Global Asset Allocation

Mar 25, 2011

Flows & Liquidity

Trends in asset allocation
Equities, EM, Alternatives, Global asset allocation or Multi-asset funds and ETFs are benefiting from investor trends. Investors remain underweight in EM assets. Covering of EM underweights has further to go. Hedge funds continue to increase their equity exposure. Foreign buying of Japanese equities keeps rising. Bond demand indicators remain weak. The supply-demand combination points to modestly higher yields. The impending bailout of Portugal leaves domestic banks vulnerable. We estimate that their borrowing from the ECB will increase by more than half by mid year. Spanish banks continue to have good access to interbank and debt capital markets. They have already refinanced 41% of this years bond maturities. The global investor, who incorporates all investors and thus by definition owns all assets in the world, has been steadily moving from cash to equities over the past two years. Chart 1 shows the share of three asset class outstandings cash (M2), bonds, and equities as share of the world portfolio, now valued at $141 trillion, since 1989. It is true that most of the rise in equity allocations is due to price appreciation, but that does not deny that the global investor must have wanted to raise its equity holdings. This is because with new equity issuance very limited compared to outstandings, the world as a whole can only raise its equity holdings by pushing up its price. Despite the steady rise in equity allocations since 2009, investors do not yet appear overweight equities. By now, the shares of each of the three assets are very close to their 22-year average. Asset holdings are near neutral, but their expected returns cannot be near neutral as two of these asset classes cash and bonds have IRRs near historic lows and only equities have an IRR near their historic mean. It must thus be the case that the global investor still perceives equity risk as well above its historic average. It is our view that the further we move away from the great recession, and the more the equity market shows it can withstand the plethora of shocks thrown at it, the more the perceived high risk on equities will fade and the more investors will want to raise their holdings versus cash and bonds. Retail investors have been heavy buyers of bond funds over the past two years. As a result, the share of bond fund AUM relative to the whole universe of mutual funds has been rising steadily since mid 2007, The certifying analyst is indicated by an AC. See page 7 for analyst certification and important legal and regulatory disclosures. Nikolaos PanigirtzoglouAC
(44-20) 7777-0386 nikolaos.panigirtzoglou@jpmorgan.com

Grace Koo
(44-20) 7325-1362 grace.x.koo@jpmorgan.com

Seamus Mac Gorain

(44-20) 7777-2906 seamus.macgorain@jpmorgan.com

Matthew Lehmann
(44-20) 7777-1830 matthew.m.lehmann@jpmorgan.com

Chart 1: Global portfolio weighting of fixed income, equities, and cash

% of total portfolios; J.P. Morgan estimates from Dec 10 45%

40% 35% 30% 25% 20% 89

Cash Equity Bonds Total

92 95 98 01 04 07 Outstandings Estim. 31. Mar Average

$54 $45 $43 $141tr 38.0% 31.5% 30.5% 36.7% 32.0% 31.4%

10 Gap
1.4% -0.5% -0.9%

Source: J.P. Morgan, BIS, Datastream. Global FI is proxied by the sum of the global domestic debt securities reported by BIS and J.P. Morgans EMBIG index for external debt. For equities, we used the Datastream world equity index. Global cash is an aggregated M2 (or close proxy of M2) of developed and developing countries.

