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July 25, 2011
Topics: US debt ceiling negotiations, a more ambitious European bailout plan (finally), and how large cap growth stocks
and rising corporate profits are patiently waiting for both of them to end
White Castle. Twenty five years ago, I had a friend with a peculiar way of responding to seeing things he didn’t like on TV: he
would throw White Castle hamburgers at the screen. I always thought this was a bad way to waste a good hamburger, but I had
one of those moments the other night when watching news reports on debt ceiling discussions. Media outlets have referred to
President Reagan’s scolding of Congressional Republicans for delaying debt ceiling increases, and the 18 increases that took
place during his Presidency. The implication: reservations about raising the debt ceiling are as irresponsible now as they were
then. This is a disingenuous argument; in the 1980’s, the debt ceiling being debated was 50% of GDP, and had no
bearing on the solvency of the United States. Today, the proposed increase raises the debt limit twice as high, measured
relative to GDP or government revenues. While a default is a very bad idea (deserving of a White Castle hurling of its own),
unconstrained debt growth with no plan to slow it is bad as well. Some suggest we not worry about debt growth, since demand
from foreign central banks and the Federal Reserve would keep yields in check. That logic is irresponsible at best. Debt limit
legislation is a rocky but healthy way for a democracy to decide whether mega-deficits are in the long-term public interest.
Debtlimitdebate of the 80’s: an entirely differentdiscussion
Percent
Multiple
110%
100%
90%
80%
70%
60%
50%
40%
30%
Reagan scolds
Congressional
Republicans for not
raising the debt
ceiling
Debt limit to
GDP
Debt limit to
gov. receipts
20%
1x
1950 1956 1962 1968 1974 1980 1986 1992 1998 2004 2010
Source: OMB, BEA, J.P. Morgan Private Bank.
8x
7x
6x
5x
4x
3x
2x
Over the last few days, the Gang of Six plan, the Reid-McConnell plan and the Obama-Boehner plan have all been
raised up the flagpole and then lowered. By the end of the process, we’re still looking for deficit reduction of $3 trillion+
over 10 years (relative to the CBO Alternative case in which there is no deficit reduction at all). However, Congress is running
short on time, and may have to do a smaller debt ceiling increase/deficit reduction first. For now, we wait to see the balance of
spending cuts and revenue increases 1 will be agreed to. Last week’s Profiles in Courage piece walked through the history and
dynamics of this process, so we won’t repeat that here. Here’s our take on what has been proposed so far, with the caveat
that many plans are not crystal clear what baseline they are using 2 , or what steps they recommend to get to that baseline first.
What's on the menu? US long-term debt scenarios
Net debt to GDP, percent
105
Reid-McConnell, Phase I
100
95
90
85
80
75
70
CBO Baseline
Reid Plan
Pres. Budget
Boehner 1 Plan
Gang of Six
65
2010 2012 2013 2015 2016 2018 2019 2021
Source: CBO, news reports, Gang of Six proposal, J.P. Morgan Private Bank.
All tax cuts extended; AMT indexed to inflation;
no Medicare reimbursement cuts
Cuts to discretionary and entitlement spending
Defense cuts,discretionary spending reductions
Top two brackets return to 2001 levels; phaseout
of itemized deductions; some discretionary
spending cuts; Medicare reimbursement freeze
Discretionary and entitlement cuts (CPI chain
weighting), limit on itemized deductions, "bracket
creep" (faster migration to higher tax brackets)
All tax cuts return to 2001 levels; AMT no longer
indexed to inflation; Medicare reimbursement
cuts to Doctors proceed as planned
Tax rates lowered, combined with reduction in
deductions to generate net tax revenue increase;
cuts to discretionary and entitlement spending
1 On the AMT: the Tax Policy Center estimates that if the AMT is not indexed to inflation, it would impact 31 million filers in 2012 (and
raise $132 billion in revenue), compared to 4 million filers in 2011 (and $39 billion in revenue).
2 For example: the Gang of Six state that they used the President’s budget as a baseline (scored by CBO in March 2011), reduced deficits by
$3.7 trillion, and ended up with a 71% debt/GDP ratio; but they do not explain how they get to the President’s baseline in the first place.
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July 25, 2011
Topics: US debt ceiling negotiations, a more ambitious European bailout plan (finally), and how large cap growth stocks
and rising corporate profits are patiently waiting for both of them to end
I have a feeling that revenue increases will be a material (e.g., 25% or more) part of the deal. The Peterson Foundation’s
sampling of 6 policy groups shown below indicate that 5 of 6 recommend revenue increases compared to where we are today;
the Heritage Foundation’s “Woody Guthrie Memorial Budget Plan” is the only exception. What kind of revenue increases?
