Global Multi-Asset Group –

Weekly Strategy Report

22 November 2010

China and the US – an inconvenient week. Neither the US or China had a

China and the US – an convenient week regarding their current set of economic challenges. The US
inconvenient week witnessed a savage back-up in Treasury bond yields, which rose by nearly 60bps
from their pre-QE2 lows to a midweek peak of 2.96%, before easing back on

Emerging markets – deserving of Friday. This followed the US reporting core inflation of just 0.6% y/y, the lowest in
a premium rating? at least 60 years. China, meanwhile, had the opposite problem, having to react to
an inflation rate that was exceeding the official target and threatening to run

Ireland – heading towards higher, fuelled by capital inflows and FX reserve accumulation. On Friday, China
raised reserve requirements by a further 50bps, effectively helping to remove
redemption?
RMB 350 billion from the banking system.

COTW: Equity valuations – The good news for the US is that the rise in yields is mainly due to higher real
Emerging vs developed markets yields rather than rising inflation expectations. In this respect, the US bond
market is pricing in increased economic viability, with ten-year real yields
doubling to 0.8% over the past month. But the sell-off of US bonds is worrying
and not part of the QE2 script, especially as mortgage rates have also backed up.
The 2.96% level is a key support level for ten-year Treasuries and breaching it
Changes over the past week would be alarming; however, it is hard to see the conditions for a new bear
(12 – 19 November) market yet, despite some thin valuations on offer. At this stage, we continue to
think that the sell-off in the long end of the yield curve, as with the pullback in
10yr Currency equities, represents a position adjustment following QE2, rather than anything
Equity Bonds Trade more serious.
Market (bps) Weighted
US 0.1% 8 0.9% Emerging markets – deserving a premium rating? We were asked by one
client whether emerging markets (EM) should be trading at a premium compared
Eurozone 1.0% 19 0.6%
to developed markets. Despite spending over half of his career working on Asian
UK -1.2% 18 -0.1% and EMEA markets, this writer has a bias towards the view that these markets
Japan 2.7% 7 -1.0% should be trading at a discount (because by definition they have faster but more
volatile growth), but this is a challenging question. Emerging markets have been
Hong Kong -1.9% 0.3%
seen as the main beneficiary of QE2, with capital widely expected to flow into the
EM world, where currencies are seen as undervalued.
Source: Bloomberg
At the end of October the EM universe was trading on a P/BV of 2.06x and a
forward PE ratio of 11.4x. EMs were trading on a level of 104.1 on our composite
valuation index (see COTW). This index takes a geometrically weighted average
Chart of the Week Equity valuations – Emerging vs developed markets
Composite Valuation Index, 1996/09 Average = 100
Our COTW shows our composite
160
valuation indices for emerging and

developed markets, comprising four 140

metrics (forward PE, P/BV, price to 120

cashflow and dividend yield). It shows that 100

emerging markets remain attractive in 80

absolute valuation terms, but look 60

relatively expensive vs. developed 40

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
markets.
Emerging markets Developed Markets 1996/09 average
Sources: Thomson Datastream, J.P. Morgan Asset Management
Global Multi Asset Group
 Global Multi-Asset Group –
Weekly Strategy Report
The Week Ahead

US. Existing home sales for
October, due on Tuesday, are
expected to show further signs of a
slowdown, falling from 4.53m to
4.48m units. Yet new home sales,
due Wednesday are expected to
rise from 307k to 315k. The
weakness in demand comes
despite record low mortgage rates,
and reflects both tightness in credit
conditions and the sluggishness of
the recovery. Durable goods
orders (out Wednesday) are
expected to fall from 3.5% m/m to
0.0%. Personal income and
personal spending (due on
Wednesday) are expected to rise
from -0.1% m/m to 0.4% and from
0.2% m/m to 0.5% respectively.

Europe. On Tuesday, November’s
eurozone PMI manufacturing index
is expected to fall slightly to 54.4
from 54.6, in line with a
moderation in global trade as the
post-financial crisis rebound has
faded. On Wednesday, the
Germany Ifo is set to rise slightly
from 107.5 to 107.6, its highest
level in over three years, propelled
by the strength of current business
conditions. Eurozone M3 data (due
Friday) are likely to show that
annual growth slightly increased
from 1.0% y/y to 1.1%.

