Goldman Sachs is widely heralded as Wall Street’s top bank, but I believe there is little doubt that Goldman could have survived the financial crisis without substantial government aid and help from people in high places. As yesterday’s earnings from JP Morgan proved, we might just have a new top dog in the world of Wall Street. JP Morgan not only handled the financial crisis remarkably well, but continues to thrive in a tough business environment.
Their outstanding performance over the last 18 months was not due to sheer luck. After all, they have some of the brightest minds on Wall Street strategizing on the bank’s every move. After navigating the reflation trade and the recovery with precision they are now changing their tune and diversifying a bit as the reflation trade gets a bit “crowded”. The following 8 themes are JP Morgan’s favorites for the coming year:
1) Asset reflation. Cash is the most expensive asset in the world, and the main reason to hold it, which is uncertainty, is fading. The flow out of cash is lifting all other asset prices globally. This will end only when G-3 central banks start hiking or investors have become underweight cash. We are far from either.
2) G-3 disinflation. A massive output gap will push core inflation rates down in the US, Japan, and Europe. This should keep G-3 central banks on hold through next year. Long-term inflation expectations should fall, supporting bonds and flattening curves, but depressing commodities. This is not a negative for equities as we expect profit margins to be maintained.
3) Policy normalization outside the G-3. Economies on the global periphery are closer to full capacity, and are thus likely to normalize monetary policy rates earlier. Think of Australia, Korea, Czech, Norway, and Brazil. This will benefit their currencies, but hurt their bond markets. It should be neutral for their equity markets.
4) The new EM trade. Emerging economies are exiting the crisis relatively unscathed and with improved economic, financial, and fiscal positions versus developed economies. This means medium-term outperformance of their equities, currencies, and credit. Near term, it means their local debt will likely
underperform, except for the highest-yielding markets, which should benefit from the search for yield. With much of the EM growth impetus emanating from commodity-hungry China, this should be bullish for commodities.
5) Banking revival. Markets are returning rapidly to normal and so are bank profits. Bank losses are not over, but we feel that we are about three-quarters through total cycle losses, with the remainder spread over the next five years. The main threat to bank earnings will eventually come from higher capital requirements. These will dilute bank earnings, but make bank debt even safer. This suggests overweighting bank debt, but underweighting bank stocks. The latter is probably somewhat premature as governments will take at least a year to decide how much these ratios should go up and will not impose changes before 2011.
6) Carry and the search for yield. The steady fall in volatility, inflation risks, and yield levels are forcing institutional investors––in particular insurers and banks––to move out along the risk/return trade-off line in search of higher yields. Many insurers are in dire need of fixed income products with higher yields as they have a lot of liabilities that promise minimum payouts. This search for yield and carry is bullish for bonds and credit, and flattens yield curves. It is a negative for USD against better-yielding currencies, which are largely in EM.
7) Death of the equity culture? Disappointing long-term equity returns, aging, and falling wealth are inducing US and European investors to depend less on equities as the mainstay of their retirement savings. Are they becoming like Japanese savers? Possibly, but there is one major force standing in the way of increased reliance on bonds to fund retirements: Yields on global bonds have fallen below 3%, requiring a massive increase in savings rates in order to meet pension needs solely with bonds (chart). We believe that ultimately the low value of bonds will trump the fear of equities and entice end investors back into stocks to fund their pensions.
8) Balance sheets and delevering. Repairing balance sheets by improving liquidity, and making greater use of equity and long-dated debt funding will be with us for years. This implies continued high issuance of equity and long-dated debt. At this moment, this neatly matches the desire by investors to move out of low-return cash holdings, thus preventing a significant steepening of yield curves or losses on equities. Longer term, it implies that the risk premiums of bonds and equities over cash will stay higher than they have been over the past decades.
Source: JP Morgan