EFTA01077283

EYE ON THE MARKET OUTLOOK 2011 J.P. Morgan Private Bank Figure I: Printing Press The illustration represents the money created by various central banks since January 2008 to buy their own government bonds. or bonds of other countries to limit exchange rate adjustments. Crates are labeled by amount created. and expressed as a percentage of GDP. See inside cover for more details. J.P.Morgan EFTA01077283 What is "money"? If you go to the Bureau of Printing and Engraving at the U.S. Treasury, you won't actually see the machines running in overdrive. In an era of electronic money, the Federal Reserve can increase the monetary base (also known as "high•powered money") by increasing bank reserves to pay for the Treasury bonds that it purchases. The same applies to government bond purchases in the United Kingdom. The other countries shown engage in a different kind of money creation: an expansion of the monetary base to fund the purchase of foreign assets instead of domestic ones, with the goal of limiting exchange rate appreciation. Most of these countries drain domestic liquidity to try and prevent inflation, but still create two separate distortions. The first is domestic: By maintaining an undervalued currency and very low real interest rates, they risk inflation of wages, goods and asset prices. The second is international: These actions contribute to the global pool of central bank savings invested in U.S. government bonds. What used to be a functioning private sector market with price signals regarding inflation and growth risks is now increasingly subject to price controls and systemic shocks. By the time QE2 is over, more than half of all Treasuries will be owned by U.S. and non•U.S. central banks. Note how the representative from the European Monetary Union, which is not engaging in this kind of activity to any large degree, looks on in despair from outside the building. EFTA01077284 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 hand, the European sovereign debt crisis, contracting housing markets and high unemployment weighed heavy on all of our minds. But at the same time, record corporate profits and strong emerging markets growth left reason for optimism. So rather than look back, we'd like to look ahead. Because if there's one thing that we've learned from the past few years, it's that while we can't predict the future, we can certainly help you prepare for it. To help guide you in the coming year, our Chief Investment Officer Michael Cembalest has spent the past several months working with our investment leadership across Asset Management worldwide to build a comprehensive view 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 proceed with caution. Sharing these perspectives and 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 zoii. Most sincerely, EFTA01077285 Eye on the Market I OUTLOOK 2O11 , 1.2011 J.P.Morgan The Printing Press As we head into 2011, global profits are rising, U.S. household incomes and debt burdens are improving, the Asian production boom continues, global services are starting to rebound, and Germany is seeing its largest manufacturing and consumer revival since reunification. The twin engines of world growth, the U.S. and China, are in expansion mode again (el). (0) U.S. and China manufacturing (c2) Excess capacity in the U.S. and (c3) Asia ex-Japan and Latin inflation output surveys, Index level. sa Asia, Output gap, GDP vs potential Percent, YoY change 65 - 4%- EPA Asia: no -- 9% excess 8% capacity 7% 6% 5% U.S.: lots 4% of excess capacity 3% 2% 6% 1% 2003 2005 2007 2009 2005 2006 2007 2008 2009 2010 Given pressures for fiscal tightening in the West, it's hard to blame monetary authorities around the globe for trying to keep these things moving. That's why the global monetary experiment captured by the cover art continues uninterrupted. But it may be beyond traditional linear thinking to grasp all the ways this could turn out. The lowest inflation since 1958 and a large output gap in the U.S. (an inexact measure of spare labor/productive capacity) give the Fed justification for its approach (c2). The same cannot be said for Asia, where the output gap is smaller (or may not exist at all), and where inflation is rising. The chart below is something we have been thinking a lot about (c4). It's a measure of global imbalances: the extent to which some countries spend more than their incomes, and rely on other countries to finance the difference; how much they intervene in their currency markets; and how much they offset inadequate private sector demand through budget deficits. Does this matter given the good news above? When PIE multiples on global equity markets (c5) are so low? And when mountains' of household, corporate and Sovereign Wealth Fund cash are capable of driving asset prices higher? We think it does, since the risks of unintended consequences are higher when the magnitude of imbalances (and experimentation) is this high as well. (c4) An index of global imbalances (a) Global equity multiples (c6) Cost of money = zero Percent of global GDP Forward PIE ratio Policy rates adjusted for inflation, percent 1 12% 16 Current account and 15 "Avg since 1988 EM countries 10% fiscal deficits/surpluses III Current value 14 8% 13 - 6% 12 11 • 4% 10 • 2%, 9 • 0% 8 1970 1978 1986 1994 2002 2010 MSCI Europe MSCI USA MSCI EM 1981 1985 1989 1993 1997 2001 2006 2010 We have invested client portfolios around the globe in the belief that the world will not suffer a major relapse, with significant holdings in public and private equity, credit, hedge funds, commodities and real estate. We expect 2011 to be like 2010: volatile, rising equity markets, and modest returns on a balanced portfolio of financial assets. That these returns are made more attractive by the world's Printing Press policy, which renders cash savings useless as a store of value (c6), is a mixed blessing at best. This publication reviews our market, investment and portfolio stance as 2011 begins. Michael Cembalest Chief Investment Officer A ratio of US corporate sector cash/tangible assets is at its highest level on record. A measure of household cash and bonds as a % of discretionary financial assets is not far off. Sovereign Wealth Fund balances have grown from $1 trillion to $4 trillion since 2005. Sources for all charts and tables, as well as a list of acronyms used, appears on page 12. 1 EFTA01077286 Eye on the Market I OUTLOOK 2011 January 1.2011 J.P.Morgan Fast growth, inflation pressures: a better set of problems in Asia and the emerging world If we are not in an Asia-dominated world yet, we may be there soon. Asia's share of world output, even when excluding Japan, is now double that of the U.S. and still growing (c7). As a result, the Asian/EM inflation question is a very important one. As shown on page 1, headline and core inflation in Asia and Latin America are rising. Inflation pressures are mostly food-driven (c8, c9), but are beginning to impact wages and prices as well. China's inflation controls (increased bank reserve requirements, Central Bank bill issuance and legions of administrative measures) may be losing their effectiveness, as shown by frequent large spikes in its residential property markets (c10). This may be why China raised its inflation target to 4% in December. Why so much discussion about China? Like a giant tractor beam (c11), China pulls the emerging world into its orbit. A positive view of the world must assume China can continue to control inflation and deliver —8% growth, unorthodox model and all (c12). (c7) Post-war share of world