JP Morgan's View on Global Asset Allocation

JP Morgan's View on Global Asset Allocation

• Portfolio strategy –– Stay with a defensive stance. High-quality bonds will be the first to recover

• Economics –– We see the Fed, the BoJ and the SNB each having policy rates near zero by early next year.

• Fixed Income –– We are bullish duration in developed markets and recommend 2s10s flatteners in the US

• Equities –– Stay underweight Cyclicals and long Value vs Growth

• Credit –– Stay overall underweight, albeit a small one only. Further HF and synthetic credit unwinding pose main downside risk to credit.

• FX –– Stay long the creditor currencies and short the debtor currencies, i.e. long JPY vs USD and EUR, short GBP vs CHF and long USD vs ZAR

• Alternatives –– Investors redeemed $40bn from hedge funds in October. Commodities markets to remain lacklustre in 2009.

• Markets remain in deep recession mode, with government bonds rallying strongly and equity and credit markets falling off a deep cliff. Despite the severe economic contraction already in the price, we advise staying in recession strategies as economic news is set to remain awful and volatility is still way too high to entice value-interested investor. The only hope we have is for
some form of short-covering when economic activity data no longer surprises super-negative investor base.

• The extremeness of the world economic contraction is likewise forcing global policymakers into extreme measures. These will eventually push up spending, but not until some time next year. In the meanwhile, investors should heed the impact of these measures.

• The zero-interest rate policy that many of the major economies are headed for will destroy the return on cash that everyone has been piling into to escape the carnage in risky markets. Once cash truly has no return, investors will venture out along the curve, first into the safer, higher-grade bonds issued by supranationals and large banks. Our high-grade bond index currently yields a high 7.8% in dollars and 6.3% in euros. The strong increase in issuance of high grade corporates and in particular of guaranteed bank bonds over the past two weeks, despite a worsening economic crisis, shows that this switch from cash to high-quality bonds has started. The relatively high excess yield per unit of risk of high grade implies to us that high-grade will recover before other risky markets such as low-grade bonds and stocks. Tactically, we are not long highgrade yet, given the remaining risk of forced unwinding by hedge funds, but we are near the point where we will likely switch to a long position.

Citigroup - Gov't Rescue: Equity Moderate, Fixed Income Positive

•Citi and the U.S. government fashioned a rescue that is a positive for the company and has broader benefits for financial markets and the economy, in our view. Fixed income investors are maintained whole, which should help getting debt investors out of their shells post the Lehman bankruptcy. The U.S. is providing insurance on the tail risk on $306 bil. of high-risk assets and investing in Citi preferred stock. The rescue results in midteens EPS dilution in 2010, sizable but less than feared. When Citi redeems the preferreds, it could do so later, after the cycle has turned, and limit additional dilution as it would also eliminate expensive preferred dividends. Citi’s town hall last week triggered a significant large decline and further wave of short selling that brought the company to the brink. Stabilization of Citi is a critical step as a failure may have further seriously damaged consumer confidence and created panic globally.

• Citi issuing two series of preferred stock totaling $27 bil. ($20 bil. to boost capital and $7 bil. as a fee for the insurance) and $2.7 bil. warrants ($10.61 strike price). Citi will bear the first $29 bil. in losses (over existing reserves for these loans) and 10% of any additional losses. Many details remain unknown, such as which loans and securities will be included in the covered assets and the amount of reserves against these assets. The assets will also be transferred with any hedges in place.

• The deal is 16% dilutive in 2010 on an economic basis due to the preferred dividends, share impact from warrants, and amortization of the $3.5 bil. discount for the $7 bil. preferreds issued as part of the deal. On a GAAP basis (assuming the warrants are out of the money) the deal is 13% dilutive in 2010.

• Dilution from future common equity issuance could be low depending on Citi’s valuation. We do not expect Citi to issue common stock until earnings have recovered materially. If Citi issues stock after 3 years and earns $2-3 per share by 2012, additional EPS dilution could be about 3-5% even if Citi trades at 8-10x P/E.

• Fixed income markets reacted positively to the bailout with sharp improvement in ABX, MBS spreads, and Citi CDS spreads (which fell by half, i.e., tightened 250 bp to levels of one week ago, before the town hall). Citi management chose to pursue the government rescue option rather than try to sell a sizable attractive business in a weak market and reduce some of the long-term strategic value. Citi already has some divestitures in negotiation but not yet announced and two that are pending closure.

Berkshire Hathaway Gets a Boost after Massive Sell-Off Last Week

Associate Editor Andrew Bary wrote in "Finally, Berkshire Looks Undervalued," that last week' selloff -- which left the stock 36% off for this year -- reflects worries about Berkshire's $76 billion equity portfolio and a sizable bet involving put options on $37 billion of equity indexes, including the S&P 500 and foreign markets.

