigirtzoglou@jpmorgan.com
  collapse, bank leverage currently stands well above pre-crisis levels.
• Both credit and money supply growth appear to be improving in                        Grace Koo
                                                                                       (44-20) 7325-1362
  developed market (DM) economies. QE2 had likely little direct impact in              grace.x.koo@jpmorgan.com
  boosting DM money supply.
• The HY bond market is growing at the expense of the loan market.                     Seamus Mac Gorain
                                                                                       (44-20) 7777-2906
• March represents a major test for the US Muni market as supply is                    seamus.macgorain@jpmorgan.com
  expected to rise steeply amid continuing weak demand
                                                                                       Matthew Lehmann
• Retail investors sell equity and buy bond funds.                                     (44-20) 7777-1830
                                                                                       matthew.m.lehmann@jpmorgan.com
• The move away from EM into DM equity funds has started fading.
• Buying of USTs by foreign central banks appears to have rebounded in
  February.                                                                           Chart 1: Hedge fund leverage
                                                                                      Weighted average of leverage for 8 HFR hedge fund styles. For each style
                                                                                      we divide the hedge fund index return volatility by asset return volatility which
                                                                                      we proxy by S&P 500 returns for Equity long/short, Equity short and Equity
• Hedge funds represent an important part of investors’ universe as they              neutral, JPM Global Bond Index USD hedged returns for Macro and Fixed
                                                                                      Income arbitrage, high yield returns for Conv Arb and Event driven/
  account for a third or more of total trading volumes on some financial         10   Distressed debt and MSCI EM returns for EM funds.                                       2.5
  assets. Their importance is a function of leverage: the higher the
  leverage the higher the amount of assets hedge funds control.                  8                                                                                            2.0

• We estimate hedge fund leverage by relating hedge funds return                 6                                        All Hedge Funds                                     1.5
  volatility to the asset class volatility. The higher the ratio of these two,
  the higher the leverage of hedge funds (see Volatility, Leverage and           4                                                                                            1.0
  Returns, Jan Loeys and Nikolaos Panigirtzoglou Oct 2005 for more
  details).                                                                      2                                                                                            0.5

• Chart 1 shows our estimate of HF leverage. HF leverage experienced a                                       Macro HFs
                                                                                 0                                                                                            0.0
  structural break since late 1990s. The low volatility during the 1996/1997
                                                                                      95           98              01             04             07              10
  period encouraged an increase in hedge fund leverage through 1998.
                                                                                      Source: J. P. Morgan
  The LTCM crisis and the resulted increase in volatility triggered a
  position unwinding and deleveraging, which was amplified by the                     Chart 2: US bank leverage
                                                                                      We proxy bank leverage by using the ratio of the volatility of their trading
  collapse of the tech bubble. Since mid 2003 volatility started declining at         profits divided by asset volatility. The trading profits are split into fixed income,
  a rapid pace laying the ground for a rise in leverage. But the Lehman               equities, currencies and commodities. See Volatility, Leverage and Returns, J
                                                                                      Loeys and N Panigirtzoglou)
  crisis caused a new wave of position unwinding and deleveraging. HF             2.5
  leverage has been declining since then and it currently stands at the low
  end of the range over the past 10 years.                                        2.0

• Banks, much like hedge funds, are active investors that can control             1.5
  more assets than their capital by using derivative instruments or
  borrowing. As in the case of hedge funds, we proxy their leverage by            1.0
  the ratio of the volatility of their trading profits over the volatility of
  their assets (Chart 2). Quarterly data on the trading profits of US banks       0.5
  are available from the Office of the Comptroller of the Currency (OCC).
                                                                                  0.0
                                           AC                                              95       97         99         01           03        05         07         09
The certifying analyst is indicated by an . See page 7 for analyst
certification and important legal and regulatory disclosures.                         Source: J. P. Morgan
Global Asset Allocation
Flows & Liquidiity




   Unlike hedge funds, US banks appear to have greatly increased their leverage                     Chart 3: Money supply vs. bank loan growth in
   after the Lehman crisis, and despite the decline seen during 2010, bank                          Developed Market economies
                                                                                                   12         % oya
   leverage remains well above pre crisis levels.
                                                                                                   10
DM money supply growth is improving with little help
from QE2                                                                                            8
                                                                                                                                                    DM broad money
• Both credit and money supply growth appear to be improving in developed                           6                                                   supply
  market (DM) economies. Loan growth has stopped contracting and the over-a                         4
  -year-ago pace of money supply growth has risen from 2.5% in the middle of
                                                                                                    2
  2010 to 3.2% in January (Chart 3). The rise to above 3% is encouraging as the
  3% threshold is what distinguishes the deflationary period seen in Japan                          0
  since late 1990s (Chart 4).                                                                       -2
                                                                                                         07                08             09             10                 11
                                                                                                                                    HH+corp loan growth within G4
• Has QE2 boosted money supply? Having purchased on net $300bn of UST               -4
  bonds, the Fed is half way through its QE2 program. These bond purchases          Source: Fed, ECB, BoJ, BoE and J. P. Morgan

