Public EyeNews and views impacting public funds

Economic Imbalances, Market OpportunitiesIt seems fitting that Godfrey Reggio’s Koyaanisqatsi would be enjoying a revival at New York’s Lincoln Center this season. The 1982 documentary film (roughly translated as “World Out of Balance”) is a 90-minute montage, showing continuous scenes of chaos and unrest from around the world—in other words, precisely the type of environment that financial markets have had to contend with for much of this year. Investors will remember 2011 for geopolitical upheaval in North Africa and the Middle East, a devastating natural disaster in Japan, inflation fears in China, congressional discord in the U.S. and endless twists and turns in Europe’s debt crisis. Volatility in equity markets is high and bond yields remain near historic lows. But while many of this year’s economic challenges are likely to remain with us into 2012, the uncertainty still presents opportunities from which investors can benefit.

“Every unhappy family is unhappy in its own way”The challenges that have been facing the global economy stem largely from two root causes: balance sheets and policy flexibility; the vulnerability of most of the major markets can be assessed according to their strength in these dimensions (see Exhibit 1 on next page).

Most vulnerable are the debtor countries that lack the ability to provide additional stimulus, either by monetary or fiscal means. This obviously describes the countries in the eurozone periphery and near-periphery, and with no fewer than six attempts made by European Union leaders to contain the euro crisis in 2011 alone (see Exhibit 2 on next page), this clearly remains the most urgent concern for global investors. The short-run task for Europe’s policymakers is to ensure that countries that have lost access to

I N T H I S I S S U E

Economic Imbalances, Market Opportunities Global markets strategist Ehiwario Efeyini sees a “world out of balance”, yet one in which economic imbalances may present selective investment opportunities across asset classes.

Unconstrained Havens In this “world turned upside down,” unconstrained fixed income portfolios may offer a diversifying compliment to core bond holdings and an opportunity to tap new sources of return.

Intermediate-term Outlook Our Global Multi-Asset Group offers its medium-term outlook for the economy and major asset classes, along with its current views on portfolio over- and under-weights.

The Global Cities Initiative JPMorgan Chase and the Brookings Institution join forces in an effort to support cities and local governments in developing and unleashing their economic potential.

F A L L 2 0 1 1 — W I N T E R 2 0 1 2

2 | Public Eye FALL 2011—WINTER 2012

Public Eye

the bond markets (Greece, Portugal and Ireland) can secure adequate funding; that countries that have maintained access (particularly Italy and Spain) continue to do so and that any losses are absorbed without unmanageable disruption to the financial system. But in the longer term, harmonization of one form or another will be needed to keep the currency union intact: weaker members will have to become more competitive and more productive, or some permanent mechanism of fiscal transfers will have to be agreed upon. In the interim, the potential for a slump in credit growth as banks suffer debt write-downs and try to recapitalize, makes for an uncomfortably high risk of a eurozone-wide recession.

Next are the debtor countries that do have some autonomy on the policy side, most notably the U.S. and the U.K. Household sector deleveraging has been the main drag on growth in these countries (Exhibit 3, on next page), but independent monetary authorities have been able to act as somewhat of an offset. The Federal Reserve and the Bank of England have each now imposed two rounds of quantitative easing, and more could follow in 2012 if unemployment fails to move lower. At this stage, a prolonged period of slow growth is more likely than outright recession for these markets, but a fiscal policy mistake remains the biggest risk. Unlike in Europe, bond markets have not forced fiscal consolidations in these countries, but a conservative political agenda has made deficit reduction the chosen course of action in the U.K., and has dominated the debate (both in Congress and among the electorate) in the U.S. If enacted, President Obama’s $447 billion jobs proposal would provide a net boost to 2012 GDP growth of around one percentage point (providing a bigger cushion against another downturn), but it remains unclear whether House Republicans will allow the bill to pass in full.

Creditor countries with hard or crawling exchange rate pegs—most notably China, but also other emerging Asian economies—have had the opposite problem: overheating. Consumer price inflation in China climbed steadily throughout the year, reaching a peak of 6.5% in July. But of more concern for investors now is the impact of the policy response. Following a string of five interest rate increases and 12 reserve requirement hikes, Chinese activity appears to have softened—particularly in fixed investment and housing construction—while bank lending growth has slowed significantly.

