Public EyeNews and views impacting public funds

The Tide of ExpansionSo far, 2011 has delivered more than its fair share of shocks and disruptions to the global economy. Most dramatic of course, were the terrible earthquake and tsunami in Japan. However, equally important for markets have been the ongoing inability of Europe to get past the debt problems in peripheral countries and rising oil prices triggered by revolutions in North Africa.

Despite all of this, both the U.S. and global economies have continued to grow. The financial markets have reflected this growth with the S&P 500 posting a very healthy 5.9% total return in the first quarter, accompanied by solid gains in small cap stocks, international stocks, commodities and other riskier assets.

Going forward, however, the basic question remains: Is the tide of U.S. and global expansion really strong enough to withstand these and other shocks? Also, with commodity prices on the rise and central banks turning more hawkish, what is the danger of more widespread inflation and higher interest rates and how should investors protect themselves against these dangers?

The U.S. expansion—still on trackIn the United States, the economy seems to have weathered the first quarter in solid, if uninspiring, fashion. Consumer confidence has taken a hit from higher oil prices and this, combined with a moribund housing market and only small gains in business investment spending, appears to have held first-quarter economic growth to a slower pace than many expected at the start of the year. However, even with this, there are good reasons to believe that growth will pick up for the rest of 2011. These reasons include pent-up demand, particularly in the household sector, reduced debt-service costs in an environment of low interest rates, and still significant federal government stimulus.

I n t h I s I s s u e

the tide of expansion Dr. David Kelly, Chief Market Strategist, J.P. Morgan Funds gives his views on the economic recovery and explains the implications for investment strategy.

GAsB timeline Stay on top of upcoming dates related to the GASB Exposure Draft.

Bank Loans: Attracting Attention and Considerable Investment from traditional Institutional Investors A primer on bank loans and their ability to mitigate the risk of rising rates while delivering an attractive yield.

From Mandate to Partnership What are “Strategic Partnerships” and why are they being embraced by institutional plans?

s P r I n G — s u M M e r 2 0 1 1

2 | Public Eye SPriNG—SUMMEr 2011

Public Eye

The jobs numbers have been a bit more encouraging than economic growth numbers recently with the unemployment rate falling from 9.8% in November to 9.0% in April, and gains of roughly 250,000 jobs per month on average in February, March and April as compared to 130,000 per month on average for November, December and January. (See Exhibits 1 and 2) However, it should be noted that at the current pace it will take roughly another three years to replace the rest of the jobs lost in the last recession and four years to drive the unemployment rate back down to a “full-employment” rate of 5%.

The profit picture is much stronger with corporate profits, by various measures, close to or above record highs. The current environment of just moderate economic growth is actually boosting profits as it is providing some revenue growth while still allowing companies to take advantage of low interest rates, breaks on corporate taxes and slow-growing wages.

Inflation still remains low in the United States. However, there are increasing signs that we are now past the lowest inflation rates for the cycle, as sharply higher global food and oil prices and an increase in rental costs in the United States boost prices.

With all of this as a backdrop, the Federal Reserve is set to end its Treasury bond buying program (known as “QE2”) at the end of June, and possibly to begin to raise the federal funds rate before the end of late this year—both of which are moves that could push long-term interest rates higher.

An out-of-sync worldEconomic conditions also continue to improve outside of the United States, although the uneven pace of this improvement is causing problems. In Europe, strong growth in Germany and rising inflation expectations among consumers led the European Central Bank to raise interest rates in April, despite a close to 10% unemployment rate across the Eurozone and continued severe fiscal problems in countries like Ireland, Greece and Portugal. In Japan, while the severe economic disruption caused by the March 11th earthquake and tsunami could cause GDP to fall in the second quarter, rebuilding efforts should lead to above-average economic growth later this year. However, given Japan’s already enormous public debt, paying for all of this could, in a worst-case scenario, push Japan to the brink of a fiscal crisis.

Growth continues to be strong in China, India, Brazil and other emerging markets. However, all of these countries are grappling with rising inflation and there is a distinct danger that many of them will not have the discipline to impose the higher taxes, higher interest rates or higher exchange rates necessary to cool their economies. Indeed, as is shown in Exhibit 3, many emerging market economies are maintaining short-term interest rates that are below their inflation rates—a clear sign of a very easy monetary policy.

exhIBIt 1: CIvILIAn uneMPLoyMent rAte

Source: BLS, J.P. Morgan Asset Management. Data are as of 4/30/2011.

