2023-04-17 12:20:40 ET
Summary
- The S&P 500 is still priced for a virtuous cycle - more stimulus coming.
- However, we're transitioning to a vicious cycle - persistently high inflation and interest rates.
- Thus, there's considerable downside for S&P 500 from here.
The transition to a vicious cycle
The CEO of JPMorgan ( JPM ), Jamie Dimon, in his letter to shareholders on April 4, 2023, (section Evaluating and Managing the Economic and Geopolitical Risks Ahead) wrote that the US economy is moving from "a virtuous cycle to a vicious cycle." Here's the full quote:
Less predictable geopolitics, in general, and a complex adjustment to relationships with China are probably leading to higher military spending and a realignment of global economic and military alliances. Higher fiscal spending, higher debt to gross domestic product, higher investment spend in general (including climate spending), higher energy costs and the inflationary effect of trade adjustments all lead me to believe that we may have gone from a savings glut to scarce capital and may be headed to higher inflation and higher interest rates than in the immediate past. Essentially, we may be moving, as I read somewhere, from a virtuous cycle to a vicious cycle .
What exactly is the difference between the virtuous cycle and the vicious cycle?
The virtuous cycle is based on the Biblical theme of talents (the Matthew Principle) whereby "the rich get richer and the poor get poorer." In fact, it's used to develop a strategy in games like Poker .
Essentially, when setting good goals and taking good actions, you will get good results, which enforces more good planning, and the virtuous cycle takes hold.
On the other hand, when you set bad goals and take bad actions, you will get bad results, which enforces more bad goals and errors, and the vicious cycle takes hold.
PokerStrategy
How does it apply in investing today?
Jamie Dimon essentially believes that currently we still have a good economy, with recovering supply chains, normalized interest rates, healthy consumer and businesses, and good credit.
However, Dimon sees "storm clouds ahead." Specifically, he sees what it appears to be 1) the excess fiscal spending, which contributes to higher inflation, and requires higher interest rates, 2) the dangerous Fed's policy of QT which could push longer term interest rates higher, and 3) the dangerous policy of de-globalization, global fragmentation, and wars, which could also push inflation higher.
Apparently, the vicious cycle starts with "bad policymaking," and "bad actions," which lead to "bad results," and cause more "bad policymaking". Investors are specifically interested in the "bad results" part. The "bad results" will likely be manifested as higher inflation, higher interest rates, lower economic growth with more frequent recessions. For stock market this means lower PE multiple (lower growth), and likely very volatile longer term trading range.
Dimon specifically sees the current period similar to the 1970s.
If we have higher inflation for longer, the Fed may be forced to increase rates higher than people expect despite the recent bank crisis. Also, QT may have ongoing impacts that might, over time, be another force, pushing longer-term rates higher than currently envisioned. This may occur even if we have a mild — or not-so-mild — recession, as we saw in the 1970s and 1980s.
Here is the Storm Clouds Ahead chart from the Dimon letter:
JP Morgan Q12023 Report
What about the greedy banks?
On the other hand, Dimon presented the record-breaking performance of JPMorgan for 2022. Specifically, the Net Interest Income increased 28-40% in 2022 for JPMorgan - driven by higher rates.
Net interest income of $66.7 billion, up 28%, driven by higher rates and loan growth, partially offset by lower Markets net interest income. Net interest income excluding Markets was $62.4 billion, up 40%.
In fact, all banks had the record-breaking 2022 with respect to Net Interest Income. Here's the chart, look at the spike in NII in 2022:
FRED
The Net Interest Income is the difference between the Interest Income, or the interest rate received on the loans, and the Interest Expense, or the interest rate paid on deposits.
The Fed increased interest rates in 2022 from near 0% to above 4%, and with it, all intermediate and short-term loan rates went up - for example credit card interest rates, car loans, etc. Thus, the Interest Income went up.
However, the banks did not increase the interest rate of deposits. The largest banks such as JPMorgan (Chase), Wells Fargo ( WFC ) and Bank of America ( BAC ) still have the deposit rate essentially at 0%. Thus, the Interest Expense did not increase.
Here are the current rates from Bankrate:
Bankrate
Why is this a problem?
The Fed has been increasing the short-term interest rates to invert the yield curve with the single purpose - to slow down lending, cool off the economy, and bring inflation down.
The inverted yield curve by definition means that short-term rates are higher than long-term rates, which implies that deposit rates should be higher than loan rates. This is supposed to tighten the credit channel.
Yet, the banks did not increase the deposit rates, and took advantage of the higher loan rates to lend more and make more profits. Thus, despite the Fed's tightening, the economy continued to grow, the unemployment stayed low, and inflation remained sticky at 5.5% level. Thus, the Fed is now forced to continue hiking with the QT, which implies a deeper and longer recession ahead.
If the banks increased the deposit rates with the Federal Funds rate in 2022, we would likely be past the recession bottom already, getting ready for a recovery.
Implications
Dimon is correct, we were in a virtuous cycle, where the policymakers somehow allowed the banks to keep the deposit rates at 0%, while the money market rates are at 5%, and then bailed out the banks when the depositors withdrew the deposits.
But don't forget, the 2008 bank bailout planted the seeds for the populist's movement globally, the creation of Bitcoin ( BTC-USD ), and the accelerating trend on de-globalization Dimond is referring to. The virtuous cycle created the wealth gap, which could be the catalyst for the vicious cycle ahead.
The S&P 500 ( SP500 ) is currently not pricing any of this forthcoming vicious cycle, with the forward PE ratio of 19, and overly optimistic earnings expectations. Many stock market investors see the Fed cutting rates in 2023 to boost the asset prices, and they still play the virtuous cycle. But the policy support will be limited this time by the sticky inflation - that's the vicious cycle limitation Dimon was taking about.
For further details see:
Greedy Banks And The Transition 'From A Virtuous Cycle To A Vicious Cycle'