Economic Imbalances, Market Opportunities (continued)

Basi

s po

ints

0

100

200

300

400

500

600

700

800

900

1,000

1,100

Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12

Greece receives€110bn loan

EFSF and ECB bondpurchase programannounced First set of bank

stress testresults released

ECB extendsliquidity provisionPledge of “determined

and coordinated action”

€78bn support packagefor Portugal announced

Second set ofbank stress testresults released€85 billion

support packagefor Irelandannounced

€159bn EFSFand private sectorsupport packageannounced

ECB extends bondpurchases to Italyand Spain

50% Greek haircut,EFSF expansionand bank capitalraising plansannounced

Italian PM Berlusconipledges to resign

EXHIBIT 2: EUROPEAN SUPPORT MEASURES TAKEN SO FAR HAVE FAILED TO APPEASE BOND MARKETS

Source: Bloomberg, J.P. Morgan. Data as of October 27, 2011. *Equal-weighted average of Portugal, Ireland, Greece, Spain, Italy.

Eurozone periphery* spread to German 10-year government bond yield

Source: J.P. Morgan.

EXHIBIT 1: KOYAANISQATSI (WORLD OUT OF BALANCE)

Debtors Creditors

Economies Western Europe

U.S., U.K. China, EM Asia

Australia, Switzerland, Canada

Fiscal Flexibility?

No Limited Yes Yes

Monetary Autonomy?

No Yes Limited Yes

Main challenge(s)

Recession in periphery, fiscal solvency, banking system risk

Slow growth, high unemployment

Consumer price inflation

Exchange rate strength

More vulnerable Less vulnerable

J.P. Morgan Asset Management | 3

However, we would not overstate the extent of the slowdown in China. Consumer spending remains firm, the manufacturing PMI survey has returned to an above-50 level (Exhibit 4) and any deficiency in growth is likely to be met with more state-directed bank lending if necessary. Notwithstanding risks from the external environment, an inflation overshoot in China is therefore likely to remain the bigger threat than a shortfall in growth over the medium-term.

Finally, creditors with policy autonomy have seemed less vulnerable from an economic point of view, but have nonetheless had downward pressure placed on growth via either higher exchange rates or higher interest rates or both. Canada has raised interest rates three times over the last 18 months despite its close ties to the U.S., and despite the two countries’ synchronized rate cycles over recent years (Exhibit 5). Australia has seen its exchange rate soar to multi-decade

Source: Bureau of Economic Analysis, Federal Reserve, Office for National Statistics, J.P. Morgan. Data as of Q2 2011.

US$

(tri

llion

s)U

S$—

200

5 (t

rilli

ons)

£ (t

rilli

ons)

£—20

06

(tri

llion

s)

11

12

13

14

02 04 06 08 10 12

6

8

10

12

14

02 04 06 08 10 12

1.1

1.2

1.3

1.4

02 04 06 08 10 12

0.8

1.0

1.2

1.4

1.6

02 04 06 08 10 12

End of productionrecession

Ongoing balancesheet recession

Ongoing balancesheet recession

End of productionrecession

EXHIBIT 3: THE PRODUCTION RECESSIONS IN THE U.S. AND U.K. MAY HAVE ENDED, BUT THE ONGOING BALANCE SHEET RECESSIONS REMAIN A DRAG ON GROWTH

U.S. Real GDP

U.S. Household Debt

U.K. Real GDP

U.K. Household Debt

EXHIBIT 4: CHINA’S MANUFACTURING PURCHASING MANAGER’S INDEX HAS MOVED OUT OF CONTRACTION TERRITORY IN RECENT MONTHS

Source: CLSA, Markit, J.P. Morgan. Data as of October 2011.

Leve

l

35

40

45

50

55

60

2007 2008 2009 2010 2011 2012

Expansion

Contraction

Chinese manufacturing PMI

Rat

e (%

)

U.S. Canada

0

1

2

3

4

5

6

2005 2006 2007 2008 2009 2010 2011 2012

Source: Bloomberg, J.P. Morgan. Data as of October 2011.