Global Asset Allocation Flows & Liquidiity

from 20% in Q3 2007 to 27% in Q3 2010. In contrast, the share of equity funds at 51% remains well below pre-crisis levels of 60% (Chart 2). Given that the share of money market mutual funds has already returned back to pre-crisis levels, the big position that retail investors have currently is to UW Equities vs Bonds. This favours equities and leaves bonds vulnerable to a potential normalization in retail investors positions, especially as bond returns are progressively looking a lot less attractive vs equity returns. Mutual fund flow data of the past months have shown the first signs of a change in retail investor flows. Since last November, retail investors injected $80bn into equity funds and sold $15bn of bond funds. What about pension funds and insurance companies? Flow of funds data show that G4 pension funds and insurance companies continue to prefer bonds over equities, a trend that started 10 years ago (Chart 3). Although anecdotal evidence had pointed to pension funds moving away from bonds into equities in Q4 2010, but this was not seen in the actual data. US Flow of Funds data for Q4 suggest that US pension funds and insurance companies continued to buy bonds and sell equities. While pension fund and insurance companies have high bond and low equity weightings relative to the past (Chart 4), this position is unlikely to change. Survey data suggest that the outlook over the long term is one of pension funds looking to diversify away from traditional asset classes, both bonds and equities, towards alternatives, especially property and hedge funds, rather than moving from bonds into equities. We infer the share of alternatives for pension funds and insurance companies by subtracting from total assets the share of equities, bonds and cash, i.e. we assume that remaining assets are invested in alternatives. The current alternatives share is around 17% for G4 pension funds and insurance companies equivalent to total assets of $34tr. It stood at 15% in mid 2007. Based on surveys we believe that half (8%-9%) of this share is invested in real estate, and the other half is invested mostly in hedge funds (3%-4%) and private equity (3%-4%). Commodities should account for no more than 1% of total assets. Indeed, the alternatives universe, which includes tradeable commercial property ($4.6tr), private equity ($1.7tr), hedge funds ($1.9tr) and commodities ($376bn), continues to grow. It stood at the end of 2010 at 9% of the global portfolio of assets, i.e. bonds + equities + alternatives, vs. a share of 7.5% in 2002. If this pace of growth were to be maintained, the alternatives universe would increase to close to 11% of the $95bn global portfolio or $16tr by the end of the decade, from $8.6tr currently. Within traditional asset classes, the share of tradeable EM equities and bonds (by tradeable we mean EM assets available for purchase by foreign investors), has been rising steeply to 10% currently, vs 5% at the end of 2004 (Chart 5). This is still well below the 33% share of EM economies in world GDP (Chart 6). This suggests that the share of EM in global equities and bonds has a lot further to rise, pointing to a multi year rising trend. Within the global portfolio of both traditional and alternative asset classes, the share of multi-asset or global asset allocation funds is also exhibiting a rising

Chart 2: Share of mutual fund AUM

Equity, bond and money market fund AUM shares of total mutual fund and ETF universe. 65%

55% 45% 35% 25% Bond funds 15% 05

Source: EFAMA, EPFR

Equity funds

Money market funds

06

07

08

10

Chart 3: G4 pension funds and insurance company bond and equity allocation
Quarterly equity and bond transactions. Last observation is Q3 2010

220 180 140 100 60 20 -20 -60 99 01 03 05 07 09

Source: Federal Reserve, BoJ, BoE, ECB

Bonds

Equities

Chart 4: G4 pension funds and insurance company allocation to bonds, equities and alternatives
Equity. bond and alternatives holdings as a % of total financial assets. Alternatives is calculated as the residual after bonds, equities and cash are subtracted from total financial assets. Last observation is Q3 2010 50% Bonds 45%

40% 35% 30% 25% 20% 15% 10% Mar-99 Mar-02 Mar-05 Mar-08
Source: Federal Reserve, BoJ, BoE, ECB

Equities

Alternatives

Mar 25, 2011

trend. The share of balanced funds within the mutual fund universe currently stands at 11% vs. 9.5% at the end of 2006. The share of global macro hedge funds currently stands at 20% vs. 11% at the end of 2006. This reflects greater investor appetite for a multi-asset investment approach which benefits from diversification and focuses on absolute rather than relative returns. Within mutual funds and ETFs, the share of ETFs has doubled in 4 years to 12.5% currently, vs 6.5% at the beginning of 2007. This reflects greater investor appetite for low-cost and liquid investment funds. Hedge funds represent an important part of investors universe as they account for a third or more of total trading volumes on some financial assets. Their importance is both a function of AUM and of leverage: the higher the leverage the higher the amount of assets hedge funds control. Chart 7 shows our estimate of HF leverage. HF leverage experienced a structural break since the late 1990s. The low volatility during the 1996/1997 period encouraged an increase in hedge fund leverage through 1998. The LTCM crisis and the resulting increase in volatility triggered position unwinding and deleveraging, which was amplified by the collapse of the tech bubble. Since mid 2003 volatility started declining at a rapid pace laying the ground for a rise in leverage. But the Lehman crisis caused a new wave of position unwinding and deleveraging. HF leverage has been declining since then and it currently stands at the low end of the range over the past 10 years. While AUM has returned to the pre-crisis peak, our HF leverage proxy is currently half of that seen at the beginning of 2007, suggesting that hedge funds control half as many assets as in 2007. Within hedge funds, event-driven (which also includes M&A arbitrage and distressed securities) and EM are on a rising long-term trend. The share of Global Macro had been falling up until 2006, but since then we have seen a sharp recovery mostly at the expense of Equity Long/Short. Government bonds represent a growing share of the bond universe and banks, including central banks, have been absorbing more of these government bonds. Central banks hold around $10tr of government bonds, $7.7tr in FX reserves and $2.3tr due to Fed/BoE QE. Following three years of strong buying, G4 commercial banks raised their holdings of government bonds to $4.5tr at the end of 2010. Applying the 6% share of government bonds in total assets by G4 commercial banks, to the $100bn global universe of banks, implies commercial bank holdings of government bonds of around $6tr globally. So central banks and commercial banks hold almost half of the total $30tr government bond universe (based on BIS data). Continued rapid increase in FX reserves and ongoing regulatory pressure on banks to hold government bonds, means that this share will continue to increase, even if this comes at the expense of non-government bond holdings in the case of commercial banks.