Raising the top two brackets, which would affect joint filers with adjusted gross incomes above $212,300, would raise $450-
$700 billion over 10 years (depending on whether you use OMB or CBO numbers). If they cannot agree to raise rates, another
option (as in the Gang of Six plan) would be reductions in the deductibility of state and local taxes, sales taxes, mortgage
interest, etc. As this gets sorted out, let’s hope everyone recognizes that the US tax system is already progressive. As shown in
the chart below, effective Federal tax rates for low earners have dropped to zero over the last decade, even after including FICA
taxes. News reports that the US tax system is regressive make me want to throw hamburgers at the screen.
Revenues and Spending as a % of GDP
Revenues Spending
Fiscal year 2011 15.3% 24.1%
Fiscal years 1950-1969 17.5% 18.1%
Fiscal years 1970-2010 18.0% 20.8%
Estimates for 2035:
CBO alternative case 19.5% 33.9%
American Enterprise 19.9% 22.8%
Bipartisan Policy Center 23.1% 23.7%
Center for Am. Progress 23.8% 23.2%
Economic Policy Institute 24.1% 27.8%
Heritage Foundation 18.5% 17.7%
Roosevelt Institute 22.9% 24.8%
Source: OMB, CBO, Peterson Foundation 2011 Fiscal Summit.
What a progressive income tax system looks like
Combined effective federal income and FICA tax rates
25%
High earners
20%
15%
10%
5%
Median
earners
0%
Low earners
-5%
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Source: Tax Policy Center.
Europe: Finally (!!), but now what?
For the first time since 2009, it felt last week like European policymakers were trying to get out in front of things. In exchange
for a modest amount of “private sector involvement”, Germany agreed to more generous financing terms for Greece, Ireland
and Portugal, and an expanded role for the EU-IMF lending facility (see following page). What would the plan accomplish if
implemented? While Greek debt to GDP ratios would remain well over 125% of GDP (the IMF estimate for next year is a
ridiculous 170%), Greece’s near-term financing obligations would decline, due to debt buybacks, exchanges into long maturity
bonds, and interest grace periods on new EU loans. More broadly, the plan also allows for money to be lent to countries before
they enter into an IMF program, for recapitalization of banks. All things considered, it’s the broadest defense of the
Monetary Union so far. On paper, it even looks like a free ride for holders of Greek paper that don’t participate in the debt
exchanges (they would be paid at par). So, what’s not to like? Well, there are still questions about Greece:
• There’s a big difference between generous financing terms and generous economic terms. Greece must still meet an
enormous 5%-6% primary budget surplus target (government revenues less spending, pre-interest) during a recession
• Greece must execute on its asset sale targets, despite having little success or experience doing this in the past
• Banks listed in the IIF document (the committee representing them) are under no binding legal obligation to participate in
the debt exchanges, and may turn out to own less Greek debt than currently believed. [Note: bank participation in the Latin
Brady bond era was high, since at the time, banks held almost all the paper, and in the form of illiquid loans].
The big question: would Germany still live up to the deal if Greece missed deficit targets or assets sales, if bank participation
was too low, or if hedge funds (once referred to by the Chairman of the German Social Democratic Party as a “swarm of
locusts”) reaped large free rider windfalls? Ultimately, this is a political question. If “yes”, Germany will underwrite Greece
no matter what; if “no”, then a broader, coercive Greek restructuring might follow in the not-so-distant future 3 .
3 This could get complicated. If there is a need for further debt forgiveness for Greece, will policymakers find a way to “ring-fence” the
banks that participated in the first round, and impose losses just on the hold-outs? Will the EU tell banks that if they don’t participate, their
older bonds will not be eligible for financing at the ECB?