Bary wrote a bearish Barron's cover story on Berkshire last December, when the stock traded at around $144,000 a share. Hurt by declining profits in the auto insurance and reinsurance markets, the stock closed at $90,000 a share on Friday.

But "now is probably a good time to buy," Bary wrote, arguing that investors have "over punished the stock" for the derivative bet. Also, in 2009, Berkshire's earnings could get a lift from improving conditions in the insurance market and new high yielding investment, including Goldman Sachs and General Electric .

In fact, Bary says Berkshire could see record profits if the stock market rallies in 2009.

Hedge Fund Trend

By Goldman Sachs

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The great reduction: Net exposure falls to 17% from 47% last year

We analyze 705 hedge funds with $607 billion of long equity assets, 31% lower than last quarter, and $513 billion of short positions. “Great reduction” refers to the industry’s smaller asset base and lower net exposure. Financials account for the largest gross exposure but is also the only sector where funds are net short. Largest net exposure is to Health Care.

Reduced net exposure amid turbulent market and tightening credit Hedge funds appear to have net long exposure of just 17% compared with 47% one year ago, signaling increased risk aversion. Lower net exposure to the equity market suggests hedge funds may have returned closer to their roots as “hedged” investors, less dependent on market direction to poduce returns, and migrated away from the levered long strategies that any funds pursued during the upward trending market of 2002-06.

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Is Berkshire currently a steal?

Some rough calculation on Berkshire’s intrinsic value based on 3Q08 results & recent acquisitions

All the cash & cash equivalents = $27,899 M (Insurance & Others) + $531 M (Utilities & Energy) + $4,939 M (Finance & Financial Products) = $33,396 M
Minus of recent acquisition, say $12,500 M = $33,396 M - $12,500 M = $20,896 M = $13,488 per A share

All fixed maturities securities = $29,584 = $23,667 M (assuming default rate of 20%) = $15,277 per A share

Equities securities = $76,042 M = $45,625 M (assuming 40% drop in equities value) = $29,450 per A share

Estimated annualised net profit = $1,057 M x 4 (assuming flat earnings for the next 3 quarters) = $4,228 M = $2,729 per A share
Intrinsic value based on (ex cash & investments) 10X multiple = $2,729 M X 10 = $27,290 per A share

All in all, the intrinsic value based on (earnings, cash & investments) = $85,505 per share A share = $2,850 per B share

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Disastrous bet ... or shrewd trade?
The trouble is, world stock indexes, including the S&P 500, have declined sharply since the trade was struck. The past two months have been particularly rough. In its third-quarter earnings release, dated Nov. 7, Berkshire said its loss to date on the trade is $1.87 billion. Surely, that's proof enough that Buffett made a disastrous bet. Right?

Wrong! In fact, Buffett had fully anticipated the possibility of such losses. Describing the trade for the first time in his 2007 letter to shareholders, he wrote: "... our derivative positions will sometimes cause large swings in reported earnings, even though Charlie [Munger] and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings -- even though they could easily amount to $1 billion or more in a quarter."

In truth, the terms of the trade are highly favorable to Berkshire:
1) At inception: Berkshire, the option seller, received the full $4.85 billion in option premiums up front. The use of this cash is now entirely at Buffett's discretion. Given his track record as an investor, that's a very valuable feature.
2) Over the life of the option: The puts are so-called "European" options -- the buyers can't exercise them until they expire. Furthermore, it's unlikely that Berkshire would have to post any margin collateral against mark-to-market losses; thus, although such losses would reduce Berkshire's earnings, they have no economic impact on the company whatsoever.
3) At maturity: These are long-dated puts, with expiration dates falling between 2019 and 2027. This is an immensely favorable situation, in light of the first point and the long-term upward drift in the stock market.

Given the misunderstanding of this options trade in the credit-default-swap market, which sets the price of insuring a company's debt, I now think the greatest economic risk of this options trade is not inherent in the trade itself. Rather, it is that the credit-rating agencies, including Moody's and Standard & Poor's, will also misunderstand the risks of the trade and downgrade Berkshire, in a move that would increase its cost of funding.
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A Look at October Retails Sales and First Data

By JP Morgan

U.S. Retail Sales Data Review (See within for detailed quarterly and monthly retail sales analysis):

• Retail Monthly Sales Softening, Directionally Consistent w/ MasterCard Spending Pulse Data. October retail sales growth (ex auto) decelerated 300bps sequentially to 0.5%. Controlling for a tough Sept/Oct sequential compare in the prior year, we estimate October retail sales growth decelerated ~100bps sequentially. Excluding auto and gasoline sales, we estimate October retail sales growth decelerated 70bps sequentially to 0.5%, on a 50bps easier (sequential) compare from the prior year period. Census Bureau statistics are directionally consistent with MasterCard’s October Spending Pulse survey released earlier this month.