Chart 5: EM share of total equity & bond universe

EM as a share of total market. EM is: MSCI EM for equities and EMBIG, CEMBI and GBI-EM for bonds. Total market is: MSCI AC World for equities and Barcap multiverse for bonds.

11%

9%

7%

5%

3% 04 05 06 08 09 10
Source: Datastream

Chart 6: EM share of world GDP

nominal GDP in USD at current prices 40%

35% 30% 25% 20% 15% 1980

Source: IMF

1986

1992

1998

2004

2010

Chart 7: 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 neutral, JPM Global Bond Index USD hedged returns for Macro and Fixed Income arbitrage, high yield returns for Conv Arb and Event driven/ Distressed debt and MSCI EM returns for EM funds.

10 8 6 4 2 0

2.5 2.0

All Hedge Funds

1.5 1.0 0.5

Investors remain UW in EM. Covering of EM UW has further to go.

The divergence between the 4-week pace of DM and EM equity fund flows continues to narrow, favouring EM vs DM equities (Chart 8). The most recent position indicators show that investors are still UW in EM, suggesting that the covering of EM underweights, currently underway, has further to go.
Mar 25, 2011

Macro HFs 95 98 01 04 07 10

0.0

Source: J. P. Morgan

Chart 8: EM vs. DM equity mutal fund flows

Indeed, the share of EM equity funds in the total equity fund universe stands significantly below its trend since 2005 ( Chart 9). The latest Merrill Lynch Fund Manager survey showed that the percentage of investors reporting an overweight in EM equities fell to further in March, to zero, its the lowest since February 2009. At the same time, the March survey showed an elevated percentage (+45%) of global asset allocators reporting an overall overweight position in equities. We get a similar picture in EM bonds. Our latest EM Client Survey showed that investors remain UW in EM bonds and that cash balances remain high. This, coupled with low issuance compared to coupons and maturities, creates a favourable backdrop for EM bonds over the near term, especially for EM sovereign bonds. For more details see J.P.Morgan Emerging Markets Client Survey, March 2011, Jonny Goulden, Trang Nguyen & Laura Bierer.

Includes ETFs. $bn, 4wk average 10

5 0 -5 -10 Jan-10 May-10

EM

DM

Sep-10

Jan-11

Source: Datastream, J.P. Morgan

Hedge funds continue to increase their equity exposure

The rolling betas of daily HF returns to global equities have been rising steadily since mid February.

Chart 9: EM equity fund AUM as a percentage of total Equity fund AUM

Grey line is a simple linear trend line. Includes mutual funds and ETFs.

Foreign buying of Japanese equities continues to rise

We use the US based iShares MSCI Japan ETF as a high-frequency proxy for foreign buying of Japanese equities (it is the largest Japanese equity ETF with over $6bn of AUM). Outstanding shares continue to climb and are now 27% above their pre-earthquake levels. This suggests foreign investors appetite for Japanese equities remains strong.

13% 11% 9% 7% 5% Mar-05 May-06 Jul-07 Sep-08 Nov-09 Jan-11

Source: J.P.Morgan, EPFR

Bond demand remains weakish

Bond demand from the sources we can monitor at a relatively high frequency commercial banks, retail investors and the official sector has been weakish YTD. G-4 commercial banks have bought some $60bn of bonds YTD (to mid-March for the US, but only Jan elsewhere). The slackening in commercial bank buying is to a significant degree a reflection of the steady rise in global loan demand (see Chart 10). Bond mutual funds saw inflows of just $20bn in Q1, the second consecutive quarter of weak retail demand. That reflects both a specific story (sustained retail selling of Muni bonds) and a broader one: weaker lagged returns cooling retail investors ardour for bonds. Our medium term outlook is for a modest bond bear market, and so for retail demand to stay weak (i.e. reinforcing the move higher in yields). Fed Custody holdings and TIC data suggest that foreign official investors have bought around $75bn of US bonds YTD, tracking shy of the past few years pace of well over $100bn per quarter. The G7s coordinated FX intervention to weaken the Yen presages a tick up in reserve manager Treasury buying, though we estimate that intervention will be no more than $100bn. (And indeed that is in any case to a large degree the counterpart of Japanese repatriation of foreign bond investments, as discussed in last weeks F+L). G-4 central banks have bought a strong $270bn of bonds YTD, almost entirely down to the Feds QE2. That, however, will come to a close in the summer, and the Bank of Japans increased QE takes up very little of the slack
Mar 25, 2011