3

4

5

6

7

8

9

11

10

12

Perc

ent

01/1

2/19

6001

/02/

1963

01/0

4/19

6501

/06/

1967

01/0

8/19

6901

/10/

1971

01/1

2/19

73

01/0

2/19

7601

/04/

1978

01/0

6/19

80

01/0

8/19

8201

/10/

1984

01/1

2/19

8601

/02/

1989

01/0

4/19

9101

/06/

1993

01/0

8/19

9501

/10/

1997

01/1

2/19

99

01/0

2/20

0201

/04/

2004

01/0

6/20

0601

/08/

2008

01/1

0/20

10

50-yr. Avg: 6.0%

April 2011: 9.0%

exhIBIt 2: eMPLoyMent—totAL PrIvAte PAyroLL

Source: BLS, J.P. Morgan Asset Management. Data are as of 4/30/2011.

-1,000

-800

-600

-400

-200

0

400

200

Tota

l job

gai

n/lo

ss (t

hous

ands

)

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

8.8mm jobs lost

2.1mmjobsgained

The Tide of Expansion (continued)

J.P. Morgan Asset Management | 3

investment implicationsSo what does all of this mean for investors? Overall, perhaps the most important thing to recognize is not the shocks and disruptions which are impacting the global economy but rather the very conservative stance of consumers, companies and investors at the start of 2011.

Because consumers have been paying down debt, increasing their savings and postponing big-ticket purchases, they are very well positioned to increase their spending this year—even in the face of some disruption. Because companies have been holding off hiring, spending on new technology or increasing their dividends, they are very well positioned to put money into the economy this year—even in an environment of uncertainty. And because investors have steadily added to their bond

holdings over the last three years, they are well able to reallocate more money towards stocks this year—even while they remain skeptical about the global expansion. (Exhibit 4)

So far this year, this movement back to balance has been the dominant theme and, if it continues to be, then valuation measures clearly show where the best opportunities lie:

Overall, stocks continue to look cheap, with the S&P 500 •ending the first quarter at a relatively low 13.1 times the expected earnings for the next 12 months. This looks particularly attractive at a time of lower-than-average inflation, interest rates and taxes on dividends and capital gains, all of which would argue for above-average P/E ratios. Within the stock market, large-cap stocks look particularly cheap as their small-cap counterparts have experienced an even stronger rally over the past two years.

In the bond market, a 30-year rally in Treasuries has left •long-term rates at very low levels and with continued strong supply (courtesy of budget deficits) and less demand (following the end of QE2), Treasury rates seem set to rise. High Yield and municipal bonds look more attractive, however, as their current spreads to Treasuries seem to more than compensate for expected losses from defaults.

International stocks also generally look attractive, although •investors should be wary of the hottest of emerging markets where rising inflation could eventually cause very sharp monetary tightening.

Commodities and real estate should also benefit from a •growing global economy.

exhIBIt 3: Country LeveL MonetAry PoLICy And InFLAtIon

Source: J.P. Morgan Global Economics Research, J.P. Morgan Asset Management. Key policy rates are the short-term target interest rates set by central banks. Inflation rates shown represent year-over-year quarterly rates for 1Q11. Real policy rates are short-term target interest rates set by central banks minus year-over-year inflation. Data are as of 3/31/2011.

-6

-3

0

3

9

6

12

Perc

ent

U.K

.

Ho

ng

Kong

Can

ada

Euro

are

a

U.S

.

Jap

an

Aust

rali

a

Developed Markets Emerging Markets

Rus

sia

Ind

ia

Arg

enti

na

Turk

ey

Kore

a

Thai

land

Mex

ico

Ind

one

sia

Taiw

an

Pola

nd

Chin

a

Sout

h A

fric

a

Braz

il

Target policy rate Real policy rateInflation rate

exhIBIt 4: dIFFerenCe Between FLows Into stoCk And Bond Funds

Source: Investment Company Institute, J.P. Morgan Asset Management. Data include flows through February 2011 and exclude ETFs. ICI data are subject to periodic revisions. World equity flows are inclusive of emerging market, global equity and regional equity flows. Hybrid flows include asset allocation, balanced fund, flexible portfolio and mixed income flows. Data are as of 3/31/2011.

80

60

40

20

0

20

40

Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10

Equity flows exceeded bond flows by $5 billion in Feb. 2011

Jul 10 Jan 11

Billi

ons,

USD

, U

.S. a

nd in

tern

atio

nal f

unds

, mon

thly

4 | Public Eye SPriNG—SUMMEr 2011

Public Eye

Overall, the most important message from the first quarter, is to have both a balanced view of the world and a balanced portfolio to match. We don’t know what further shocks are lurking to disrupt both the economy and financial markets in the rest of 2011. We do know, however, that even over the last few very turbulent years, investors who stayed balanced and diversified experienced far better outcomes than those who bought into euphoria in the top and despair at the bottom. Very likely the same will apply in the hopefully brighter years ahead.