EXHIBIT 5: DIVERGENT FUNDAMENTALS HAVE ALLOWED CANADA TO TIGHTEN AHEAD OF THE U.S. DESPITE HISTORICALLY SYNCHRONIZED RATE CYCLES

Nominal Central Bank Policy Rate

4 | Public Eye FALL 2011—WINTER 2012

Public Eye

highs, both against the U.S. dollar and on a trade-weighted basis. And Switzerland was forced to peg its franc to the euro in September following sharp upward moves in the currency.

With challenges, come opportunitiesAs unsettling as 2011 has been for investors and as uncertain as the outlook remains, we still see a number of investment opportunities in the current environment. With rate normalization by the major central banks moving further away (and further cuts looking more likely in the nearer term), we expect that today’s low yields can be sustained. We therefore see higher quality extended fixed income as a way for investors to gain additional income. Spreads on external emerging market and high yield debt are already priced near past recession wides, while U.S. corporate credit spreads are above their peaks of the 1990-1991 recession. And assuming, as we do, that another global recession can be avoided, returns could be boosted significantly by capital gains from spread narrowing.

For equities, the threat of a deeper crisis in Europe remains a major constraint on risk taking, keeping risk premiums high and limiting sustainable price gains. Without more clarity, capital appreciation may therefore remain scarce for the time being. However, equity strategies that offer high dividend yields and dividend growth pay investors to wait, while today’s depressed valuation levels offer an attractive starting point for longer-term returns.

In addition, alternative assets can capture key economic trends while dampening overall portfolio volatility and offering less correlated sources of return. Commodities, for example, benefit from strong economic growth in the emerging economies without the high correlation to global stock markets of emerging market equity and debt. Further, the likelihood of more rounds of monetary easing from the major central banks could lead to rising expectations for global inflation and may therefore also favor real return assets. Breakeven rates in inflation-linked fixed income markets in the U.S. and Europe, for example, remain below historical norms, making entry points for these bonds relatively attractive.

— Ehiwario Efeyini Global Markets Strategist

Unconstrained HavensThe fixed income markets over the past year are a world turned upside down. Once considered a safe asset—sovereign debt, including that issued by the U.S.—looks a lot riskier, and risky assets—emerging market and high yield debt—look a lot safer. The dramatic changes call into question the most basic precepts of fixed income investing—not least, the efficacy of benchmark-constrained investing.

In the current environment, the standard benchmark for U.S. fixed income investors, the Barclays U.S. Aggregate Bond Index, falls short in three respects:

• It may be excessively concentrated.

• Tracking the index’s duration in a volatile environment may add an unacceptable level of interest rate risk.

• Limiting portfolios to debt matching the index’s sector composition limits the opportunity set.

A government index?In the Aggregate’s early years, the widely varied corporate sector constituted roughly 40% of the Index, making it the largest single representation. Today, corporates account for less than 20%. The Aggregate’s big gainer has been mortgage-backed securities. When the index first came out, mortgage-backeds constituted less than 10% of the index. Now they rank alongside Treasuries as its largest component. Since the housing crash decimated the privately issued asset-backed market, the government mortgage finance agencies Fannie Mae and Freddie Mac have stepped into the breach.

But the two government-sponsored enterprises depend on explicit government guarantees themselves. All this now means that two sectors, mortgage-backeds and Treasuries, and one issuer, the U.S. government, comprise more than 80% of the benchmark. Even allowing for the fact the U.S. government debt market functions as the world’s deepest and most liquid, this seems a heavy weight to bear.

Economic Imbalances, Market Opportunities (continued)

J.P. Morgan Asset Management | 5

Duration handcuffsThe typical benchmark-oriented portfolio tends to hold duration within a narrow band calibrated to the benchmark itself. That narrow band may be yoking the portfolio to largely avoidable risk. After a 30-year decline culminating in near-zero policy rates, the intermediate-term risks of rate increases and corresponding bond price declines now appear greater than prospects for a resurgence in values. An unconstrained manager can seek to contain these risks.

Our unconstrained portfolios, by way of example, can shrink duration down to zero or stretch it out to nine years. So not only can they hedge the risk of rising rates, they can extend duration exposure when circumstances warrant.