GDP (c8) Brazilian Inflation fueled by food (a) Chinese inflation driven by food Percentof total world PPP GDP 3 month percentage change, annualized as well, Percent change - YoY 35% 9% Headline 25% Asia ex-Japan 8% 20% 30% US 7% 6% 15% 25% 5% 10% 4% 20% 3% 5% 15% 2% 0% 1% 10°/ 0% 5% 1950 1959 1967 1975 1983 1991 1999 2008 2007 2008 2009 2010 2005 2006 2007 2008 2009 2010 (00 Frequent overheating In Chinese (ell) Most EM counties correlated to (c12) How Chinese monetary policy property markets, Avg. dailysates, 1mma China, correlation to China GDP YoY growth works In one slide, Billions, USD 1,000 100% $2,500 FX RESERVES: China 900 80% accumulates reserves to 800 $2,000 prevent Its exchange rate Shanghai 60% • 700 from rising 600 40% 51,500 500 20% 0% 51,000 STERILIZATION: China issues Central -20% $500 Bank bills and raises -40% 14 EM countries bank reserve re • ulrements 60% SO Nov-09 Apr-10 Sep-10 1991 1997 2003 2009 2003 2005 2007 2009 We expect EM Central Banks to cool things down, after which we expect EM growth to continue. Asian exports are already rising after their fall slowdown, particularly in countries like Korea, Taiwan and Singapore. EM ex-China bank credit is growing (c13), supporting the business cycle and employment growth (c14). This is in stark contrast with the West, where de- leveraging still rules. Should EM countries overdo monetary tightening, fiscal deficits and debt ratios are generally low enough (el 5) o support additional stimulus, with some exceptions (India, Czech Rep.). In China, bank loan and money supply growth of 20% (down from 30% in 2009) indicate that the risk of over-investment and capital misallocation remains high. As in 2010, we hold positions in Asian currencies (funded vs G3 currencies), as we believe they are undervalued. (c13 Private sector bank credit (c14 Developed and emerging world (c15) 2010 fiscal deficits growth, Percent of GDP, annualized emp oyment growth, % change- Goo Percent of GDP 11% 4% 0% Developed Emerging 9% 3% 2% ■ Markets 2% 7% 1% 5% 0% 3% -1% Developed 1% -2% -3% -1% -4% Brazil Day EM Europe Japan US 2000 2002 2004 2006 2008 2005 2006 2007 2008 2009 2010 Asia Asia 2 EFTA01077287 Eye on the Market I OUTLOOK 2O11 Januar , 1.2011 J.P.Morgan The United States: modest private sector recovery trumps fiscal problems, for now... With many emerging economies limiting FX appreciation, a rebalancing of demand to the East will happen more slowly. As a result, the world still relies on the US consumer, whose discretionary and non-discretionary purchases make up 70% of US GDP. Recent spending data have been positive, despite weak job creation. This may reflect two factors. First, labor incomes have risen faster than job growth (c16), and second, household debt service burdens have now erased the last 15 years of excess, courtesy of both lower interest rates and defaults (c17). Credit card and early-stage mortgage delinquency rates are showing marked improvements as well. Based on a variety of recent indicators and surveys, we expect payroll gains of --200k per month in 2011, and 3.0%-3.5% GDP growth. Corporate sector cash balances are at a 50-year high, and are finally being spent. Business and equipment spending (c19) and productivity (c20) will probably slow but remain positive. Commercial construction, at its lowest level since 1958, should stop declining. These gains will be partially offset by $80 bn of belt-tightening at the state/local level. NY is one example; absent changes to current law, its structural deficit for 2012 is $9 bn on $90 bn in expenditures. Housing is still a mess (30% of mortgages underwater, shadow inventory 2x the number of homes for sale), and credit creation remains low. (c16) A proxy for labor Income (c17) Household financial obligations (c18) U.S. retail sales growth Percentchange, 3 month rolling average ratio, Percent of disposable income, sa Percentchange YoY 10% Payroll proxy: hours 19.0% - 15% worked times hourly 18.5% - income 10% 5% 18.0% - 5% 17.5% - 0% 17.0% - j 0% 16.5% - Decade of Ern p loymont household excess -5% -5% 16.0% - unwound 15.5% -10% -10% 15.0% 15% 2007 2008 2009 2010 '80 '83 '86 19 '92 '95 '98 '01 '04 '07 '10 1993 1996 1999 2002 2005 2008 2011 (c19) Business equipment and (c20) Nonfarm business productivity (c21) An expensive recovery software spending, YoY - % change Percent change - 3 year In Increase In Federal Debt/GDP(%) 16% n Increase In ISM manufacturing Survey (pts) 25% 38 14% I 34 • Through 12% 30 - yearend % 010 15%It 5% ' Bo 22 26 • 1 II .1. IJ 2 if 6ok 18 - JJ -5% 14 - 10 • 6• 2• -2 -25% -2% 52- 53- 58- 60- 70- 74- 80- 82- 91- 01- 08- 1955 1963 1971 1978 1986 1994 2002 2010 1952 1960 1968 1976 1984 1992 2000 2008 52 55 59 61 73 76 80 83 93 04 10 The elephant in the room: the eventual need for fiscal tightening. The production rebound was consistent with prior ones, but cost a lot more in terms of Federal debt to generate (c21). Tax cut extensions and payroll tax reductions will increase 2011- 2012 deficits by $800 bn compared to current law. If this "all-in" strategy results in consistent 4% growth, 2015 budget deficits could fall to 3%. Otherwise, the US will eventually need to make tough choices (c22) Short & long-term fiscal (the IMF estimates required US 2010-2020 fiscal adjustments that are greater than pressures from goy' t spending, %GDP Spain's). Bowles-Simpson recommendations tried to spread the pain equitably (tax 25% increases and spending cuts), but were rejected by legislators on the Commission that drafted them. How does the US fiscal picture look to China? A recent paper 20% published by Peking University was entitled "Eying the Crippled Hegemon: China's 15% All other spending Grand Strategy Thinking in the Wake of the GlobalFinancial Crisis". A lot of faith resides in the Fed's "portfolio rebalancing channel" theory of 10% lowering interest rates, driving up equity markets, increasing confidence and Healthcare spending consumer spending, and eventually, employment. In its interim stages, it lifts 5% financial asset prices more than employment, destroys the purchasing power of nodal security 0% savings, and may result in much higher commodity prices. Jury: still out. 1974 1986 1998 2010 2022 2034 3 EFTA01077288 Eye on the Market I OUTLOOK 2O11 January 1.2011 J.P.Morgan Europe: Irreconcilable Differences? Our writings on Europe in 2010 might have been as long as the EU Constitution2. Here's an abbreviated 5-point summary: 1. Germany is rebounding impressively (c23), but in Q2 and Q3, net exports were the largest contributors to German growth (c24). German export performance does not help pull other EMU countries along. 2. The periphery is stuck in austerity as a quid pro quo for bilateral EU and IMF assistance (c25), which is worsening GDP, unemployment (see c57 on page 11, worst on record) and VAT tax declines. Can it be sustained? In contrast, over in Iceland, real wages, employment, exports, stock markets and tourism are rising after their default/devaluation. 3. During crises in Latin America (1980s) and Asia (1990s), Argentina (1984) and Thailand (1997) were first thought to be exceptions, and that problems could be ring-fenced. In both cases, a broken paradigm applied to more countries. 4. Spain is now the Maginot Line. Its international banks should be able to survive a period of low growth, and its regional banks could be fixed for 5%-10% of Spanish GDP. But there's still all the Spanish private sector non- financial debt, which is among the highest in the world. This is not just a sovereign debt or banking sector problem. 