— David Kelly Chief Market Strategist, J.P. Morgan Funds

Upcoming Dates related to the GASB Exposure DraftOn June 16, the Governmental Accounting Standards Board (GASB) issued its Preliminary Views on Pension Accounting and Financial Reporting by Employers, providing its thoughts on how the effectiveness of the existing pension standards for state and local governments could be improved. The deadline for submitting input regarding the GASB Preliminary Views was September 17, 2010 and public hearings were conducted in Dallas, San Francisco and New York City throughout the month of October 2010.

Although the comment period for the Preliminary Views has closed, the comment period for the Exposure Draft will begin during June 2011. Any individual or organization that wishes to provide a written response to the GASB documents for public comment is encouraged to do so. Follow the instructions provided in the Request for Written Comments section of the downloadable document, which will be posted in the “Due Process” section of www.gasb.org.

June 2011 GASB will issue their Exposure Draft

September 2011 End of comment period and field testing of Exposure Draft

November 2011 Public hearings of Exposure Draft

June 2012 GASB will issue their Final Statement on employer and plan Pension Accounting and Financial Reporting.

The GASB expressed preliminary views about the following accounting and financial reporting issues related to pension benefits provided by government employers to their employees:

How pension benefits are earned, what entity is responsible •for the obligation, and whether the obligation would be reported as a liability

How a pension liability would be measured, such as:•

whether projected future salary increases, years of future –employment, and cost-of-living adjustments would be included in projections of benefit payments

what interest rate to use to discount projected benefit –payments to calculate the present value of the future payments

how to systematically attribute the present value to –specific periods for financial reporting

When to report expenses related to year-to-year changes in •a pension liability deriving from employees earning benefits, interest on the liability, differences between assumed and actual economic and demographic changes, selection of new assumptions, changes in pension plan terms that affect benefits earned in prior years, and increases and decreases in the value of a pension plan’s net assets

How a government in a cost-sharing multiple-employer •pension plan would report a liability related to its proportionate share of the cumulative unfunded liability of all participating governments

The frequency and timing of actuarial valuations conducted •to produce the data needed for pension accounting and financial reporting

Please continue to be involved in the process to make sure your plan’s views are heard.

— Source: www.gasb.org Preliminary Views, Pension Accounting and Financial Reporting for Employers Fact Sheet

The Tide of Expansion (continued)

J.P. Morgan Asset Management | 5

Bank Loans: Attracting Attention and Considerable investment from Traditional institutional investorsBank loans are justifiably earning an increasing amount of attention and investment among the traditional institutional investor base. This article describes the compelling attributes of bank loans and the rationale behind their increasing appeal, including:

Mitigation of interest rate (inflation) risk•

Enhanced portfolio diversification•

Collateral that provides downside protection relative to •unsecured debt

Seniority within the capital structure•

Lower volatility relative to high yield bonds•

Strong fundamentals •

Attractive risk/reward proposition•

Market OverviewBank loans (also known as leveraged loans) are loans made to businesses with generally below investment grade credit ratings. They are typically senior instruments, secured by the debtor’s assets. They rank first in priority of payment in the capital structure, ahead of unsecured debt. As a result of their senior secured status, bank loans have historically had lower default rates, higher recovery rates and lower volatility relative to corporate high yield bonds.

Bank loans typically pay a cash coupon that resets in accordance with changes in short-term interest rates, primarily LIBOR. This floating rate coupon mitigates the risk of rising interest rates. A standard bank loan coupon is LIBOR (“L”) plus a spread expressed in basis points. For example, L+325 or LIBOR plus 3.25%. Given the current historically low levels of LIBOR, new issuances of bank loans have a LIBOR floor that often ranges from 100-200 basis points.

Below are market statistics from the Credit Suisse Leveraged Loan Index as of March 31, 2011. The current pricing of the bank loan market presents favorable risk/reward characteristics as part of a diversified portfolio when considered together with the interest-rate risk mitigation and downside protection properties of the market.

Average Price (Excluding Defaults) 96.77

Average Coupon 4.28%

Discount Margin to Maturity 516 bps

Please note that bank loans typically possess limited call protection, if any. Accordingly, it is unusual for a loan to trade substantially above par.