Outside the box

High yield bonds amount to 25% of all corporate issuance today (Exhibit 6). Profitability has so far managed to buck the macroeconomic headwinds, defaults have fallen and high-yield issuers have taken advantage of rock-bottom interest rates to fortify their balance sheets. Even so, spreads between high yield and Treasuries have stayed at levels that imply recessionary-magnitude defaults and offer substantial incremental income potential as a result.

The emerging markets have emerged as another source of non-Agg diversification. Over the past decade they have become increasingly creditworthy borrowers. Their current account surpluses are propping up their currencies, giving foreign investors the added return of monetary appreciation. Along with strengthened finances, their governance, both public and private, is becoming more transparent and aligned with developed market standards.

Alongside the structural improvements, the emerging markets are benefiting from cyclical tailwinds. While the developed markets are struggling against recessionary headwinds, they are booming, powered by the rapid expansion of their middle class.

Uncorrelated to the core

Decoupling from the Aggregate benchmark opens a portfolio to a broad spectrum fixed income gains—not only from the emerging market and high yield sectors, but from foreign exchange, illiquid securities and convertible and preferred stock. It also opens the portfolio to volatility from these sources. Bear in mind, however, that unconstrained portfolios do not seek to neutralize risk altogether but rather to deploy it to realize more return per unit of risk, a goal that they have achieved historically.

We view unconstrained portfolios as a diversifying complement to a core holding. Benchmark-tracking portfolios have provided vital diversification in a time of almost unprecedented equity volatility. An unconstrained holding adds yet another dimension of diversification that can moderate duration exposures and tap new sources of return for an asset class that has proven itself a robust “anchor to windward” in exceedingly stormy seas.

— Richard Oswald Head of Product Development, New York-London-Asia Fixed Income

US$

(bill

ions

)

0

200

400

600

800

1,000

1,200

1,400

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

200

020

01

200

220

03

200

420

05

200

620

07

200

820

09

2010

2011

EXHIBIT 6: COMING OF AGE—U.S. HIGH YIELD IS A MAJOR AND LIQUID MARKET TODAY

Source: Source: Federal Reserve, Altman/NYU, S&P LCD. Some data available on a quarterly lag

The charts and/or graphs shown above and throughout the presentation are for illustration and discussion purposes only.

Size of high yield market—1987–3Q11

6 | Public Eye FALL 2011—WINTER 2012

Public Eye

Source: J.P. Morgan Asset Management Global Multi-Asset Group.

The Asset Allocation table reflects the positions adopted by J.P. Morgan Global Multi Asset Group’s strategy team as of October 31, 2011.

Large Underweight Underweight Neutral Overweight Large OverweightAs of October 31, 2011

STOCKS VS. BONDS Equity Bonds (includes cash)

EQUITY COMPONENTS U.S. Large Cap U.S. Small Cap Global REITs International Developed Equity

UK Europe ex UK Japan Australia Hong Kong Canada

Emerging Markets

FIXED INCOME COMPONENTS Core Fixed Income High Yield Emerging Markets Fixed Income Duration

PORTFOLIO VIEWSJ.P. Morgan Asset Management Global Multi-Asset Group

Global Multi-Asset Group—Intermediate-term outlookOur Global Multi-Asset Group blends its capital markets, strategic and tactical asset allocation, portfolio construction and risk budgeting capabilities, together with our broad product offerings, to develop and implement optimal portfolio solutions for public pension plans and other institutional as well as individual investors. The following summarizes the Group’s intermediate-term outlook across asset classes, as of October 31, 2011. The underweights and overweights in the Portfolio Views table below reflect GMAG’s overall views in managing

global balanced portfolios as of that date.

• Macro outlook: Continued deleveraging is acting as a secular headwind, but there are signs of renewed strength in the U.S. economy. Policy stimulus is still needed in Europe and perhaps the U.S., otherwise this could remain a challenging environment for risk assets.

• Government bonds: Yields could remain lower for longer, helped by deleveraging and risk aversion. Systemic risks in

Europe remain a concern; the contagion effects of a Greek default are not fully priced into other peripheral markets.