5. Germany and France might have to agree to more direct subsidies, larger bilateral aid facilities or something more explicit, like "European Union government bonds". Will they do it? Last month, former EU President Jacques Delors said in response to the crisis that Europe needs to find its "soul". In 2011, we will find out whether the soul of Europe is based on its national identities, or a new Federal one. See page 11 for more on this topic. (c23) German retail & manufacturing (c24) German GDP driven by exports (c25) Core vs. periphery GDP surveys, Index, sa Percent contribution to 2010 GDP Index,100 = 2007 110 - 4% 105 Manufacturing 104 • 105 •02 103 • 100 •03 102 - 95 101 • 100 • 90 99 - 85 98 • 97 - 80 96- -2% 75 . . . Exports Captai Household Govt 95 1991 1994 1997 2000 2003 2006 2009 Spending Speocing Consumpt. 2007 2008 2009 2010 Bottom line: while there are some safe zones (e.g., the health of banks and less reliance on foreign bond buyers in Italy; lower public debt in Spain), the concentration of red flash points in our Sovereign Risk Scorecard is high. We expect the question of the periphery to overshadow the German recovery until it is resolved in some way. Oct 2010 Interest Gross Domestic Req. Fiscal 2010 Net Intl Unempl. Lebec Payments! Debt/GDP Ownership Fiscal Adjustment Current Investment Rate Mobility Tax Receipts 2012E of Govt Debt Deficit 2010 2010-2020 Acct %GDP Pos. %GDP Portugal 11.0% 7.4% 7.9% (7.3%) 8% -10.3M- (114%) Ireland 14.E &2% 9.5% 116% 17% (11.7%) 10% -0.3% (102%) Italy 8.6% 0.8% 10.6% 133% 48% (5.0%) 4% -3.3% (20%) Greece 12.2% 0.7% 13.1% 142% 33% 416%) a 9% -10.5% (87%) Spain 20.7% 0.7% 4.2% 80% 56% 3%),M 10% -5.5% (98%) Price/wage Q3 2010 O3 2010 03 GDP, Bank foreign World cup / World differential Tradables ECB Bore. % PMI PMI 000 lender Euro cup reserve s Germany %GDP Bank assets Senices Manufact. Annualized reliance ,Actories currency in: Portugal 11% 13% 62% 7.2% N/A N/A 1.6% .28% 0 1450.1530 Ireland 25% -3% 164% 7.8% 50.8 51.2 N/A 32% 0 N/A Italy 10% 35% 46% 0.8% 54.4 52.0 0.7% 8% 5 200BC-275AD Greece 19% 20% 42% 17.5% MA 43.9 (4.5%) 1 15% 1 500BC-200BC Spain 20% 33% 53% 2.1% 48.3 49.1 0.1% 15% 3 1530.1640 Notes: "Net International Investment Position" measures external debt less external assets (loans, bonds, equity). A larger negative number ind sates a greater net external liability; those shown are among the highest in the world. Price/wage differentials vs Germany as of Q3 2010 based on consumer prices and unit labor costs for manufacturing, both indexed to December 1998. The OECD considers the wage measure more relevant for assessing competitiveness. Ireland was never the world's reserve currency, but according to author Thomas Cahill, its monks safeguarded Western civilization during the Dark Ages by transcribing works before Barbarians burned them. 2 The original "Treaty for a Constitution in Europe" was 784 pages. The 2009 Lisbon Treaty was whittled down to 280 pages. 4 EFTA01077289 Eye on the Market I OUTLOOK 2011 January 1.2011 J.P. Morgan On our investment portfolios Equities: pricing in a fair bit ofpessimism The prior pages refer to challenges the world is still facing; the good news is that equity markets are pricing a lot of them in. Forward P/E multiples for the US, Europe and the Emerging Markets are clumped together around 10x-13x (c26). That's why we are comfortable holding 35%-45% equities in Balanced and Growth portfolios (both figures exclude additional equity exposure through private equity and certain hedge fund categories). Growth stocks in particular look cheaply priced (c27), although there is something strange going on in the large cap technology space, where P/E multiples are low and cash holdings are extremely elevated (c28). A ratio of P/E to earnings growth is at a 20-year low for the S&P 500, another sign of market pessimism. Flows into equities have been negative this year, suggesting a lot of underweight positions. (c26) Forward PIE equity multiples (c27) Growth stocks price in a lot of (c28) Cash balances and PIE multiples Ratios pessimism, PE relative to market of mega-tech stocks, Billions, USD 20 - 2.5x 70x 8220 18 Price to Earnings 11200 Emerging 2.3x 60x Ratio (LHS) 16 Markets 11180 US 2.0x 50x Cash& 14 11160 Equivalents 1.8x 40x (RHS) 11140 12 30x 11120 10 1.5x 11100 8 1.3x 20x S80 6 1.0x 10x 560 2003 2004 2005 2006 2007 2008 2009 2010 1978 1986 1994 2002 2010 2000 2001 2003 2005 2006 2008 2010 US profits growth and margins are in good shape, which is why the US is our largest regional equity allocation. Keep this in mind: S&P 500 revenues over the last 15 years have been more linked to World GDP growth than US GDP growth (c29), driving offshore profits higher as a % of GDP (c30), and to 35% of total US profits. Another positive: the S&P 500 tends to have less exposure to the US consumer than the US economy does, and more exposure to capital spending, energy and healthcare. In terms of valuation, technology and healthcare appear most attractively priced. We prefer large cap to small cap as the latter trades at a 30% P/E premium, and generally prefer growth over value. (c29) S&P revenues tied to global (c30) U.S. corporate profits from the (c31) Share of S&P 500 earnings by growth, not U.S. growth, Avg 1996-2010 rest of the world, Percent of GDP end-market Medical 6.5% 3.5% Consumer 3.0% Business 14% Staples 6.0% • U.S. 2.5% 5.5% • 21% 18 20% 5.0% • 1.5% 4.5% • 4.0% S&P 500 World GDP Ciao •I GOP Final Sales to Domestic 1.0% 0.5% 0.0% En erg y & Commoditie 16% 14% Consumer Disc. Revenues Purchasers 1948 1960 1973 1985 1997 2010 Financials Analysts have underestimated S&P 500 earnings by around 10% per quarter (C32) U.S. profit drivers since Jan 2009. During the recession, US companies kept costs down as demand Percent plunged. Now, as demand rises, incremental margins on new revenues are high. 70% We expect this to continue in 2011. We expect 8%-10% earnings growth and 68% • stock buybacks (now running at 2% of market cap) to deliver roughly 10% S&P 65% • 63% - 0 44‘144A.V 500 returns in 2011, with some bumps along the way. 60% • Labor Cost as %of Sales \ i‘ While US profit margins are high, US corporate sales are at a 50-year low (c32). 58% • How can these 2 things co-exist? Because labor costs as a % of revenues are 55% - 53% • at their lowest levels, by some measures since 1929. That's why we're reluctant 50% • Salesas %of GDP to forecast much higher multiples; earnings are too reliant on low real wages. 