  do not affect money supply directly when bonds are bought from banks. But
  there is a direct increase in money supply when central banks buy bonds from      Chart 4: Money supply in G4 vs. Japan
  non-bank entities (i.e. in this case the cash balances of households,          14 % oya
  corporates and other non-bank entities increase). The fact that G4 commercial 12
  banks reduced their bond holdings by close to $280bn since the beginning of 10                                                DM broad money supply
  November suggests that the vast majority of the bonds the Fed bought under 8
  QE2 were sold by banks. In other words, QE2 had likely little direct impact in
                                                                                  6
  boosting DM money supply.
                                                                                               4
• This contrasts with the previous round of QE, when bond purchases by the      2
  Fed, the BoE and the ECB, totalled $1.68tr in the year to March 2010. Around                                 M3 money supply in Japan
                                                                                0
  55% of these bonds were bought from non-bank entities. On our calculations, Jul-82                            Jul-88           Jul-94        Jul-00         Jul-06
                                                                               -2
  the previous round of QE had been responsible for 62% of the increase in DM
  money supply in the year to March 2010.                                      -4
                                                                                                    Source: J. P. Morgan

Spanish banks outside BBVA and Santander need to
accelerate their bond issuance
• Santander issued €2bn of covered bonds this week which met strong demand                         Chart 5: Divergence between equity and bond
  from investors outside Spain. Foreign investors accounted for 86% of the
                                                                                                   fund flows globally
                                                                                                   Includes mutual funds and ETFs, weekly reporting
  €4.3bn order book. Bankinter tapped its Nov 2014 covered bond by issuing                         funds only
  another €400m this week. This brings the total issuance by Spanish banks                         4wk average, $bn
  YTD to €24bn or 29% of 2011 maturities.                                                          8                                                                   10
                                                                                                                                          Equity funds
• Spanish banks outside BBVA and Santander issued €7bn of bonds YTD,                               6
                                                                                                                                                                       5
  which represents 18% of total 2011 maturities or 1/3rd of €21bn of bond                          4
  maturities during the first 4 months of the year. Spanish banks outside BBVA
                                                                                                   2
  and Santander need to accelerate their bond issuance over March/April for
  them to avoid resorting to the ECB.
                                                                                                                                                                       -5
                                                                                                   -2
Retail investors sell equity and buy bond funds                                                                                           Bond funds
• The gap between equity and bond fund flows, which opened last November,                          -4                                                                  -10
  has now closed (Chart 5). Retail investors have reduced their pace of equity                      Jan-10       Apr-10         Jul-10     Oct-10        Jan-11
  fund buying over the past 4 weeks to only $800m per week from $6bn per                           Source: J.P.Morgan, EPFR
  week at the end of the year. The pace of bond fund buying has instead
  increased to $1.4bn per week over the past 4 weeks from an outflow of -$2bn
  per week at the end of the year. Over the past 2 week, equity investors
  withdrew $5.3bn from equity funds and injected $4.7bn into bond funds.


Mar 4, 2011                                                                                                                                                       2
                                                                                                     Chart 6: Divergence between DM and EM equity
                                                                                                     fund flows
The move away from EM into DM equity funds has                                                       Includes mutual funds and ETFs, weekly reporting
started fading                                                                                       funds only
• The divergence between DM and EM equity fund flows has started shrinking                        4wk average, $bn
  (Chart 6). Retail investors withdrew $3.2bn per week over the past 4 weeks                       10
  from EM equity funds and injected a similar amount into DM equity funds.
                                                                                                      5
  This is lower than the $4.6bn per week pace seen two weeks ago.                                                                         EM

Buying of USTs by foreign central banks appears to                                                    0
have rebounded in February
                                                                                                     -5
• Fed custody data show that foreign central banks increased their buying of
  USTs in February following a flat January (Chart 7). Both January and                                                      DM
                                                                                                  -10
  February data include the impact of Tbills, so we need to wait for the monthly
                                                                                                    Jan-10        Mar-10         Jun-10   Sep-10   Dec-10
  TIC data to get a better idea of the amount of long-term USTs bought by
  foreign central banks in January or February. Chart 5 also shows that buying                       Source: J.P.Morgan, EPFR