Chart 10: G-4 corporate loan demand and bank bond buying
1800 1600 1400 1200 1000 800 600 400 200 0 03 04 05 06 07 08 09 10 11
Source: J. P. Morgan, National Central Banks

Net % of G-4 banks seeing stronger loan demand (RHS)

20 10 0

G-4 bank bond buying ($bn, 4Q ave, LHS)

-10 -20 -30

Global Asset Allocation Flows & Liquidiity

(with an additional 2tr, or $25bn, of bond purchases). That leaves major central banks on track to buy around $600bn of bonds this year, in line with 2010. All told, that points to a moderately weak environment for bond demand going forward. Against that, we expect 2011 bond supply to be only around a tenth lower than last year, at around $3.3tr, reflecting lower government issuance (see Chart 12). That supply-demand combination points to modestly higher yields.

Chart 11: Global bond demand

$bn 5000

Insurers/Pension funds Central banks Retail Reserve managers G4 banks

4000 3000 2000 1000 0 -1000 03

Irish bank stress tests will not resolve funding problems

Ireland will announce bank stress test results next week. Irelands 85bn rescue package earmarked 35bn for bank recapitalisation, of which 10bn was expected to be injected initially, with the remainder as a contingency. We now know that next weeks stress tests will require an initial recap of more than 10bn; the question is how much more. There are two problems for Irish banks: asset quality, and the sheer scale of deposit flight in the past few months. For example, in Q4 Irish banks lost 57bn of deposits (6% of domestic deposits, 29% of overseas deposits). Over half of that was government-guaranteed wholesale deposits i.e. implying a loss of confidence in the sovereign as well as the banks. An optimistic scenario would see deposits flow back into Irish banks postrecapitalisation. But that loss of confidence means that overseas investors are likely to be wary of lending to Irish banks even after a substantial recap. That in turn means that they will likely need official sector funding for a sustained period, and most likely a willingness of the ECB to allow banks to remain addicted to its liquidity facility for much longer. We noted last week that Greeces EU/IMF package assumes that it will return to bond markets in 2012, but that now seems unlikely, implying that Greeces rescue package will have to be upsized this year. In a similar vein, the European Commission assumes that Ireland will also return to bond markets next year, issuing 24bn (ex T-Bills) in 2012/13. See GFIMS Euro Cash for details.

04

05

06

07

08

09

10

Source: National Central Banks, J.P.Morgan. Insurers and pension fund number for 2010 is Q1-Q3 annualised. Reserve manager buying is for US bonds only.

Chart 12: Global bond supply

$bn 6000

Agency Corporate Securitised Government

5000 4000 3000 2000 1000 0 -1000 03 04

05

06

07

08

09

10

11

Source: Barclays, J.P.Morgan.

The impending bailout of Portugal leaves domestic banks vulnerable

Over the past few months, Portuguese banks have managed to avoid resorting to the ECB as an increase in domestic deposits offset reduced access to funding markets. Since June 2010, there has been a 7bn fall in outstanding Portuguese commercial paper, negative net bond issuance of 3bn and a contraction in repo financing of around 7bn. However, this has been offset by a 15bn increase in domestic deposits over the same period. But the impending bailout of Portugal leaves local banks more vulnerable. Borrowing from the experience of Greek or Irish banks immediately following the bailout, we see a high chance that domestic deposits will start falling, forcing Portuguese banks to increase their borrowing from the ECB. In the three months following the Greek or Irish bailout, banks lost 6% of their domestic deposits. Assuming a similar loss for Portuguese banks would mean deposits decline by 15bn. Furthermore, if repo financing, which on our

Chart 13: Banks common equity to total assets ratio

median is denoted by the yellow marker, lower and upper quartiles at the bottom and top of the blue bars 0.12

0.11 0.10 0.09 0.08 0.07 0.06 0.05 0.04 US Italy Spain Portugal
Source: Bloomberg, J.P. Morgan