48% - 45% 1947 1959 1972 1984 1997 2010 Stocks used for this analysis include: Microsoft, IBM, Apple, Intel, Hewlett-Packard, Cisco, Oracle, Google, Qualcomm, Coming EFTA01077290 Eye on the Market I OUTLOOK 2O11 hnuaii, 1.2011 J.P.Morgan After the US, emerging markets are our next largest equity allocation, followed by Europe and then Japan. Over the last 1 and 3 years, these equity tilts have worked well (c33). We expect these relative rankings to continue in 2011; we are more inclined to suffer the risk of inflation in the emerging world than the risk of deflation in Europe. Within Europe, most of our equity exposure is tied to German exporters, whose stock prices generated strong gains in 2010. We hold Asia as the bulk of our emerging markets exposure, with smaller exposures in Latin America and Eastern Europe. On Brazil, we are encouraged by the development of the middle class (c34), and increased international trade (its mining, oil and agricultural exports to China have quadrupled since 2004). But there are some risks related to inflation, an overvalued exchange rate, and reliance on portfolios inflows rather than foreign direct investment. Our preferred approach to Latin America and Brazil in particular involves long and short positions; private equity investments, particularly in consumer-related companies which are only 10%45% of the Bovespa (see page 8); and investments in local Brazilian credit and interest rate markets. (c34) Ascent of Brazil's middle class BRAZIL: Pluses and Minuses (c33) Global equity returns consumer, Millionsof people Positives Negatives Total returns through 12/10/10 Local anew/ 720 • Household credit low • Wage & price initaion risks USD tonna tams ■ 2003 100 ■ 2009 • Rapidly growing trade • Real exchange rat: 1 war 3year 1 year 3 year • 2014 80 veil China/Asia looking expensive S&P 500 15% (4%) 15% (4%) " Higher ins7tIonal • Increased relance on MSCI EM 18% (2%) 15% (1%) 40 parkipalion in equity portfolio lows over breign markets direct investment MSCI EM Asia 19% (2%) 16% (0%) 20 "RE multples: 12x ' High corporat tax rat MSCI Europe 5% (10%) 11% (6%) 0 • Arrong world's highest MSCI Japan 9% (7%) 4% (16%) Upperdass Middle Lower Bottom 50% poverty decline class class class &WV+ real intrest rat Fixed income: government bonds and credit The global Printing Press creates money that needs to find a home. At the same time, total issuance in the US has been negative: while Federal and municipal issuance grew, companies and households reduced issuance at an even faster pace (c35). The result: a supply-demand imbalance that supported global bond prices. Think about this: by the time QE2 is finished, the Fed will own 1/3 of all Treasuries outstanding in 4-20 year maturities, and finance 94% of the 2011 Treasury deficit. We expect G3 banks and EM Central Banks to continue to buy Treasuries. However, our sovereign and municipal durations remain low, given limited yield benefits of longer duration paper, and the risk of higher yields at some point (see page 10for more on bond market risks). Our current underweight to government bonds is one of the largest active positions in portfolios. We expect another year of stable credit spreads, although returns will be markedly lower than in 2009 and 2010 given how much spreads have already tightened. We hold senior bank loans alongside high yield, which is still reasonably priced at a spread of 600 bps after last year's rally. We expect to trim high yield positions in 2011 as spreads tighten further. The current decline in default rates (c36) helps explain why spreads have tightened this much, but liquidity conditions are undeniably affecting the pricing of credit. (c35) Net issuance of U.S. Credit (c36) U.S. corporate default rates (c37 Property decline cushion, AAA Instruments over last 12 months ($bins) Percentof par value CMBS subordination adjusted for LTVs 76% 45% Treasuries $1,468 14% 40% Agencies -$70 A 5% property decline Municipals $94 12% Bonds 35% would have exposed Corporate & Asset Backed -$129 10% 30% AAA Investors to losses Mortgages -$598 8% 25% Bank Loans -$424 20%• 6% Consumer Credit -$47 15% 4% 10% Commercial Paper -$249 Other loans -$241 2% 5% Total -$195 0% 2000 2002 2004 2006 2008 2010 2001 2603 2045 2607 2010 The structured credit market reached its cams moment in 2007, when it offered little value to investors. At that time, a AAA- CMBS investor could barely sustain any property losses before losing principal (c37). We did not recommend structured credit to clients during this period for this reason. Since then, subordination protections have improved substantially, and spreads are wider. As a result, we have been adding structured credit to portfolios since markets re-priced this kind of risk in early 2009. We also see opportunities in US bank preferred stock that may be called early as banks restructure their capital. 6 EFTA01077291 Eye on the Market I OUTLOOK 2O11 January 1.2011 J.P.Morgan US commercial real estate After having reduced allocations to commercial real estate in 2007, we are now reinvesting. Our preferences: where capital is scarce and where lending positions can be well-collateralized (commercial mortgage backed securities rollovers, mezzanine lending [c40] and distressed real estate). A silver lining of the biggest residential housing mess ever: there was less of a commercial overbuilding boom this time around. The worst commercial property boom took place in the mid 1980s (c38), after a 1981 tax reform bill which allowed active income to be offset by passive losses, a provision which ended with the Tax Reform Act of 1986. The next biggest mess: the tech boom of the late 1990s. In contrast, overbuilding during the credit boom (a different concept from overpaying) was less of an issue this time. The liquidity boom which has led to lower credit spreads has also pushed up real estate prices, but mostly for "bond-like" office and multi-family properties that are well leased, and in major market locations. Opportunities persist in properties with leasing, debt maturity or completion risks that require the experience of an operator and not just a financial buyer. It will take time for all the vacant space to be absorbed (CB Richard Ellis forecasts that office vacancy rates won't peak until the second quarter of 2011). But as is typical with most business cycles, asset prices tend to rise well before their respective fundamentals do. This has been the case over many decades, as US and European equities, bank stocks and high yield bonds started to rise well before improvements in unemployment, earnings declines, bank failures and corporate bankruptcies (See EoTM December 6, 2010for more details). (c38) New office supply, Pdvatefixed (c39) New retail center supply, Private (c40) Evolution in capital structures investment in office, PercentGDP fixed investment in retail, PercentGDP Illustrative exam pie 1.0% 0.30% $100 30% assumed decline in valuations 0.8% 0.25% $75 0.6% 0.20% $50 Senior Debt 0.4% 0.15% -75% $25 Senior Debt 0.2% 0.10% • 50 00% 0.05% Pm-Credit Crisis Post-Credk Crisis '59 '65 '71 '77 '83 '89 '95 '01 '07 '59 '65 71 77 '83 '89 '95 '01 '07 Scenario('07) Scenario ('10) Het funds We are optimistic about prospects for continued merger activity (c41), and hedge funds which benefit from them. We also see little reason to pull back on macro hedge funds, given the world's unresolved imbalances shown on the first page. Macro hedge funds often benefit from volatility in equity, commodity, interest rate and FX markets. We also maintain exposure to credit hedge funds, which focus on opportunities related to refinancing and restructuring of overleveraged balance sheets. However, we are looking to reduce funds which face challenges from the high correlation of individual stocks. In the US, the pairwise correlation of stocks has risen sharply (c42). This makes some long-short investing styles such as statistical arbitrage harder to do. A consequence of high correlations: a collapse in the "unexplained alpha" of stock price movements, after stripping out common factors (capitalization, sector, growth vs value, etc) that drive individual stock prices (c43). Outside the US, stock selection appears to have more promise, given lower correlations. (c41) Rising WA premiums and (c42) Tough environment for stock (c43) Company specific drivers of transaction volumes picking, Median pahwise correlation stock performance, Unexplained alpha Percent Thousands 55 - 30 - A I ll ucr Easier 35% 9.0 50 - Number of 8.5 25 - 45 - 30% deals (RHS) - 8.0 Stock picking 40 - 20 - 25% A \ ► • 7.5 e • 7.0 6.5 35- 30- 15 - Harder 20% • 6.0 25 - 10 - . 