• No Surprise, Discretionary Remains Weak... Discretionary spending growth continues to decelerate and, in some cases, contract from the prior year period. Home furnishings and electronics, which collectively account for roughly 6% of retail sales and are generally view as the most discretionary purchases, contracted 13.5% and 5.6%, respectively, from the prior year period, versus an 11.5% and 2.4% y/y decline in September, continuing a trend of decelerating growth. Clothing, which accounts for roughly 7% of retail sales, declined 4.0% from the prior year period, a 60bps deceleration from the revised September figure. October food service sales, which represent roughly 14% of retail sales, increased 3.9% from the prior year period. October food service growth was roughly flat to the revised September figure.

• …But Staples Holding Up Relatively Well. The less discretionary categories (e.g., food and general merchandise) are seeing some softness, but are generally holding up well. Food (and beverage) and general merchandise sales, which collectively account for roughly 36% of retail sales, increased 4.8% and 2.3%, respectively, from the prior year period, decelerating about 70bps each from September.

• Gasoline Could Be Swing Factor, Worth Monitoring. Gasoline sales were roughly flat to the prior year period, but October gasoline sales growth decelerated 17 points sequentially from September, as gas prices declined and consumers filled up less. We believe this is a trend worth monitoring as it could have a meaningful impact on MasterCard's December quarter domestic purchase volumes and Visa's March quarter domestic purchase volumes. We believe gasoline purchases represent 10-15% of Visa/MasterCard domestic purchase volume.

First Data 3Q Earnings Call Takeaways:
• U.S. Merchant Services trends. Transaction growth was up 9% in 3Q (vs. up 11% in 2Q08), which decelerated throughout the quarter -consistent with broader trends in the industry. By type, credit was up 6%, PIN-debit up 17% and prepaid up 36%. Not surprisingly, October slowed (but still positive according to management) and First Data gave some trends by category: (1) general retail same store declined 2% in Oct. vs. being flat in Sept., (2) discounters and wholesalers saw same store growth of 3%

U.S. Mid-Cap Banks - Regulators pushing for more dividend cuts

By Goldman Sachs Steven Alexopoulos & Preeti S Dixit

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• Regulators pushing for more dividend cuts. Although we have already seen several rounds of dividend cuts, it appears that regulatory pressure is building that could force sky high dividend payout ratios lower. On November 12, an interagency statement was issued by the Fed, FDIC, OCC, and OTS, providing several guidelines for financial institutions to ensure that banks are supplying sufficient credit to meet borrower demand. One of the notable guidelines was for banks to strengthen capital, with the guidelines specifically indicating that banks should not
maintain a cash dividend (1) that is inconsistent with capital position, (2) could weaken overall financial health, or (3) impair the banks ability to meet the needs of credit worthy borrowers. The guidelines also state that regulators will take action when dividend policies are found to be inconsistent with sound capital and lending policies. Given that only three banks covered their dividend with earnings in the most recent quarter, we think cash dividend levels are about to be slashed.

• Banks most at risk for dividend cut: MI, TCB, BBT, SNV, MTB. Regulators are pointing to adequacy of loan loss reserves, dividend payout ratios and capital position as key metrics banks should focus on in setting cash dividend levels. Ranking the mid-cap banks on this basis, the banks most at risk for a dividend cut are M&I, BB&T, TCF Financial, Synovus, and M&T. Although each of these banks has recently commented that they do not feel a need to cut their dividend, the regulators might see this point differently. The banks least at risk of a cut are CYN,
PVTB, PBCT, and ZION.

• TARP update – capital injections officially replace asset purchases as key use of funds. Shortly after the interagency guidelines mentioned above were released, Treasury Secretary Henry Paulson said in a statement that the Treasury was no longer considering buying illiquid mortgage related assets as part of TARP. Although the potential use of TARP funds for targeted asset purchases remains on the table, capital injections appear to be the most likely use of the remaining $60 billion of TARP funds not yet allocated of the original $350 billion authorized.

• TARP capital approved banks: BBT, CMA, CYN, FHN, MI, RF, TCB & ZION; Still waiting on: CNB, MTB, PVTB & SNV. Eight banks under coverage have been approved for $13.6 billion of TARP capital. We have yet to receive official approval announcements from Colonial, M&T Bank, PrivateBancorp, and Synovus. PBCT does not plan to apply for TARP capital. The remaining banks under our coverage would be eligible for up to $3.5 billion of TARP capital.

• Macro view: Near term downside risks - stay defensive. The economy is in a recession with the question now, in our view, being how deep and for how long. We believe a string of poor economic headlines through year-end will continue to put downward pressure on valuations. Despite that many valuations seem cheap, our view is to avoid getting caught in a value trap. As the valuations become more reflective of the risks, that will be the time to add to or establish positions. At the current time, we continue to advocate a more defensive posture, focusing on names such as PBCT and PVTB, which we think are positioned to take advantage of the
negative impact a challenged economic environment will have on their competitors.

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