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July 25, 2011
Topics: US debt ceiling negotiations, a more ambitious European bailout plan (finally), and how large cap growth stocks
and rising corporate profits are patiently waiting for both of them to end
What the EU gave: an easing of lending conditions, and an expanded role for the EU lending facility (EFSF)
* Another 109 bn for Greece, allowing the country to continue to pay off maturing debt (to those not participating in the exchanges)
* Rate on new EU loans to Greece, Portugal and Ireland cut to 3.5%, maturities on new & old loans extended from 7.5 to 15-30 years
* 10 year grace period on interest on new EU loans to Greece; the unpaid interest accumulates
* EU loan facility has the ability to buy sovereign debt in the secondary markets, including a plan to purchase 40 bn of Greek debt
(most likely including much of the Greek debt purchased by the ECB)
* EU loan facility has the ability to lend to countries (even those not in an IMF program) to recapitalize their banks
* Language (with no specifics) regarding the use of EU structural funds to boost growth in Greece
What the EU gets: more austerity, Maastricht with teeth (?) and private sector involvement in Greek debt rollover
* Legally binding national fiscal framework to be developed by end of 2012; fiscal deficits brought to 3% by 2013 at the latest
* Private sector involvement in Greek debt rollover, committed in principle by 30 financial institutions listed in the document released
by the Institute of International Finance; target participation rate of 90%; exchange appears to result in Selective Default credit rating
* Voluntary participation options include exchanging existing debt into 15 or 30 year bond with AAA-guarantees of principal. Bonds
exchanged at par will carry low coupons (4.25% effective), while bonds with higher coupons will be exchanged at a 20% discount
Source: Eurozone draft proposal July 21, 2011, IIF press release July 21, 2011
In addition to execution risk in Greece, we are left with
3 other concerns. First, while there’s enough in the EU-
IMF lending facility 4 to deal with problems in Greece,
Portugal and Ireland, if you include Spain, it gets tight
(note: the chart excludes costs to recapitalize banks). If
Italy or Belgium entered Europe’s Liquidity Hospital, a lot
more money might be needed from European parliaments
(in one worst-case scenario, Alliance Bernstein estimates
that the EU lending facility would have to increase from
440 bn to 1.7 trillion Euros, mostly from Germany). Italy
faces a multi-notch downgrade from Moody’s, which is
not going to help. As we discussed two weeks ago, Italy
has been a model citizen in terms of running low budget
deficits for 20 years, but still cannot escape the confines of
its very large existing debt stock (120% of GDP).
Limited capacity at the European Liquidity Hospital
Official sector lending capacity vs sovereignfunding needs (including
deficits) through 2013 - Billions, EUR
1,800
1,600
1,400
1,200
1,000
800
600
400
200
0
IMF
EFSF
Total lending
capacity
Greece package
EFSM
Greece,
Portugal, Ireland
Spain
Plus Spain
Belgium
Italy
Spain
Plus Italy and
Belgium
Possible sovereign borrowingneeds from official sources
Source: AllianceBernstein, Public Filings.
Second, as shown below, Europe is now a two-speed economy, with the periphery stuck in neutral (industrial production is one
proxy for this; there are others, such as unemployment, consumption, export shares, etc). If the idea behind the EU/IMF effort
is that austerity will boost growth and lead these countries back to the public markets, there is very little momentum in this
direction. If the status quo in the periphery does not change, all the EU package does is allow the current approach
more time to fail.
Industrial production
Index, 100 = January 2007
110
105
100
95
90
85
80
Germany
Europe
Periphery
75
2007 2008 2009 2010 2011
Source: INE, CSO, ISTAT, NSS, Eurostat, Bundesbank, J.P. Morgan
Securities LLC, J.P. Morgan Private Bank. Periphery = Portugal, Ireland, Italy,
Greece, Spain.
Unemployment rates - core vs. periphery
Percent, Peripheral rates weighted by population
18%
Greece, Ireland, Spain & Portugal
16%
14%
12%
10%
8%
6%
4%
2%
Germany
0%
1970 1975 1980 1985 1990 1995 2000 2005 2010
Source: J.P. Morgan Private Bank, Bank of Spain, Bank of Portugal, OECD,
CSO, NSS, Bundesbank.
4 The current EFSF lending capacity is Eur 255 bn, but we anticipate that as agreed, national parliaments will expand it to 440 bn.
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July 25, 2011
Topics: US debt ceiling negotiations, a more ambitious European bailout plan (finally), and how large cap growth stocks
and rising corporate profits are patiently waiting for both of them to end
The third concern: Germany as paymaster. We are often told that Germans across both major parties are unflinching
supporters of the European project, and will do whatever it takes to prevent a break-up. The objections from members of the
Bundesbank are described as lonely voices of opposition that carry no weight 5 . But how large are the costs going to be?
German politicians and voters may see current circumstances as exceptional, and that if they just agree to one more package, the
problem will go away. However, we are starting to see analyses of how costly a permanent transfer union may be for
Germany. Bernard Connolly at Hamiltonian Advisors sent me a recent paper from the Centrum fur Europaische Politik 6 in
Freiburg, which provides some clues. They see three alternatives for the deficit countries:
• massive reduction in regulations and unit labor costs to regain competitiveness
• exit from the EMU, re-introduction of national currencies
• permanent transfer union from surplus countries to deficit ones
On the last option, they estimate a “creditworthiness gap” in European deficit countries of Eur 108 billion in 2010. The gap
measures how much European deficit countries rely on capital inflows to fund consumption, rather than investment (which
contributes to future GDP). Germany’s share of the European surplus is around ¾, so let’s assume a pro-rata burden on
Germany to maintain the transfer union. As a result, the theoretical economic cost could be 3.3% of German GDP every year,
which as shown, gets close to some expensive episodes in German history. If German citizens were faced with costs this high,
it could be a White Castle hamburger-throwing moment of national proportions.
