Speaking at an investor conference on Friday, JPM CEO Jamie Dimon again impressed the audience with his particular brand of optimism, saying he doesn’t see any reason the nine-year economic recovery will end soon and stating that “We’re probably in the sixth inning,” while predicting that “it’s very possible you’re going to see stronger growth in the U.S.”
Dimon also took a swipe at Moelis co-head of restructuring Bill Derrough who last week said that “we’re feeling like where we were back in 2007” countering that “I’ve heard people say, well, it’s looking like 2007. Completely untrue. There’s much less leverage in the system. The banks are much better capitalized.”
While it is to be expected that a billionaire (who will always be “richer than you”) such as Jamie Dimon will tend to have an optimistic bias, especially after his bank was bailed out by taxpayers a decade ago, there is one problem with his assessment of where we are in the business cycle: he is dead wrong.
First, it is by now well known that consolidated leverage in the system is at an all time high, with both the IMF and the IIF calculating in April that total global debt has hit a new all time high of $237 trillion, up $70 trillion in the past decade, and equivalent to a record 382% of developed and 210% of emerging market GDP.
Meanwhile corporate leverage in the US is also at all time highs, whether as a percentage of GDP…
… or on a net debt/ETBIDA basis. As for banks being “better capitalized”, let’s see how capitalized they are when the Fed removes $2 trillion in excess reserves, i.e. liquidity, from the financial sector.
Further to the key point of “where we are in the economic cycle”, two weeks ago Morgan Stanley said that we are so “late cycle” that the bank issued a very explicit warning that we have now reached the “end of easy”…
… and that “2018 is seeing multiple tailwinds of the last nine years abate”, as the bank’s strategists warn of a “tricky handoff” to a very late cycle economy “which suggests not just a harder environment, but a fundamental shift in how we approach the market.”
As part of its late cycle transition, Morgan Stanley showed its “tricky handoff” checklist…
… where the bulk of adverse transformations are already taking place right now, while the rest – of which the most important one is the shift from growing central bank balance sheets to shrinking balance sheets – is expected in Q3 and Q4 2018: in other words over the next 3-6 months.
Morgan Stanley was even kind enough to show schematically when it expects every key asset class to peak in the immediate future, and with both IG and HY already in a downslope, it only leave bonds and stocks, the former expected to peak around September, while Stocks seen as hitting their cycle highs just around December, to wit:
Exhibit 3 suggests reducing risk aggressively now, especially with those structural challenges waiting in the wings. But our US equity strategists believe that stocks can mount one last rally into 3Q as earnings estimates continue to rise, and our top-down cycle markets are still giving positive signals. We’re retaining a small net long equities (+2%) for this reason, mindful that this last phase is a risky one.
A bit more equity strength, however, would be consistent with history. Equities have tended to top ~9-12 months after a credit spread trough. If that credit trough was late January/early February 2018 (we think it was), that ‘normal’ timing would put an equity peak in November/December this year. 10-year yields, in turn, tend to peak around three months ahead of stocks, which would place that peak in August/September.
The actual sequencing may differ (no two cycles are exactly alike). Our point is simply that we think our forecasts are consistent with the usual late-cycle pattern, where topping is a process, not a point in time.
But it’s not just Morgan Stanley. Recently, Bank of America joing the “late cycle” warning, writing that its proprietary “Global Wave” indicator just peaked for only the tenth time in 25 years, noting that in the last month, five of the seven components deteriorated including confidence, market, and real economy indicators.
As the name implies, the “global wave” is an advance indicator for global economic expansion and contraction, with virtually every peak in recent decades resulting in either a recession or a sharp market drop: of which, the last two took place just before the European sovereign debt crisis and around the time of the Chinese post-devaluation turmoil.
As BofA explains, previous downturns in the Global Wave averaged 12 months, although it concedes that some downturns have been brief, and as it is still relatively bullish on stocks, hopes the current one will be as well.
Previous negative-but-brief signals occurred in 2002 after President Bush introduced steel tariffs, and in 2005 when PMIs fell quickly before recovering.
Still, the facts are adverse for global stocks, as subsequent to previous peaks in the Global Wave, the MSCI All Country World Index averaged -3.4% in the next 12 months, and defensive regions (the US), defensive sectors (Telecom, Health Care, Consumer Staples) and defensives styles (Quality, Dividends) outperformed, on average.
In fact, even BofA is hard pressed to spin the historical precedent, and writes that while “a brief downturn is possible, but peak signals have been followed by sustained downturns more often than not.”
At the same time, in a separate analysis by BofA’s James Barty who looks at the contextual aftermath of the recent fireworks from Italy’s political drama, also disagrees with Jamie Dimon’s optimistic take, and writes that “we have to admit that the global economy is not firing on all cylinders anymore, and it is a similar story for earnings revisions, which have rolled over from their tax reform distorted highs of earlier this year.”
He then warns that “given the additional risks around Italy (and possibly trade), there are more than enough reasons for investors to remain cautious and not want to put capital to work, at least until it becomes clearer whether any slowdown in growth is merely temporary or something more serious.”
So what are investors to do? “Be patient. Be careful about crowded positions – short vol, long equities, long EM fixed income and FX were all crowded positions – and start to tilt portfolios later cycle.”
That’s textbook. What is the reality? Well, thanks to central banks once again assuring that there is nothing to worry about after the barrage of fireworks so far in 2018, the market remains upside down and not only did tech and small caps close at all time highs on Friday, but selling of vol is once again the go-to trade…
… for all the 23-year-old trading veterans who are merely following the “all clear” signs from central bankers who have created a centrally-planned market monster in which every BTFDer is a genius, if only for a few more months when for the first time in a decade, central banks will shift from injecting liquidity into the system, to draining it.