The bank loan trading market is a large liquid market comparable in size to the high yield bond market. Prior to the recent financial crisis, highly levered investors such as

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Portfolio 2011: A Compendium of Investment •Perspectives from J.P. Morgan Asset Management

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.

sAMPLe CAPItAL struCture1

Senior Secured Loan

Preferred equity

Common equity

High yield bonds and/or subordinated

mezzanine debt

30-50%

20-30%

20-40%First Loss

% o

f tot

al c

apita

lizat

ion

Senior Secured Loans

70.7%

43.2%

High Yield Bonds

Source: Credit Suisse 1 This sample capital structure does not describe any particular company.

Regime ChangeImplications of macro shifts on asset class and portfolio performance

FOR INSTITUTIONAL USE ONLY | NOT FOR PUBLIC DISTRIBUTION

G L O B A L S T R A T E G I C R E S E A R C H

6 | Public Eye SPriNG—SUMMEr 2011

Public Eye

collateralized loan obligations (CLOs) and hedge funds were prominent market participants. These over-levered vehicles were generally obliged to de-lever during the financial crisis. This de-levering was often accomplished through the hurried disposition of portfolios thereby creating poor market technicals and significantly contributing to the uncharacteristic market volatility and dramatic mark-to-market price

fluctuations experienced during the financial crisis. Today, the bank loan market has considerably less explicit leverage and strong technicals, driven by the increasing presence of traditional un-levered institutional investors and the diminished prominence of highly levered investors.

investor appealIn an environment rife with inflationary fears, it is not surprising that many investors are turning to bank loans to mitigate the risk of rising interest rates. In addition, as previously noted, bank loans offer other attractive attributes such as enhanced portfolio diversification, collateral that provides downside protection relative to unsecured debt, seniority within the capital structure, lower volatility relative to high yield bonds, strong fundamentals and an attractive risk/reward proposition. Likely as a result of these positive attributes, bank loan funds have experienced extremely strong in-flows recently.

How J.P. Morgan Asset Management invests in bank loans2

At J.P. Morgan Asset Management, we utilize fundamental research to build a diversified portfolio of leveraged loans through both the primary and secondary bank loan market. Our investment strategy is to take specific, targeted credit risk when our analysis indicates a favorable risk/reward opportunity, while

building a core of improving credits. Our assessment of risk/reward is derived from our analysis of the underlying fundamentals and circumstances of each issuer as well as the specific properties of each loan, including covenants, collateral and placement in the capital structure. Please contact your client advisor for more detailed information on our strategies.

— William J. Morgan Managing Director, Portfolio Manager, Columbus High Yield

— James P. Shanahan Managing Director, Portfolio Manager, Columbus High Yield

— Cory L. Pollock Vice President, Portfolio Manager, Columbus High Yield

— Jon J. Salstrom, CFA® Vice President, Client Portfolio Manager, Columbus High Yield

From Mandate to PartnershipCross asset class mandates take a giant step toward holistic solutionsInterest in cross asset class mandates covering both traditional and alternative assets has been growing among both public and private pension funds over the past several years. The term itself—cross asset class mandate—can apply to a number of assignments with a single feature in common: the plan sponsor awards an asset manager broad discretion to deploy capital, not only within a particular asset class but across a range of investments to achieve a specified objective. The objective can range from identifying best investment ideas irrespective of asset class to assembling alternative investment portfolios to keeping pace with liabilities.

J.P. Morgan Asset Management’s Global Multi-Asset Group (GMAG) has managed cross asset class mandates since the mid 1990s when smaller plans first started outsourcing investment decision making. However, interest really grew in the Post-Tech-Bubble environment as plan sponsors sought diversification away from equity volatility. Institutional investors began to ease restrictions on conventional asset managers, relaxing their long-only mandates so that their equity managers could short stocks and permitting fixed income managers to trade in below-investment-grade and emerging markets. The opportunity set expanded in alternatives as well as public markets, but the

Bank Loans: Attracting Attention and Considerable investment from Traditional institutional investors (continued)

2 FOR QUALIFIED INVESTORS ONLY. The information above has been prepared for investors who qualify to invest in the types of investments described herein. Generally they would include investors who are “qualified purchasers” as defined in the Investment Company Act of 1940, as amended, and “accredited investors” as defined in the Securities Act of 1933, as amended. This information may not be reproduced or used as sales literature with members of the general public.

J.P. Morgan Asset Management | 7

uncertainty about correlations and downside risk also increased. In response, plan sponsors sought managers with the skills required to exploit the full extent of opportunity in market dislocations and asset and risk mispricings.