Japan. On Friday, October core
inflation is estimated to move from
-1.1% y/y to -0.5%, owing to the
tobacco tax hike and higher non-
life insurance premiums from
October.
This document is produced by The
Global Multi-Asset Group
The aim of the Weekly Strategy Report is to give general information regarding financial markets and economic trends in an educational context only. This
document is published for illustrative purposes only and is issued by the strategists of the Global Multi-Asset Group at J.P. Morgan Asset Management. The
opinions expressed in this report are those held by the authors at date of this document and may be subject to change. The views expressed herein are not to be
taken as advice or recommendation for investors to sell or buy shares. For information adapted to their personal situation, investors should check with their financial
advisor.
Issued by: JPMorgan Asset Management (Europe), S. à r. l., EBBC, 6 route de Trèves, L-2633 Senningerberg, Grand Duchy of Luxembourg, R.C.S. Luxembourg
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of four simple metrics and rebases each index back to the 1996 to 2009 average.
As a rough rule of thumb, when the absolute valuation index exceeds 120, then a
warning signal goes up. Other investor colleagues talk in terms of a P/BV in
excess of 2.5x as being their red flag.
The COTW shows that EMs on an absolute basis are valued in line with the long-
term average. This is also the case for the P/BV measure. By contrast, the
equivalent series for developed markets (excluding EM) shows that they are still
trading 26% below their long-term average. As a result, our relative valuation
indicator between EM and DM (the ratio of the two indices) looks extreme. From a
multi-asset perspective, we are not too worried about a seemingly extreme relative
valuation. EM returns on equity (ROE) are in excess of developed markets while
the macro fundamentals are better, given stronger growth prospects, sound
banking systems and a business environment that is favourable to foreign minority
shareholders. A valuation premium therefore can be justified.
What would get us worried, though, is if EM valuations moved to extremes, or if
there were any factors that could undermine these higher ROEs. We can think of
two such scenarios. The first would be if (or when) QE2 leads to inflation in the
emerging world, eroding margins and ROEs. With the exception of China this is
not yet a major concern. The second would be if there was a global slowdown
sufficient to bring a sizeable drop in commodity prices, denting earnings and ROEs.
In summary, we are not too worried about a premium valuation, should it
materialise. The irony is that should there be another leg-up in equities within the
next three-to-six months, if global investors scramble to rebuild their equity
positions, then the markets of choice could in fact easily be the more liquid and
undervalued developed markets. We retain our longstanding overweight position
in emerging markets.
Ireland – heading towards redemption? The end of last week saw signs that
Ireland’s problems were about to be addressed, with a visit from the IMF and
expectations that a rescue package was due shortly. Up to then, the CDS market
had been pricing a one in three chance of an Irish default within the next five years
– similar to Portugal, and nearing the evens chance of a Greek default. Ireland’s
woes have centred around its banks, which were effectively taken under public
sector control earlier in the crisis, tying together the solvency risks of the banking
system and the sovereign. The good news is that the government does not need
to go back to the debt markets until the middle of 2011. But the bad news is
evidence of deposit flight from the banking system. Consequently, the ECB has
had to offer short-term liquidity support to the Irish banks, such that Ireland now
accounts for EUR 130 billion – one quarter – of the total ECB disbursements.
Any IMF package will include some painful conditions. One sacred cow likely to be
slaughtered is Ireland’s 12.5% corporate tax rate, which will probably be increased.
It is also possible that public sector wages will be reduced again, while real GDP
growth forecasts are set to be slashed. This could be the start of the redemption
process, but it is likely to be a long and painful one. There is no longer an Irish
punt to devalue to bolster the export sector and help promote rapid recovery. In
short, this will be no Asian-style recovery – in fact, it is more likely to be like Latvia,
another euro-linked economy. If Ireland’s recovery does resemble Asia’s, it will be
like Hong Kong, with adjustment occurring through asset prices (and employment)
rather than exchange rate. While Ireland may avoid Latvia’s 20% drop in GDP and
23% unemployment rate, the going is likely to be tough.