Goldilocks and the Wolf

Last week in his annual letter to shareholders, JP Morgan CEO Jamie Dimon described the U.S. economy as having a Goldilocks moment. He noted that we could see a period of faster economic growth, with both inflation and interest rates rising in a “just right” manner. Dimon’s comments are consistent with a building consensus that this will be a year of extraordinary economic growth, with stock prices rallying to new highs and interest rates rising far more slowly. What could go wrong?

Well, there are some clues in JP Morgan’s own earnings report. Let’s dig into that.

Clues in Bank Earnings

This week JP Morgan (JPM) reported earnings of over $14 billion for the quarter, above expectations and well above the $2.87 billion they earned during the first quarter of last year. One of the reasons for the better performance was the release of $5.2 billion initially set aside for loan loss reserves during the earlier days of the pandemic.

Many banks increased reserves in anticipation of having greater losses from businesses hurt by the economic downturn last year. The fact that banks like JPM are comfortable releasing these reserves indicates that the government and Federal Reserve programs intended to assist businesses are working. More importantly, we’ve heard many stories of creative business owners transforming their companies to survive the downturn.

There was some additional information to note in JPM’s report:

• Revenue from corporate and investment banking activity was up 46% due to an increase in the number of transactions taking place. To be sure, the stock market making new highs has created an appetite for raising equity capital, and we’ve seen tremendous volume in this area since the beginning of the year.
• Though market volatility has declined to levels not seen since before the pandemic, the firm’s trading operations saw a revenue increase of 25%.
• That’s all well and good, but one area where growth was absent was in the consumer and commercial loan segments of JPM’s business. And here’s where we start to see a “caution” flag waving. The bank’s consumer business revenue was down 6% and commercial lending was down 4%.

Weakness in lending isn’t too surprising as the economy is improving but not back to full strength. But this theme raises unavoidable caveats we must consider when looking at the consensus view that the Goldilocks environment will continue to develop throughout 2021.

Almost Over

That slowdown in consumer revenue at JPM represents a cautious consumer. Certainly, we’ll see a big increase in consumption this year and next resulting from the economy’s opening. There is some uncertainty, however, stemming from our vaccination plan.

The key word in the title above is “almost.” We know that the daily vaccination rate has climbed significantly since the beginning of the year. We also know that there is a percentage of the population resistant to getting vaccinated, and that new variants of the virus are causing an increase in infections in a different age cohort of the population. This could lead to a “fourth wave” of rising infections that deters the economy’s accelerated rate of reopening and cause a delay in economic activity.

We need to continue to monitor this closely to understand the potential impact on companies who would benefit most from the recovery as those are stocks that had underperformed most dramatically last year and been outperforming since November when vaccines were announced.

That slowdown in commercial or business lending is also expected to pick up this year. However, the ship stuck in the Suez Canal a few weeks ago isn’t the only supply chain problem businesses are experiencing. There are many areas of the economy including materials and energy sectors that are seeing an increase in prices (i.e., inflation) as a result of production being taken offline during the height of the pandemic. It is very expensive for energy companies to substantially reduce and then reintroduce production capacity for oil. Getting the supply right relative to economic activity takes some time.

The auto industry’s microchip problem is another example of a similar supply chain concern. Companies recently met with the Biden administration to determine how best to resolve the issue as they are concerned about having to continue to reduce production of new vehicles. In yesterday’s consumer price index (a measure of inflation), we saw a 9% jump in used car prices as demand for vehicles is high.

These issues will take some time to resolve themselves and so could have a deleterious effect on the economic recovery as we move through 2021.

Wolf in Sheep’s Clothing

Apologies for mixing fairy tales. We believe one of the biggest potential challenges facing the economy is deficit spending. The Federal government has created a tremendous amount of stimulus, nearly $6 trillion or over 40% of annual GDP to fill the gap left by the pandemic. This has resulted in two things: a substantial increase in deficit spending and very few budget hawks left in Washington D.C. As a result, we are seeing a push to increase spending on the policy front and this could have further consequences for deficits and interest rates.

While the proposed American Jobs Act has some revenue associated with the spending, it is mismatched in time horizon. Spending increases by about 1% of GDP per year over the next 8 years, while proposed tax increases provide revenue over 15 years. Given the potential lack of bipartisan acceptance of the new taxes, they aren’t likely to last as long as the spending.

Modern Monetary Theorists (an economic premise that says deficits don’t matter) are becoming more widespread and include members of Congress.

While our long-term view of economic growth is positive, especially due to the demographic benefits of the Millennial generation, policymakers must want to take advantage of this growth to reduce deficits built over the last year during the pandemic. This should include a reduction in spending, not just an increase in taxes. There seems to be little interest in that today.

We have an optimistic view for the economy over the next two years. There are some things to keep close watch on however, that can have both near and long-term effects on how we view our investments.

ABOUT THE AUTHOR

Brian Andrew

Chief Investment Officer | Johnson Financial Group

As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy to provide consistent, actionable investment solutions for our clients.