Crash courseWhile some plan sponsors were moving toward multi-asset class mandates, most still oversaw portfolios from individual asset class silos. They typically hired consultants to track separate allocations and monitor market risk exposures, leaving overall portfolio positioning to a relatively inflexible strategic policy. This static approach made for rigid allocations and management structures that inhibited timely decision making. The crisis of 2008-09 and the subsequent recovery exposed a flaw in the model. In many cases, the strategic allocations did not work as advertised and portfolios failed to perform as modeled when correlations converged in the downturn. Worse, institutional investors who hunkered down and reduced their risk exposures were caught off guard during the subsequent V-shaped rebound in assets like credit and equities.

The frustrations in being fully exposed to the down leg of the cycle and missing out on the upside has prompted a new focus. Jeff Geller, GMAG’s CIO, explains. “Of course, clients are looking to improve their returns, but that’s not all they’re looking for today. They want to use the cross asset mandate to become smarter, more decisive investors themselves.” Institutional investors employ the cross asset class mandate to reconcile complexity and volatility and overcome budget and staffing constraints. Just as they rely on the asset manager’s infrastructure to supplement their own, they count on the manager’s depth of knowledge to capture the upside and its breadth of product to diversify their portfolios and limit the potential downside. In short, John Ide, a senior J.P. Morgan Asset Management client advisor, observes, “clients expect the cross asset class manager to deliver the firm.”

Seeing the world through a client’s eyes“At their best, these capabilities combine deep, boutique-like insight at the asset class level with a dedicated portfolio construction team proficient in fitting together customized solutions,” says GMAG’s Pat Jakobson. “In effect, the managers aren’t sitting across the table from the investment committee. They’re sitting alongside, extending the capabilities of the committee’s CIO,” says Jakobson. “The committee comes away

with a better understanding of a manager’s allocation decisions and a closeup look at the opportunities the manager is seeing.” The collaboration gives sponsors a real-time, real world view of the markets and it puts a manager’s best thinking at their disposal. Two examples from the recent past show how this can translate into both tactical and strategic benefits:

Tactically,• cross asset class managers, looking over the shoulder of fixed income traders around the world, could assess first hand the magnitude and timing of the current credit rally. Many global tactical asset allocation models spotted the fundamental credit mispricing long before the rally took place. Cross asset class managers added a qualitative dimension to the quantitative analysis. They had a surer handle on liquidity conditions and a clearer idea of when prices had reached the inflection point and how explosive the rally was likely to be.

Strategically, • cross asset class managers had access to a variety of ways to participate in the rally that gave their clients greater diversification and a more favorable combination of risk and return than the off-the-shelf Barclays Aggregate “remedy”: high yield bonds, emerging market debt and senior secured bank loans to name a few.

Top down meets bottom upIf the integrated global investment platform provides the framework for strategic relationships, a dedicated team that combines global and macro portfolio perspective with bottom up market intelligence provides the engine that makes them run. The strong team not only collects the global firm’s best ideas, it has a hand in shaping them. Portfolio construction moves past spreadsheets into a dialogue that targets products and strategies to specific client needs.

Operating this way, a cross-asset mandate can add more than pure investment return. Properly delivered and properly held accountable, it extends the plan sponsor’s opportunity set across the entire global markets complex. That kind of relationship doesn’t come prepackaged in the cross asset class mandate, however. It evolves, and it’s less a matter of size or assets than of culture. GMAG’s Bob White emphasizes the partnering aspect of strategic relationships. “They’re organic and ongoing. They can be very rewarding but they involve a lot more than just awarding a mandate and sitting back to wait for the results every quarter. They build on relationships and they take time and work—from both sides.”

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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. 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 recommendations.

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. Equity securities are subject to “stock market risk” meaning that stock prices in general may decline over short or extended periods of time. Real estate investments may be subject to a higher degree of market risk because of concentration in a specific industry, sector or geographical sector. Real estate investments may be subject to risks including, but not limited to, declines in the value of real estate, risks related to general and economic conditions, changes in the value of the underlying property owned by the trust and defaults by borrower. Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates, or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.

Exchange rates may cause the value of underlying overseas investments to go down or up. Investments in emerging markets may be more volatile than other markets and the risk to your capital is therefore greater. Also, the economic and political situations may be more volatile than in established economies and these may adversely influence the value of investments made.

The S&P 500 Index is an unmanaged broad-based index that is used as representation of the U.S. stock market. It includes 500 widely held common stocks. Total return figures reflect the reinvestment of dividends. An individual cannot invest directly in an index.

Past performance is not indicative of future returns. Diversification does not guarantee investment returns and does not eliminate the risk of loss.

irS Circular 230 Disclosure: JPMorgan Chase & Co. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with JPMorgan Chase & Co. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.

J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc.

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