• Credit: Expect high yield to continue to deliver attractive risk-adjusted returns given the strong free cash flow and low default rates. Relative to history, emerging market debt appears somewhat expensive but we remain comfortable with its credit quality. Any slowdown in the emerging markets could provide future opportunities to add.

• Equities: A growing positive gap between dividend yields and bond yields is noteworthy. There are growing risks to the earnings cycle but valuations are attractive barring a severe recession, which is not our central case.

• Real Assets: Real estate fundamentals continue to improve. U.S. REITs, while not absolutely cheap, are trading at a discount to their NAV, so value is improving relative to private markets. Gold should continue to be in demand due to current systemic risks.

• Currencies: The re-appearance of systemic risk and the potential risk of a recession in Europe continue to be significant negatives. At the margin, this backdrop favors the U.S. dollar.

J.P. Morgan Asset Management | 7

The Global Cities Initiative—Supporting the economic growth of America’s citiesBeyond our commitment to work with public plans and provide them with innovative pension investment solutions, JPMorgan Chase is focused on doing the right thing to help improve the nation’s economic health.

Reflecting our conviction that helping the nation means supporting our city and local governments in developing and unleashing their economic potential, the firm recently announced that it will give $10 million to the Brookings Institution to underwrite the Global Cities Initiative, a Joint Project of Brookings and JPMorgan Chase, to be chaired by former Chicago Mayor Richard M. Daley, a senior advisor to the firm.

“Our nation’s cities hold incredible, untapped potential for economic growth and job creation,” said JPMorgan Chase CEO and Chairman Jamie Dimon. “We need to put capital and knowledge to work in partnership with local governments and businesses so that cities can invest in the kind of 21st century infrastructure and export capabilities they need to compete and win in today’s global economy.”

The Global Cities Initiative will focus on the 100 largest U.S. metropolitan areas, marrying JPMorgan’s long-standing commitment to investing in our cities, states and localities with Brookings’ recognized expertise and extensive metro-focused research. Bruce Katz, Vice President and Founding Director of the Brookings Metropolitan Policy Program, notes local leaders often lack the data critical for making informed decisions on business investments and regulatory policies. “We will be able to provide a city-by-city overview of the key metrics for economic development and help leaders retool their industries to be better prepared to compete in the global market,” said Katz, who will direct the project at the Brookings Institution.

As chairman of the initiative, Richard M. Daley brings a wealth of experience both from his 22-year tenure as mayor of Chicago as well as his leadership activities through the Richard J. Daley Global Cities Forum (a forum, named for his father, established for the discussion of urban challenges and solutions among municipal leaders around the world).

Findings from the Global Cities Initiative will serve as a platform for a series of annual conferences (three U.S. regional and one international) to help promote the exchange of ideas and best practices for regional economic growth. This work will provide U.S. metropolitan leaders with tangible ideas for how to expand their competitive position globally and domestically, building on policy and practice innovations from across the nation and around the world.

For more information on the Global Cities Initiative visit: jpmorganchase.com or brookings.edu.

Note:

Former Mayor Daley, the Brookings Institution and its representatives and the Global Cities Initiative will not solicit business on behalf of JPMorgan Chase or its affiliates.

About the Brookings Institution

The Brookings Institution is a private nonprofit organization devoted to independent research and innovative policy solutions. For more than 90 years, Brookings has analyzed current and emerging issues and produced new ideas that matter—for the nation and the world. The Metropolitan Policy Program at Brookings provides decision-makers with cutting-edge research and policy ideas for improving the health and prosperity of metropolitan America.

LATEST PUBLICATIONS

• Generating Income in a Low Yield Environment

• Mortgage Refinancing Initiatives—Implications for the MBS market

• Price/Earnings Investing: One picture requires a thousand words

To access our recent publications and thought leadership, please visit us at jpmorgan.com/institutional. To request a hard copy, please contact your J.P. Morgan representative.

