Submitted by Simon Black of Sovereign Man
The most powerful banker in the world, JPMorgan Chase CEO Jamie Dimon, just released his annual letter to shareholders. Behind Warren Buffett’s annual missive, Dimon’s letter is probably the most read and deliberated executive report out there.
For one, Dimon is one of the most connected (and, to some, respected) men in finance. And given his bank’s massive size (it earned $24.4 billion on $103.6 billion in revenue last year) and reach (it’s a giant in consumer/commercial banking, investment banking and wealth management), Dimon has incredible visibility and intel on what’s going on around the world.
This year Dimon used a large chunk of his 46-page letter to share his thoughts on government and public policy, saying it’s hard to look at the last 20 years in America “and not think that it has been getting increasingly worse.”
And if you’d like to hear how Dimon suggests we fix regulation, immigration, taxation, infrastructure, education and every other problem in America today, it’s all in there.
I’m not really interested in his political views. Dimon runs one of the biggest banks in the world, so I’m much more interested in his insights into the economy and financial markets. Fortunately, Dimon didn’t waste all of his letter on politics.
He says the US economy seems healthy today and he’s bullish for the “next year or so.”
He sees lower unemployment, higher capital spending, wage growth, low housing supply and “relatively strong” consumer and corporate credit aiding growth.
Well, it’s easy to have rose-colored lenses when your profits come from lending money… because there’s more debt in the world today than ever before. Both corporations and consumers are sitting on a record amount of debt. And as I pointed out earlier this week, the fastest growing bank asset last year was subprime loans… meaning that the quality of debt is getting worse and worse.
Then there’s the US government, whose debts just passed $21 trillion for the first time in history. And they’re projecting adding another trillion dollars of debt each year into the foreseeable future.
Later in his letter, Dimon admits that the US is facing some serious economic headwinds today.
For one, he’s concerned the unwinding of quantitative easing (QE) could have unintended consequences. Remember- QE is just a fancy name for the trillions of dollars that the Federal Reserve conjured out of thin air.
According to Dimon [my emphasis added]:
Since QE has never been done on this scale and we don’t completely know the myriad effects it has had on asset prices, confidence, capital expenditures and other factors, we cannot possibly know all of the effects of its reversal.
We have to deal with the possibility that at one point, the Federal Reserve and other central banks may have to take more drastic action than they currently anticipate – reacting to the markets, not guiding the markets.
To that point, the Dow dropped over 700 points intraday on Monday. Then it dropped over 500 points on Wednesday, before ending the day slightly higher.
But this extreme volatility does suggest the bull market is nearing its end… if it hasn’t ended already. And if we see the bottom fall out in stocks, you can be sure the Fed will change course, as Dimon suggests.
While nobody has a crystal ball when it comes to the markets, Dimon seems pretty sure we’re in for more volatility and higher interest rates. Again, given his position, he knows what he’s talking about. One scenario that would require higher rates from the Fed is higher inflation:
If growth in America is accelerating, which it seems to be, and any remaining slack in the labor markets is disappearing – and wages start going up, as do commodity prices – then it is not an unreasonable possibility that inflation could go higher than people might expect.
As a result, the Federal Reserve will also need to raise rates faster and higher than people might expect. In this case, markets will get more volatile as all asset prices adjust to a new and maybe not-so-positive environment.
Now– here’s the important part. For the past ten years, the largest buyer of US government debt was the Federal Reserve. But now that QE has ended, the US government just lost its biggest lender.
Dimon thinks other major buyers, including foreign central banks, the Chinese, etc. could also reduce their purchases of US government debt. That, coupled with the US government’s ongoing trade deficits (which will be funded by issuing debt), could also lead to higher rates…
So we could be going into a situation where the Fed will have to raise rates faster and/ or sell more securities, which certainly could lead to more uncertainty and market volatility. Whether this would lead to a recession or not, we don’t know.
We’ll leave you with one final point from Jamie Dimon. He acknowledges markets have a mind of their own, regardless of what the fundamentals say. And he sees a real risk “that volatile and declining markets can lead to a market panic.”
Financial markets have a life of their own and are sometimes barely connected to the real economy (most people don’t pay much attention to the financial markets nor do the markets affect them very much). Volatile markets and/or declining markets generally have been a reaction to the economic environment. Most of the major downturns in the market since the Great Depression reflect negative future expectations due to a potential or real recession. In almost all of these cases, stock markets fell, credit losses increased and credit spreads rose, among other disruptions. The biggest negative effect of volatile markets is that it can create market panic, which could start to slow the growth of the real economy. The years 1929 and 2009 are the only real examples in the United States in the past 100 years when panic in the markets caused large reductions in investments and hiring. I wouldn’t give this scenario very high odds – in fact, I would give it low odds. Most people think of those events as one-in-a-thousand-year floods. But because the experience of 2009 is so recent, there is always a chance that people may overreact.
If truly negative events started to unfold, we could expect the Federal Reserve, with its enormous authority and power, to take strong action, including changing regulations, if the Fed thought it necessary.
The most powerful banker in the world believes we’ll see more volatility and higher interest rates in the future. And he sees a chance of an all-out panic. Given that scenario, I’m happy to watch this from the sidelines. As we’ve talked about before, this is a really good time to think about increasing your cash position.