  of US bonds by either US or Japanese banks remains rather muted.                                   Chart 7: Monthly buying of long-term US bonds
                                                                                                     $bn per month, end of month data, solid line denotes the
March represents a big test for the US Muni market as                                                monthly total
supply is expected to rise steeply amid continuing weak
                                                                                                            US banks
demand                                                                                         200
• Municipal bond fund outflows rose this week to $0.9bn versus only $0.3bn                                  Japanese banks
                                                                                  150
  last week. This broke the declining trend in outflows from Muni bond funds                                Foreign central banks
  since mid-January when investors withdrew a record $3.6bn over one week.        100
  As Chart 8 shows, the 4-week average outflow from Muni funds fell from a
  peak of $2bn to $0.77bn last week, but increased slightly this week to $0.81bn. 50
                                                                                                 0
• CDS positions on Municipals keep growing with net notional outstanding
                                                                                       Jan        Mar         May        Jul        Sep                Nov       Jan
  reaching another record high since data became available in Oct 08. As of 25    -50 2010                                                                         2011
  Feb, the net CDS position on Munis rose to $8bn, a 21% increase since the
  start of the year (Chart 9). The increase in CDS positions continues to be     -100
  more concentrated at the index level, likely due to investors shying away from
  taking positions on a particular municipal entity.                                  Source: US TIC, Federal Reserve and J.P. Morgan


• Despite continued weak demand in Municipal bonds, the yield of Muni
  bonds stabilized in recent weeks. This is likely due to low supply and trading                     Chart 8: Municipal bond fund flows
  volumes over the past two months. Issuance of Municipal bonds was weak in                          $mn
  the first two months of the year, with an average monthly issuance pace of                                       4-week average
                                                                                                     2,000
  $14bn, half the pace seen during the same period last year and 40% of the                          1,500
  average 2010 monthly pace of $35bn. However, we expect the pace of issu-                           1,000
  ance to rise steeply in coming months, jumping to $25bn in March then                                500
  gradually rising to $30bn in June. As the wave of new supply arrives, the risk                          0
  is that municipal bond yields rise if demand does not recover rapidly. For
                                                                                                       -500
  2011, we expect total issuance to be $300bn, a quarter lower than the 2010
                                                                                                     -1,000
  issuance of $414bn (see USFIMS, Municipals, for more details).
                                                                                                     -1,500
The HY bond market is growing at the expense of the                                                  -2,000
loan market                                                                                          -2,500
• The HY market consists two major sectors, HY bonds and HY loans. In 2010,                               Jan-07 Nov-07 Sep-08 Jul-09 May-10
  we saw another year of record HY bond issuance of $302bn after previous                            Source: J.P. Morgan, EPFR
  record issuance of $181bn in 2009. This generates the fear that the HY market
  is growing at an unsustainable pace.



Mar 4, 2011                                                                                                                                                  3
• In HY bonds, the total gross supply including supply from rating changes was          Chart 9: CDS net notional outstandings on Muni
                                                                                        $bn
  actually unchanged between 2009 and 2010. In 2009, $150bn of HG bonds were            8
  downgraded into HY, a record amount since 1999, beating the previous peak
                                                                                        7                Total Muni (incl single name)
  set of $141bn during 2002. As the economy improved in 2010, the volume of
  fallen angels fell to only $28bn, bringing the total gross HY bond supply in          6
  2010 to $330bn ($28+$302), the same amount total gross HY bond supply as              5
  2009 ($150+$181).
                                                                                        4
• However, for a comprehensive picture of the total investable HY universe, we          3                                                                                 MCDX
  need to include ‘supply’ from rating downgrades, i.e. the volume of fallen            2
  angels net of rising stars, the supply from the HY loan market and the
  redemptions. In contrast to the rapidly growing HY bond market, the aggre-            1
  gate HY universe (bonds+loans) saw net issuance in 2010 that was 20%                  0
  below that seen in 2009 and 38% below that seen in 2007 levels.                            08                  09               09                   10                  10
                                                                                       Source: J.P. Morgan
                                                                                       Note: Single-names include the States of California, Florida, New York,
• In particular, the total investable HY universe, including both bonds and loans      Texas, New Jersey, Illinois, Massachusetts and the City of New York.
  and net of redemptions, grew slower in 2010 compared to 2009 due to the
  heavier call and tender activity (Chart 10). In addition to annual maturities of     Chart 10: US HY bond net total supply
                                                                                       HY bonds only, $bn per year. Net of maturities, rating
  approximately $34bn in 2009/10, we saw high yield companies calling/tender-
                                                                                       changes, call and tender activities
  ing $68bn in 2009 and $122bn in 2010. In total, with the contraction of the loan
                                                                                      350                         Maturities, calls, tenders and rising stars
  market and net of all call/tender/maturities, the total investable HY universe
                                                                                                                  Total gross supply
  grew by $148bn in 2009 and $118bn in 2010.                                          300                         Net total supply

• As Chart 11 shows, this pace of increase of the total HY universe is not            250
  exceptional by historical standards. During the credit boom years of 2006 and
                                                                                      200
  2007, the total HY universe including both bonds and loans was growing at a
  pace of $166bn and $190bn respectively.                                             150