5.5 20 • .0 5- 0%. I 10% 11 II mi.I i hil 4.5 •- 5 4.0 15 10 04 2000 2002 2004 2006 2008 2010 2007 2008 2009 2010 1950 1960 1970 1980 1990 2000 2010 7 EFTA01077292 Eye on the Market I OUTLOOK 2O11 January 1, 2011 J.P.Morgan Private equity: opportunities in high and low growth areas of the ',mid Investing where growth is low: Europe As explained in prior notes, European household, business and government borrowing levels are among the highest in the world. Should the European Monetary Union continue along its current path, we believe that many borrowers will face deflationary pressure, and shrinking banks (in particular, RBS, Hypo Real Estate, WestLB and HSH Nordbank). We are working with private equity managers focused on distressed European residential mortgages, corporate debt and real estate. Recent purchases of senior-secured bank loans have taken place at around 65 cents on the dollar, which we estimate as 50% on a traditional loan- to-value basis. European non-performing residential mortgage purchases have traded as low as 35 cents of face value. Investing where growth is high: Brazil While private equity has a long history in Brazil (with BNDES, starting in 1982), its penetration is not deep. Even in the boom- year of 2007, more private equity capital went into Africa and the Middle East than Latin America. However, these trends are changing as Brazil evolves. Brazil has made substantial progress on issues valued by private equity investors (c44). The accompanying table shows what these attributes are, according to the Economist Intelligence Unit. The top nine are where Brazil ranks highly, while the last three in italics are where Brazil has very low marks. In aggregate, its scores are now similar to Israel, Taiwan and Spain. That may explain why Brazil accounted for 18% of all EM private equity fundraising in 2009. Services, transports and telecoms (ex-financials) make up around half the Brazilian economy but only make up 15% of the Bovespa, given the latter's large weights in commodities and industrial metals (c45). As a result, a lot of private sector output related to the consumer is not represented on Brazil's publicly traded equity markets, creating opportunity for private capital. (c44) EIU Private Equity Attractiveness EIU Brazil PEIVC scorecard (c45) Services, Transports and Index, max 100 + Laws regarding VC/PE hind formation Telecoms, ex-Financials 80 + Tax treatment of VC/PE funds Chile 50% 75 + Protection of minority shareholder rights 70 Brazil + Restrictions on institutional investment 40% 65 + Bankruptcy procedures/creditors rights + Capital markets development/exit feasibility 30% % Brazilian 60 Mexico + Corporate govemance requirements GDP 55 ColombiQ + Use of international accounting standards 20% + Entrepreneurship 45 % - Strength of judiciary 10% % Bovespa Argentina 40 - Perceived corruption 2006 2007 2008 2009 2010 - Protection of intellectual property rights 0% Investing where usage is high: "demand for band" We are working on investments related to the global explosion in bandwidth usage and demand. A decade ago, many business models failed due to excess leverage and the lack of an application that could command premium pricing. However, the infrastructure created at the time has become a foundation for a new generation of electronic content (online and mobile video) and e-commerce. OECD broadband users continue to grow (from 15% of total population in 2006 to 25% in 2010), along with bandwidth demands by new products for new services (c46, c47). In addition, as cable companies upgraded their networks for HD content starting in 2004 (c48), they increased their network capacity. This in turn created opportunities for companies involved in digital rights management, bandwidth connectivity, "TV-everywhere" services and software, video content aggregators and applications that enable mobile e-commerce. We will cover this topic in greater detail early next year. (c46) Mobile data traffic growth (c47) Mobile data traffic composition (e.48) U.S. cable industry infrastructure Terabytes per month, Millions Terabytes per month in 2014, Millions expenditures, Billions, USD 3.6 - 3.6 $16 3.2 - 3.2 $14 • 2.8 - 2.8 $12 - 2.4 - 2.4 Notbooks and $10 2.0 - 2.0 1.6 - 1.6 tablots $o - 1.2 - $6. 1.2 0.8 • 0.8 sa • Smart- 0.4 • 0.4 phones 52 • 0.0 $0 11111111 0.0 2009 2010 2011 2012 2013 2014 Byapplication By device type '00 '01 '02 '03 '04 135 '06 '07 '08 '09 8 EFTA01077293 Eye on the Market I OUTLOOK 2O11 January 1, 2011 J.P.Morgan Commodities/The US dollar We are holding onto commodity investments, with a focus on copper'', oil, gold, platinum and palladium. We expect easy monetary policy from the Fed, and only modest steps from emerging markets countries to tighten. However, buying commodities does not always imply taking an outright long position, particularly at today's higher prices. Many of our commodity investments are designed to have downside protection, wherein we receive a payment as long as the commodity is rising, even at a very slow rate (this has worked well in oil markets, stable since mid-2009 [c51]). Commodity demand is still growing in the emerging world, where job creation tends to take precedence over inflation-fighting (a country like Mexico would be an exception). Emerging economies require a greater share of the world's natural resources in order to grow (c49). Some of the shares shown have doubled in just 15 years, a remarkable demand shift versus history. (c49) Rising share of EM commodity (c50) Commodity supply grid (c51) Oil prices since 2007 usage, Percent of global consumption Commodity assetclass USDibbl 75% $160 Agriculture Cocoa Wheat Corn Coffee Cotton Sugar $140 Soybeans 65% Crude oil Coal $120 Energy Natural gas 55% $100 Industrial Copper Lead Nickel Aluminum 45% metals Zinc $80 Precious Gold Silver $60 35% metals Platinumdkalladium $40 Supply tightly Potential for No maior 25% constrained Intermittent structural $20 1995 1998 2000 2002 2004 2006 2008 2010 dollupti3in constraints 2007 2008 2009 2010 We select commodities based on scarcity rather than momentum (see c50 and c52 for what we prefer and avoid). On oil, gains in Iraq are needed to offset production declines in Mexico, Norway and the UK that began to accelerate in 2004. There have been improvements in oil recovery rates, and the lEA estimates an additional 6 million barrels per day from CO2 injection and other Enhanced Oil Recovery techniques by 2030. However, given the expected loss of many more barrels per day from existing fields, there's still a huge projected production gap. Overall, we expect spare capacity to decline, as demand growth and non-OPEC production losses exceed new OPEC supply of both conventional and non-conventional liquids. On gold, we expect its wild ride to continue. While concerns about the dollar's reserve currency status are premature (see below), the Printing Press increases demand for gold. Emerging markets Central Banks own gold at less than 5% of reserves, which might account for increased demand. However, a November surge in (c52) Production shortfall, %, trend Chinese gold imports came from its private sector. China just approved the first growth in demand minus 10-yr production "QDII" gold fund, which allows Chinese citizens to buy gold through an ETF. 3% EM inflation risks play as large a role as US inflation concerns in driving demand I 1 . 1. Shortfalls. for gold. For all the hype, the market cap of gold ETFs is roughly the same as that 2% of Verizon. In other words, a lot of individuals, institutions and sovereign entities 1% are likely to be underinvested relative to some abstract definition of "normal". 