All W. Europe

Mar 25, 2011

Global Asset Allocation Flows & Liquidiity

estimates accounts for 10% of Portuguese banks liabilities, were to continue declining at the current pace, it would result in a further 5bn loss of financing between now and June. Portuguese banks have also not refinanced any of the 8bn of debt maturing in the first half of 2011, further exacerbating the issue. If we add the potential loss of deposits and repo financing to the unfunded maturing debt we get a total potential funding gap of around 28bn. This would most likely have to be funded at the ECB which would mean a 2/3rds increase in ECB borrowing. But in contrast to Irish or Greek banks, Portuguese banks do not face a collateral availability issue as they appear to hold 40bn of domestic and 50bn of foreign bonds. Regulatory pressure to raise equity is another headache for Portuguese banks. By looking at simple common equity to asset ratios, we find that listed Portuguese banks fare slightly better than Spanish banks, but are significantly more leveraged than their Italian or US counterparts (Chart 13). If listed Portuguese banks, which have 330bn of assets, had to increase their common equity ratio to 6.8%, the median for Western Europe, they would need to raise 7.5bn of equity. If Portuguese banks had to increase their common equity ratio to 8.4%, the median for their Italian counterparts, they would need to raise 12bn of equity. Does the risk of an increase in LCH haircuts pose an additional problem for Portuguese banks? The answer is no. Portuguese banks were not members of LCH. Two of them became members only this week. Back in October when LCH increased the haircut for Irish bonds, there was an impact, as two Irish banks were members already.

Flows&Liquidity Weekly Monitor

$bn per week. Mutual fund flows are across all domiciles and by fund objective. The gap from 2006 is the difference between the 4wk average and the 2006 average. 2006 Avg. is the weekly average over 2006. Corporate gross issuance includes financials and non financials, HG and HY. The region of issuance is by the parent company of the issuer.

Mutual Fund Flows All Equity Funds All Bond Funds EM Equity Funds EM Bond Funds DM Equity Funds DM Bond Funds US Equity Funds US Bond Funds W. European Equity Funds W. European Bond Funds US HG Corporate Bond Funds US HY Corporate Bond Funds US Muni Funds Equity Supply Global IPOs Global Secondary Offerings Gross bond issuance US W. Europe Corporate activity Global M&A US share buybacks Non-US share buybacks

This Week 4wk Avg. 2006 Avg Gap from 06 -8.4 1.3 -2.7 -0.1 -5.8 1.5 -5.3 0.8 -1.2 -0.2 1.1 -0.8 -0.4 4.0 11.3 27.2 33.2 63.3 2.0 2.4 -3.2 2.0 -1.8 0.0 -1.4 2.1 -1.0 1.0 -0.7 -0.3 1.1 -0.1 -0.6 4.6 9.6 17.6 20.8 53.8 9.0 2.1 1.2 0.2 0.0 0.1 0.4 0.1 -0.1 -0.1 0.2 0.0 -1.0 0.8 0.0 6.9 10.4 29.3 29.6 76.6 7.5 3.3 -4.4 1.8 -1.8 -0.2 -1.8 2.0 -0.9 1.1 -0.9 -0.3 2.1 -1.0 -0.6 -2.4 -0.8 -11.8 -8.8 -22.7 1.5 -1.1

This Week 4wk Avg. 2006 Avg Gap from 06

This Week 4wk Avg. 2006 Avg Gap from 06

This Week 4wk Avg. 2006 Avg Gap from 06

Source: Bloomberg, EPFR, Dealogic, Reuters, Federal Reserve, ECB, J.P.Morgan

Monthly Trading Volume Monitor

Equity volumes are in trillions of USD. All data are updated on a monthly basis. USTs are primary dealer transactions in all US government securities. JGBs are OTC volumes in all Japanese government securities.

Equities ($tr) EM DM Govt Bonds (tr) USTs JGBs Credit (bn) US HG US HY US Convertibles

Feb-11 Trading Volume $1.22 $3.63 Feb-11 Trading Volume $2.6 604 Feb-11 Trading Volume $265 $101 $29

YTD Avg $1.46 $4.61 YTD Avg $2.4 634 YTD Avg $239 $105 $30

2007 Avg $1.19 $5.92 2007 Avg $2.5 991 2007 Avg $178 $88 $45

Source: Bloomberg, Federal Reserve, Trace, Japan Securities Dealer Association, WFE, J.P.Morgan

Mar 25, 2011

Global Asset Allocation Flows & Liquidiity

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Global Asset Allocation Flows & Liquidiity

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Mar 25, 2011