• In conclusion, the strong growth in the HY bond market gives only a partial         100
  picture of the overall growth of the HY universe. Companies have been
                                                                                       50
  locking record low yields by issuing bonds instead of loans. The HY loan
  universe has been shrinking over the past two years.                                   0




                                                                                                                                                                                      YTD
                                                                                                  2000
                                                                                                          2001
                                                                                                                 2002
                                                                                                                        2003
                                                                                                                               2004
                                                                                                                                       2005
                                                                                                                                               2006
                                                                                                                                                       2007
                                                                                                                                                               2008
                                                                                                                                                                        2009
                                                                                                                                                                               2010
                                                                                       -50
                                                                                       Source: J.P.Morgan.
                                                                                       Chart 11: US HY net total supply
                                                                                       Both HY bonds and loans, $bn per year. Net of
                                                                                       maturities, rating changes, call and tender activities
                                                                                     250
                                                                                                Net bond supply
                                                                                                Net loan supply
                                                                                     200


                                                                                     150


                                                                                     100


                                                                                      50


                                                                                       0
                                                                                                                                                                                         YTD
                                                                                              2000
                                                                                                         2001
                                                                                                                 2002
                                                                                                                        2003
                                                                                                                               2004
                                                                                                                                        2005
                                                                                                                                                2006
                                                                                                                                                        2007
                                                                                                                                                                 2008
                                                                                                                                                                           2009
                                                                                                                                                                                  2010




                                                                                      -50


                                                                                     -100
                                                                                       Source: J.P.Morgan.


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Mar 4, 2011                                                       5
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Flows&Liquidity Weekly Monitor                                                      Monthly Trading Volume Monitor
$bn per week. Mutual fund flows are across all domiciles and by fund                Equity volumes are in trillions of USD. All data are updated on a monthly
objective. The gap from 2006 is the difference between the 4wk average and          basis. USTs are primary dealer transactions in all US government securities.
the 2006 average. 2006 Avg. is the weekly average over 2006. Corporate              JGBs are OTC volumes in all Japanese government securities.
gross issuance includes financials and non financials, HG and HY. The region        Equities ($tr)               Jan-10 Trading Volume                YTD Avg 2007 Avg
of issuance is by the parent company of the issuer.
                                                                                    EM                                       $1.44                      $1.44           $1.19
$bn
                                                                                    DM                                       $3.71                      $3.71           $5.92
Mutual Fund Flows                        This Week 4wk Avg. 2006 Avg Gap from 06
                                                                                    Govt Bonds (tr)              Jan-10 Trading Volume                YTD Avg 2007 Avg
All Equity Funds                             -1.5           0.8       1.2    -0.4
                                                                                    USTs                                     $10.5                      $10.5           $12.3
All Bond Funds                                2.1           1.4       0.2    1.2
                                                                                    JGBs                                     ¥544                       ¥544            ¥991
EM Equity Funds                              -2.5           -3.2      0.0    -3.2
                                                                                    Credit (bn)                  Jan-10 Trading Volume                YTD Avg 2007 Avg
EM Bond Funds                                 0.0           -0.3      0.1    -0.4
                                                                                    US HG                                    $259                       $259            $178
DM Equity Funds                               1.0           4.0       0.4    3.6
                                                                                    US HY                                    $134                       $134             $88
DM Bond Funds                                 2.1           1.7       0.1    1.6
                                                                                    US Convertibles                           $35                        $35             $45
US Equity Funds                               1.3           1.1       -0.1   1.2
                                                                                    Source: Bloomberg, Federal Reserve, Trace, Japan Securities Dealer Association, WFE, J.P.Morgan
US Bond Funds                                 0.1           0.4       -0.1   0.5
W. European Equity Funds                     -0.8           1.1       0.2    0.8
W. European Bond Funds                        0.2           -0.5      0.0    -0.5
US HG Corporate Bond Funds                    0.9           0.8       -1.0   1.8
US HY Corporate Bond Funds                    0.1           0.6       0.8    -0.2

 Corporate Gross Issuance                This Week 4wk Avg. 2006 Avg Gap from 06
 US                                          15.4           21.2      29.3   -8.2
 W. Europe                                   21.5           20.2      29.6   -9.4
Source: Bloomberg, EPFR, Dealogic, Federal Reserve, ECB, J.P.Morgan




Mar 4, 2011                                                                                                                                                                           6
Global Asset Allocation
Flows & Liquidiity




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Mar 4, 2011                                                                                                                                   7
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General: Additional information is available upon request. Information has been obtained from sources believed to be reliable but
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“Other Disclosures” last revised January 8, 2011.

Copyright 2011 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or
redistributed without the written consent of J.P. Morgan.



Mar 4, 2011                                                                                                                                    8

				
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