0% There will be bouts of profit-taking, since gold has had a great run. But we expect gold prices to be higher by the end of 2011 rather than lower. -1% Surplus What next for the US dollar? -2% Roughly 85% of all FX transactions occur in US$ (BIS data), with 39% in Euros, =see 1 a 19% in Yen, 13% in Sterling and 0.3% in Chinese RMB (numbers add to 200% given two sides to cads FX transaction). No smoking gun here. However, there are parallels between the Sterling's loss of reserve currency status in the early 20ih century and the US$ today. Members of the British Commonwealth maintained Sterling reserves after WWI/II despite Britain's financial and military decline; it was in their mercenary self-interest to do so given a desire for export-led growth. Commonwealth countries held on until 1967, when Sterling devaluation imposed losses that were too great to bear. The relationship between EM Central Banks and the US dollar looks eerily similar. Policy-driven swings in $-Euro will continue (we do not have a high-conviction view on this bilateral pair), but we believe the tide of history and economics leans towards higher values for Asian exchange rates versus the US$ and Euro. 4 Copper-intensive products are flying off the shelves in China: cars, refrigerators, and TV consumption is up 40%-80% since 2008. .IPMS estimates that hotels will be constructed at the rate of 1,000 per year, with internal tourism growing at 15%. An increase in electrification in countries like Pakistan, India and Indonesia are also part of the copper demand picture. 9 EFTA01077294 Eye on the Market I OUTLOOK 2011 January 1.2011 .J.P.Morgan Appendix I: there better not be a policy mistake related to interest rates The good news is that world GDP is driven by as much by countries with low fiscal deficits as by high-deficit countries (c53)5. The bad news: some high-deficit countries are like unexploded land mines. The cost ofservicing public debt is not extremely high in Japan'', Italy or the United States, but that's mostly because interest rates are so low, rather than debt being at a sustainable level. Low servicing costs also reflect low average debt maturities for the US and Japan, at around 4 years. This "OK-as-long-as-rates-don't-rise" paradigm extends to households as well. In the US, improved household obligations ratios shown on page 3 are more a function of lower interest rates and defaults than paydown of debt (c54). Household debt has only declined from 130% to 118% of disposable income. In Hong Kong, where apartment prices are skyrocketing, some research asserts that affordability ratios don't look so bad. To us, this is another example of something looking normal only because of abnormally low interest rates. HK affordability looks good (c55) since mortgages only cost 2.5% in a country growing at 9% per year, and where inflation is 2.7%; again, the real cost of money is zero. Another example: a modest rise in Japanese interest rates would render its fiscal accounts inoperable (c56). Theoretically, the Fed has the infinite ability to create money, finance budget deficits and keep rates low. The problem: there may be economic and political limits preventing central banks from doing this for too long; see Bernanke's "change of heart" (box)7. For whatever reason, if interest rates rose sharply without a commensurate rise in private sector incomes and government tax receipts, we would expect another round of debt-related problems ahead. There was an article in the LA Times discussing the benefits of plentiful liquidity, too much bearish sentiment, the low hurdle rates for stocks, a weaker dollar to stimulate exports, low equity valuations and the scope for dividend increases. The thrust of the article, "Despite Caution Signs, Market Stirs High Hopes", was to explain how all these things were good news for stocks. Publication date: March 8, 1987. (c53) World growth driven by low (c54) U.S. household debt levels and Bernanke 2002: The central bank budget deficit countries, Percent service ratio, % of disposable income can finance government spending, at 9% zOther Emerging Economies 16% no cost: 140% 8% • SurplusCounbies ~Household debt (LEIS) "Under a fiat (that is, paper) money • Low-Deficit Countries 130% 15% 7% • • High-Deficit Countries system, a government (in practice, the 120% 14% central bank in cooperation with other 6% 110% Debt service (RHS) 13% agencies) should always be able to 5% • 4% 100% 12% generate increased nominal spending 3% 90% • 11% and inflation, even when the short term 80% 10% nominal interest rate is at zero.... The 2%• 70% 9% US government has a technology, 1% called a printing press (or, today, its 0% . . . . 60% 8% electronic equivalent) that allows it to 2010E 2011E 2012E 2013E 2014E 2015E 1980 1985 1990 1995 2000 2005 2010 produce as many US dollars as it (c55)fiong Kong housing affordability? (c56 Japanese Interest expense as a wishes at essentially no cost." Monthly installmenUmedan household inc. percent of tax revenue, Rate sensitivity 120% 60% Bernanke 2009: Or maybe not 100% 50% "Prompt attention to questions of fiscal sustainability is particularly critical 80% 40% because of the coming budgetary and 60% 30% economic challenges associated with the retirement of the baby-boom 40% 20% generation and continued increases in 10% medical costs.... With the ratio of 20% debt-to-GDP already elevated, we will 0% not be able to continue borrowing 0% 2009 Avg rate+ Avg rate+ Avg rate+ 1994 1997 2000 2003 2006 2009 100 bps 150 bps 200 bps indefinitely to meet these demands." 5 This chart weights each country according to its purchasing power GDP, rather than its nominal GDP. 6 We generally have limited interest investing in Japan, unless it becomes very cheap (e.g., below lx book value). Japanese equities tend to outperform the US for a quarter or two, and then slip back into extended periods of underperformance. Growth is stalling (5 months of production declines through October), retail sales and bank lending to corporate and households are fading, and deflation remains around -1.0% per year. The long-term issues: Japan's old-age dependency ratio (the worst in the world, followed by Italy and Germany); and debt ratios (see "Are JGBs the Short of a Lifetime", EoTM, August 23, 2010). 7 "Bernanke's Paradox: Can He Reconcile His Position on the Federal Budget with His Recent Charge to Prevent Deflation?", Pavlina Tcherneva, Bard College, November 2010 10 EFTA01077295 Eye on the Market I OUTLOOK 2011 January 1.2011 J.P.Morgan Appendix II: European Federalism and the cultural/social divide The Sovereign Risk Scorecard on page 4 tries to capture the economic and fiscal challenges that Europe is facing. The visual below attempts to capture some of the cultural and social ones. Since 1981, Professors Ron Inglehart (University of Michigan) and Christian Welzel (University of Bremen) have used data from their World Values Surveys to assess belief systems and their impact on social and political change using surveys from 90 countries. After plotting the proxy for each country's "relative value system" (y axis) and "degree of individualism and self-expression" (x axis), the authors superimpose geographical regions, which fit pretty neatly over the data. Each axis represents a synthesis of 10-15 different survey questions'. Countries in the European Monetary Union share a lot in common regarding the x-axis, as Germany, Italy, Spain, France, Belgium, Portugal and Greece appear in a very tight corridor. However, on the y-axis, they are quite different. These latter differences, for example between Spain and Germany, are large. They are greater than differences between countries in Latin America, Eastern Europe or China/Korea. They're also greater than differences the authors compute within each country (e.g., university-educated vs rest of sample). As Europe deals with regional austerity, the highest Periphery unemployment on record (c57) and the need for large fiscal transfers (if not MI-blown Federalism), these cultural differences will need to be overcome as part of the process. Recent Eurobarometer polls showing almost the lowest level of support for EU membership since 1973 indicate that Europe's leaders still have a lot of work to do (see "A Don Quixote Thanksgiving", EoTM, November 18, 2010). Japan From the authors • "Cross-national differences dwarf the ' .