Generating Income in a Low-Yield EnvironmentOctober 2011

FOR INSTITUTIONAL AND PROFESSIONAL INVESTOR USE ONLY | NOT FOR RETAIL USE OR DISTRIBUTION

The coming years present an extraordinary challenge for policymakers and investors. Governments across many developed markets are trying to rein in multi-decade high budget deficits and debt-to-GDP ratios, their hands forced to a degree by credit-rating agencies (indeed, debt-related concerns pushed Standard & Poor’s to downgrade the U.S. long-term sovereign rating for the first time in history in August).

IN BRIEFIn this “low for long” rate environment, generating income remains a challenge for investors who need to maintain portfolio yields. However, certain market dynamics are creating opportunities to pick up yields across a range of

asset classes.• A recovering economy and low default rates make the

risk/reward trade-offs for high yield debt and leveraged loans potentially attractive.

• Strong corporate balance sheets are creating equity income opportunities as companies look to increase dividends.• As market volatility makes it more expensive and

difficult to access traditional financing, investors can find higher yields in other fixed income sectors, such as mezzanine debt.

• Given the current recovery in property values, fundamentals and cash flow, real assets and REITs are generating attractive and stable yields with the potential for equity-like upside through measured growth in payouts.

jpmorgan.com/institutional

Public Eye

This material is intended to report solely on the investment strategies and opportunities identified by J.P. Morgan Asset Management. Opinions and estimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. J.P. Morgan Asset Management and/or its affiliates and employees may hold a position or act as market maker in the finan-cial instruments of any issuer discussed herein or act as underwriter, placement agent, advisor or lender to such issuer. The investments and strategies discussed herein may not be suitable for all investors. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommenda-tions. Changes in rates of exchange may have an adverse effect on the value, price or income of investments.

Securities rated below investment grade are called “high-yield bonds,” “non-investment-grade bonds,” “below investment-grade bonds” or “junk bonds.” They generally are rated in the fifth or lower rating categories of Standard & Poor’s and Moody’s Investors Service. Although these securities tend to provide higher yields than higher rated securities, there is a greater risk.

International investing involves a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in accounting and taxation policies outside the U.S. can raise or lower returns. Also, some overseas markets may not be as politically and economically stable as the United States and other nations. Investments in emerging markets can be more volatile.

The price of equity securities may rise or fall because of changes in the broad market or changes in a company’s financial condition, sometimes rapidly or unpredictably. These price movements may result from factors affecting individual companies, sectors or industries or the securities market as a whole, such as changes in economic or political conditions. Equity securities are subject to “stock market risk” meaning that stock prices in general may decline over short or extended periods of time.

The value of real estate securities in general, and REITs in particular, are subject to the same risks as direct investments in real estate and mortgages, and their value will depend on the value of the underlying properties or the underlying loans or interests. The underlying loans may be subject to the risks of default or of prepayments that occur earlier or later than expected, and such loans may also include so-called “subprime” mortgages. The value of these securities will rise and fall in response to many factors, including economic conditions, the demand for rental property, interest rates and, with respect to REITs, the management skill and creditworthiness of the issuer. In particular, the value of these securities may decline when interest rates rise and will also be affected by the real estate market and by the management of the underlying properties. REITs may be more volatile and/or more illiquid than other types of equity securities.

The opinions expressed in this report are those held by the authors at the time of going to print. The views expressed herein are not to be taken as advice or recom-mendations to sell or buy shares. Our consensus estimates may differ from other publicly available sources due to our selection criteria. This material should not be relied on as including sufficient information to support an investment decision.J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide.

J.P.MorganAssetManagement•270ParkAvenue,NewYork,NY10017

© 2011 JPMorgan Chase & Co. All rights reserved.

FOR PUBLIC FUND SOLUTIONS, PLEASE CONTACT

Joel Damon Client AdvisorTel: 415-315-5246joel.v.damon@jpmorgan.com

We welcome your feedback. Your suggestions for future topics and ideas on how to enhance the newsletter are most welcome. Please e-mail us at jpmam.info@jpmorgan.com.

Come visit us at these 2012 Industry Conferences

March CALAPRS General Assembly

FPPTA NYSE Trip

April CII Spring Meeting

May NCPERS Annual Conference

SACRS Spring Meeting

MAPERS Spring Conference

SCTR Conference

June NASP Annual Conference

FPPTA Annual Conference