Cost to German taxpayers of major events
Percent of GDP, annual
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
Peak Versailles
reparations (1929)
Unification (since
1991)
Potential cost of EMU
transfer union
Source: Carl-Ludwig Holtfrerich, Halle Institute for Economic Research,
Zentrum fur Europaische Politik (Freiburg), J.P. Morgan Private Bank.
Europe equities, priced for the risks
Europe 10-yr trailing PE divided by US 10-yr trailing PE
1.25
1.15
1.05
0.95
0.85
0.75
0.65
1998 2000 2002 2004 2006 2008 2010
Source: Factset, MSCI.
Bottom line. At a time when European equities are trading close to 2009 lows relative to earnings and book value, this package
could result in a relief rally for European equities, particularly banks. The chance of a disorderly default in 2011 has decreased
markedly, and a process has been put in place to create more seamless transfers to areas (and banks) in need. But the size of the
transfer union fund is not big enough to allay all concerns, particularly with Spain and Italy growing at anemic levels, and there
is execution risk in Greece.
Recent bank stress tests conducted by the EU concluded that only Eur 2.5 billion of capital needs to be raised (70 to 80 billion
sounds more reasonable to us). And in the package announced last week, the following Orwellian clause indicates how
European policymakers feel about rating agencies these days:
Point 15. We agree that reliance on external credit ratings in the EU regulatory framework should be
reduced, taking into account the Commission's recent proposals in that direction, and we look forward to the
Commission proposals on credit ratings agencies
In Europe, denial appears to be an essential ingredient to the process (See “Five Stages of Greece”, June 30, 2011). Last
week’s package is a bold step towards Federalization and the worst-case outcomes have been avoided (money market
failures, bank runs, etc), but markets will remain nervous about Europe.
5 Bundesbank President Weidmann, in response to last week’s package: “By transferring significant risks to the support-giving countries and
their taxpayers, the Euro area has taken a large step to socialising risks created by unsound government finances and macroeconomic
problems. This weakens the foundations of the fiscal self-responsibility that EMU is built on”.
6 Centrum fur Europaische Politik, “Creditworthiness trends in European countries”, Lüder Gerken & Matthias Kullas, 2011
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July 25, 2011
Topics: US debt ceiling negotiations, a more ambitious European bailout plan (finally), and how large cap growth stocks
and rising corporate profits are patiently waiting for both of them to end
While we’re waiting: large cap growth stocks
One day, the melodramas around US and European sovereign debt will end. While we’re waiting, one of the asset classes that
looks attractive is large cap growth stocks. As shown below (for a universe of 300 U.S. large cap growth stocks that meet
certain earnings quality and stability factors), free cash flow relative to both revenues and stock prices looks good compared
to the last four decades. This is where we believe investors should be adding exposure if they are underweight versus their
desired equity allocations. This is also an asset class where active management can still provide a lot of value; the dispersion of
large cap growth managers is higher than large cap core, large cap value and international equity manager dispersion.
Q2 earnings season in the US is off to a good start. Nearly
30% of the S&P has reported, and results have generally been
positive. Earnings are beating consensus estimates by almost
4% (7.4% ex-financials), all ten sectors are beating on revenue
targets, and only 7% of companies are reporting belowconsensus
earnings. Given earnings expectations for 2011 at
$98.50, the S&P 500 is trading at a reasonable 13.5x forward
multiple. However, y/y earnings growth expectations appear
to be flattening out for both 2011 and 2012 at around 11%-
12%. While Q2 earnings are doing well so far, some company
guidance for the remainder of the year has been below
consensus, which would be consistent with the recent batch of
reports indicating a slowdown in manufacturing and service
sector surveys.
Michael Cembalest
Chief Investment Officer
Attractive valuations for US large cap growth stocks
Percent
9%
8%
7%
Nominal free cash yield
6%
5%
4%
3%
2%
1%
0%
-1%
Post-dividend free cash flow margin
-2%
'71 '74 '77 '80 '83 '86 '89 '92 '95 '98 '01 '04 '07 '10
Source: Empirical Research Partners.
CBO Congressional Budget Office
OMB Office of Management and Budget
EFSF European Financial Stability Facility
FICA Federal Insurance Contributions Act
EU European Union
IMF International Monetary Fund
IIF Institute of International Finance
ECB European Central Bank
EMU European Monetary Union
AMT Alternative Minimum Tax
A White Castle hamburger is smaller than its competitors’ offerings, measuring 2.5 inches square.
The material contained herein is intended as a general market commentary. Opinions expressed herein are those of Michael Cembalest and may differ from those of other 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
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