° W C2% Sweden. differences within given societies.... se ......... OS es <JP jes os, " \ Protestant Despite globalization, nations remain Staged Europe • pommy Bulgaria EStalla • China i Ciermats / an important unit of shared Russia • • I uech•Ser • experiences, and the predictive in 10 • SO 5 / Western Germany Denmark Ukraine gelato • if S. Korea , power of nationality is much stronger helherlandS • • Lithium # S 413 SlOvenia% Finland • than that of income, education, Montenegro • • Taman l. Latvia, • Serbia •• p• r. 8 a I •Greece Switzerland region or gender." O5 Albania SlOvakia Foote • r it e Moldova • ',Hungary • AuSiriaOutland "Even today, the nation remains a . Brasil • MaCedOnia• CO°osnist ttergium •• • key unit of shared socialization, and %• 0 -- Bosnia • , • Italy. Great Polon in multiple regression analyses, Cr011ia pain New Zealand • Se nationality explains far more of the SAxerbalian Catholic Euitpe English • Canada I variance in these attitudes than does /. speaking • rvneme• Armenia Pohlrii Uruguay Australia education, occupation, income, .0 5 • • N. Ireland • gender or region." India USA Vietnam • Turkey (e57) Unemployment In the periphery .1 0 South • • Poi weal rel., r.<1 Percent, weighted by population Asia Indonesia (rile Ilitgeorpm 18% • • Philip:thn • Greece. Ireland. Spain & Portugal Traditional Values Bangladesh Iran. • • Dominican 16% • •• Peru Republic Pakistan S'xith • Mika •Brazil Latin America 14% • lobar • • uganda• Ghana • • Mexico 12% Dmlistwee • •- Opera Morocco Egypt • S migtia •VeneZuela Tanzania 10% • Colombia Poole 8% .2.0 Africa Rico El SalyadOr • 6% 4% -2 .1 s .1 .0 5 0 a.5 -1 -1.5 -2 2% Survival Values Self Expression Values 0% Factor Scom 1970 1977 1984 1990 1997 2003 2010 8 "Changing Mass Priorities: The Link between Modernization and Democracy", Ronald Ing lehart and Christian Welzel, Perspectives on Politics, June 2010, Volume 8, Number 2. Their conclusions about the durability of cultural and national differences are similar to Geert Hofstede's pioneering analysis on the subject. An aggregation of Hofstede's 4 cultural dimensions show that Spain, Portugal and Greece are considerably more "different" vs Germany than Switzerland, Italy and the entire English-speaking world. 11 EFTA01077296 Eye on the Market I OUTLOOK 2011 January 1.2011 J.PMorgan Acronyms EM - Emerging Markets; IMF — International Monetary Fund; EMU — European Monetary Union; EU — European Union; VAT — Value- Added Tax; QE —Quantitative easing; CMBS - Commercial Mortgage-Backed Securities; FX — Foreign exchange; M&A — Mergers and acquisitions; E&P — Exploration and production; ETF — Exchange-traded fund; QDII — Qualified Domestic Institutional Investor; OECD — Organization for Economic Co-operation and Development; lEA — International Energy Agency; BIS - Bank for International Settlements Chart sources (c1) Institute of Supply Management, CLSA-Markit, Nov 2010 (c30) Bureau of Economic Analysis, Q3 2010 (c2) J.P. Morgan Securities LLC, October 2010 (c31) Bank of America Merrill Lynch, November 2010 (c3) J.P. Morgan Securities LLC, October 2010 (c32) Bureau of Economic Analysis, Q3 2010 (c4) OECD, J.P. Morgan Securities LLC, September 2010 (c33) Bloomberg, December 2010 (e5) Factset, November 2010 (c34) FGV, IBGE, LCA, Ministerio da Fazenda, September 2010 (c6) J.P. Morgan Securities LLC, September 2010 (c3S) Bridgewater Associates, LP, September 2010 (c7) Historical Statistics for the World Economy - Angus Maddison (c36) J.P. Morgan Securities LLC, December 2010 (c8) J.P. Morgan Securities LLC, November 2010 0 37/ J.P. Morgan Securities LLC, Trepp, rating agencies, Bloomberg (c9) National Bureau of Statistics, J.P. Morgan Securities LLC, (c38) Bureau of Economic Analysis, Q3 2010 November 2010 (c10) J.P. Morgan Securities LLC, Centaline, November 2010 (c39) Bureau ofEconomic Analysis, Q3 2010 (ell) International Monetary Fund, 2009 (c40) J.P. Morgan Securities LLC (c12) "The Costs and Implications of PBC Sterilization", John (c41) Bloomberg, Q3 2010 Greenwood, Cato Journal, Spring/Summer 2008, CEIC (c13) Bridgewater Associates, LP, October 2010 (c42) J.P. Morgan Securities LLC, November 2010 (c14) J.P. Morgan Securities LLC, September 2010 (c43) Barclays Quantitative Equity Strategy, November 2010 (els) IMF, European Commission, OECD, Institute of International (c44) Latin American Venture Capital Association — EIU Scorecard Finance, Banco Central Do Brasil Report, 2010 (c16) Bureau of Labor Statistics, November 2010 (c45) Economic Commission for Latin America, Bovespa, Q2 2010 (c17) Federal Reserve Board, Q2 2010 (c46) Cisco VNI Mobile, 2010 (els) Census Bureau, November 2010 (c47) Cisco VNI Mobile, 2010 (c19) Bureau of Economic Analysis, Q3 2010 (c48) Kagan Research, December 2009 (c20) Bureau of Labor Statistics, Q3 2010 (c49) Wood Mackenzie, October 2010 (di) Federal Reserve Board, Bureau of Economic Analysis, Office of (c50) Barclays Capital Management and Budget (c22) Congressional Budget Office, Q2 2010 (c51) Bloomberg, December 2010 (c23) Markit, IFO Institute, December 2010 (c24) German Federal Statistics Office, Q3 2010 (c52) Bridgewater Associates, LP, November 2010 (c25) Various central banks, Q3 2010 (Q2 2010 for Ireland) (c53) IMF, OECD, World Bank, Malaysia Ministry of Finance, Indonesia Ministry ofFinance, Empirical Research Partners, October 2010 (c26) Factset, November 2010 (c54) Federal Reserve, BEA, Q3 2010 (c27) Corporate reports, Empirical Research Partners, Q3 2010 (c55) Gavekal. Centaline, September 2010 (c28) Factset, Q3 2010 (c56) Japan Ministry of Finance, June 2010 (c29) S&P, U.S. Department of Commerce. IMF, corporate reports, (c57) J.P. Morgan PB, Bank of Spain, Bank of Portugal, Greece National Empirical Research Partners, BEA, Q2 2010 Statistics Service, Ireland Central Statistics Office, November 2010 Table sources (II) OECD, "Labor Mobility and the Integration of European Labor Markets", IZA Institute for the Study of Labor, February 2009, European Commission, Fitch Ratings, Hong Kong Monetary Authority, International Monetary Fund, J.P. Morgan Securities LLC, Greece National Statistics Service, Ireland Central Statistics Office, Italy National Institute of Statistics. National Statistics Institute of Spain, Eurostat The material contained herein Lc intended as a general market commentary. Opinions expressedherein are those ofMichael Centbalest andmay dijkrfrom those ofother J.P. Morgan employees and affiliates. This information in no way constitutes J.P. Morgan research and should not be treated as such. Further, the views expressed herein may differ from that contained in J.P. Morgan research reports. The above suntmary/prices/quoies/statistics have been obtainedfrom sources deemed to be reliable. but we do not guarantee their accuracy or completeness. Past performance is not a guarantee offiaure results. Investment products are not insured by the U.S. Federal Deposit Insurance Corporation: are not guaranteed by the bank or thrift affiliates: andmay lose value. Not all investment ideas referenced are suitableler all investors. These recommendations may not be suitablefor all investors. Speak with your J.P. Morgan representative concerning your personal situation. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument Private Investments often engage in leveraging and other speculative investment practices that may increase the risk ofinvestment lass. can be highly illiquid, are not required to provide periodic pricing or valuation information to investors and may involve complex tax structures and delays in distributing important tax information. Typicalty, such investment ideas can only be offered to suitable investors through a confidential offering memorandum whichfulo"describes all terms. conditions. and risks. In the United Kingdom. this material is approved by J.P. Morgan International Bank limited (JPMIB) with the registered office located at 125 London Wall EC21' 5AJ, registered in England No. 03838766 and is authorized and regulated by the Financial Services Authority. In addition. this material may be distributed by: JPMorgan Chase Bank, N.A. (JPMCB) Paris branch, which is regulated by the French banking authorities Aurorae de Controle Prudentiel and Aurorae des Marches Financiers: J.P. Morgan (SLasse) SA. regulated by the Swiss Financial Market Supervisory Authority: JPMCB Bahrain branch, regulated by the Central Bank ofBahrain; JPMCB Dubai International Financial Centre branch. regulated by the Dubai Financial Services Authority: JPMCB Hong Kong branch. regulated by the Hong Kong Monetary Authority: JPMCB Singapore branch, regulated by the Monetary Authority ofSingapore. Cover illustration C Douglas Smith, 2011. Numbers on front cover am as of September 2010. 02011JPMorgan Chase & Co 12 EFTA01077297 MICHAEL CEMBALEST is Chief Investment Officer and Head of Investment Strategy of global private banking at J.P. Morgan. As Managing Director of the firm, he is responsible for development of investment strategy, tactical and strategic asset allocation, and portfolio construction for over $700 billion in client assets. He is also a member of the 1.P. Morgan Asset Management Investment Committee, which oversees $1.2 trillion in institutional, high net worth and retail assets. In addition, Mr. Cembalest serves on the Investment Committee for the J.P. Morgan Retirement Plan for the firm's 236,000 employees. Mr. Cembalest was formerly head of a fixed income division of 1.P. Morgan Investment Management with responsibility for high grade, high yield, emerging markets and municipal bonds. Prior to joining Asset Management, Mr. Cembalest served as head strategist for Emerging Markets Fixed Income at J.P. Morgan Securities. Mr. Cembalest joined J.P. Morgan in 1987 as a member of the firm's Corporate Finance division. Mr. Cembalest earned an M.A. from the Columbia School of Business and International Affairs in 1986 and a B.A. from Tufts University in 1984. INVESTMENT STRATEGY TEAM STUART SCHWEITZER is global markets strategist for J.P. Morgan Private Bank and J.P. Morgan Asset Management. He is responsible for analysis of global financial markets and economies with an emphasis on asset allocation and market strategy, and serves as the firm's senior voice on the economy, investment outlook and portfolio strategy. He is a frequent speaker at investment conferences, a frequent guest on CNBC, Bloomberg TV and PBS Nightly Business Report, and is quoted regularly in the Financial Times, The Wall Street Journal and other business periodicals. Mr. Schweitzer is a graduate of City College of New York and holds a Ph.D. in economics from the University of Minnesota. RICHARD MADIGAN is Chief Investment Officer and Head of the Investment Team managing the Global Access Portfolios and Access Funds at J.P. Morgan. With over twenty years of experience in portfolio management and international capital markets, he is a senior member of the global Strategy Team, where he is responsible for the development of investment strategy. In addition, Mr. Madigan is Chairman of the Hedge Fund Advisory Council, a senior member of the firm's International Portfolio Construction Committee, and an officer of J.P. Morgan Private Investments, Inc. Mr. Madigan's commentaries have appeared in the Financial Times, The New York Times, The Wall Street Journal, Bloomberg and Reuters. He has been a guest speaker on CNN, CNBC and Bloomberg News, as well as various industry conferences. He holds an M.A. from New York University, where he majored in finance and international business. 13 EFTA01077298 IVAN LEUNG is chief investment strategist for Asia. Mr. Leung is responsible for setting the regional investment strategy as well as managing the model portfolio that is implemented for discretionary portfolios. He is a member of the Global Private Bank Investment Team and chairs the Asia Local Investment Committee. Mr. Leung's articles and interviews have appeared in newspapers and newswires including the Financial Times, Business Times, The Edge Singapore and Bloomberg. He holds a B.A.S. from the University of Toronto and an M.B.A. from the Schulich School of Business in Toronto. CESAR PEREZ is chief investment strategist for Europe. the Middle East. and Africa and a member of the global Private Bank Investment Team. Mr. Perez has worked in investment management across all asset classes and regions for both institutional and private clients for the past 17 years, including two years at Credit Suisse Asset Management as head of equities, five years at M&G Investments in London and nine years at J.P. Morgan Investment Management in Madrid, London and New York. His interviews appeared in the Financial Times, Les Echos, 11 Sole, La Stampa and Reuters, among others. Mr. Perez specialized in management and industrial organization at Instituto Catolico de Artes e Industrias. PHIL GUARCO is chief investment strategist for Latin America. He is part of the team that is responsible for global investments and portfolio strategy for the firm's international client relationships. Prior to J.P. Morgan, he was senior credit officer for Latin American financial institutions at Moody's. His commentaries have been frequently covered in the Financial Times, The New York Times and The Wall Street Journal. Mr. Guarco has been a guest speaker on Bloomberg and Reuters News and has been cited frequently in World Bank and IMF publications. He holds a B.A. from Grinnell College and an M.A. from The School of Advanced International Studies of The Johns Hopkins University. EYE ON THE MARKET SPECIAL EDITIONS 2010 NOVEMBER 18, 2010: A DON QUIXOTE THANKSGIVING A closer look at the ongoing strains in Europe's periphery region OCTOBER 26, 2010: FROM NEHRU TO NOW A close up of India's economy and current investment opportunities AUGUST 23, 2010: ARE JGBS THE SHORT OF A LIFETIME? What to make of the world's most over indebted sovereign JULY 13, 2010: 5 BEST THINGS ABOUT THE FLASH CRASH JUNE 1, 2010: NORTHERN STAR Chinese consumption and opportunities for global investors FEBRUARY 11, 2010: THE SICK MEN OF EUROPE A detailed look at the challenges facing the European Monetary Union 14 EFTA01077299 EFTA01077300 ASIA AMERICAS EUROPE MIDDLE EAST WORLD HEADQUARTERS Hong Kong United States France Bahrain 270 Park Avenue Singapore Brazil Germany Dubai New York. NY 10017 Chile Italy Mexico Spain Switzerland United Kingdom EFTA01077301