Hot Hot Hot, China Inflation Data

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HOT Data:  In China, the producer price index rose 6.3 percent in August from a year earlier, versus an estimated 5.7 percent in a Bloomberg survey and a 5.5 percent July reading.

Weak Dollar Side Effects: PPI exceeded all but one of 38 estimates in Bloomberg’s survey of economists.

China Inflation: The consumer price index climbed 1.8 percent, compared with 1.4 percent a month earlier, the statistics bureau said Saturday.

China Producer Price Index (Output)

Deep inside the Federal Reserve, there’s a growing concern. Commodity prices are rising at the fastest pace in five years.  The global reflation picture is nearly on the Fed’s doorstep.  In our view, there’s a surging probability the Fed gets thrown off track in 2H 2017.  They are behind the curve relative to suppressed market expectations* (outlook for low inflation) – which the Fed has fostered, embraced and enabled.  Over the last decade, we’ve learned academics at central banks are poor risk managers – especially when it comes to misjudging sharp moves in the U.S. dollar.

*Thanks to dovish Fed guidance (leaving the punch bowl filled at the party far too long – more accommodation), the interest rates futures market now sees September 2018 (yes 2018!) as the earliest FOMC rate hike (with >50% chance of Fed hike).  A year from now, the FOMC will have serious regrets looking back on their latest policy moves.  Nearly 10 years after Lehman, it’s sad – they have NOT learned the error of their ways.

As Long Time Bond Bulls, we’re Now Bears – The Fed is Behind the Curve

If we look back at the 2014-2016 regime and ask what did the Wall Street’s economists get most wrong in “trying to read” the Fed?  Far and away the answer to this question is found in global economic (disinflation) pressures.  Back then, U.S. economists were far too focused on “robust” domestic (U.S.) economic data.  The Fed coached them into looking for 12 (yes twelve!) rates hikes (2014-2016) – while ultimately the central bank only delivered two.

Global Economic Strength

In August, China reported imports up 13.3 percent in dollar terms. Street forecasts were looking for a 10.0 percent move higher in the same period.  Keep in mind, since January, China imports have sustained 11% growth.  This is the most impressive level of sustained trade growth we’ve seen in six years.

China Imports, Strong thanks to a Weak U.S. Dollar

Friday’s strong (August) import data, points to domestic demand in China far more resilient than expected in the second half of 2017.  China can thank the Fed and a weak U.S. dollar in our view.  We must NEVER forget, the Federal Reserve is conducting monetary policy in an $80T global economy, NOT a petri dish.  As the Fed attempted to hike rates 2014-2016, the dollar surged and the global economy suffered (see above – left). Today, as the Fed has dramatically softened the rate hike outlook – the dollar plunged (top – right) and the global economy is picking up steam (see above – bottom right).  In the months ahead, it will be pure entertainment – watching the Fed try and deal with this global economic feedback loop back yet again.

Policy Path Veto

It’s clear, the lessons from 2014-2016 come down to the “global economic picture” overpowering the Federal Reserve’s STATED policy path.  In the end, the global wrecking ball found in U.S. dollar side effects – vetoed the Fed’s beloved rate hikes.

From 2014 – 2016, U.S. economists were blinded by the positive U.S. data and couldn’t see the deteriorating global macro risk factors tied to the U.S. dollar’s violent surge (see above).  Global economic weakness was a colossal drag on Fed policy – eventually forced the central bankers to lay down on their loudly promised rate hikes.  The old Lucy and the Football, “sorry Charlie Brown.”

$80 Trillion Global GDP

Outside the USA: $62T*
Inside the USA: $18T

Why are U.S. economists so myopically focused on U.S. economic data?  It’s 2017, NOT 1997.  Bloomberg GDP data.  The St. Louis Fed Real GDP Nowcast Model Sees U.S. Q3 GDP up at nearly 3.7%.  The question no one is asking: If economic growth is picking up sharply in the $62T bucket above, how with that impact the $18T economic output in the USA and Fed policy???

*11% plunge in the dollar (in 8 months) is fueling growth here.

Twelve Rate Hikes 2014-2016?

Of course, Lucy became the FOMC and Wall Street’s economists were poor Charlie Brown.

The Ultimate Question of 2017?

If global – strong dollar induced – disinflation pressures (2014-2016) vetoed the Fed’s widely advertised policy path (beloved rate hikes), why won’t global – weak dollar induced – inflation pressures today do the same (force more rate hikes)?  How do you spell complacency?  Wall Street expectations for this year have moved from 4 rate hikes to just two?  If you look at the December euro dollar contract – in just three months – we’ve moved from a 70% chance of a December rate hike to just 24% today.  Ignoring global reflation risks – this summer the Fed has dramatically talked DOWN rate hike expectations.

The Weak Dollar Ignites Global Inflation Pressures

Fresh Year Highs this week*

Palladium: 16 yr high
Zinc: 10 yr high
Lithium: 6 yr high
Aluminum: 6 yr high
Copper: 3 yr high
Coal: 3 yr high
Iron Ore: 0.4 yr high

*Side effects of weak dollar FOMC, China regulatory issues heading into 19th Congress, demand expectations for electric cars (Lithium, Copper).

Oil, the Upside Trend Break

The last holdout has been oil.  Several global secular pressures have been suppressing this beast, but she’s making some noise lately.

Dinner with Bill Dudley of the New York Federal Reserve

Thursday evening, we attended a  dinner with the NY Fed’s Bill Dudley,  He delivered a speech at the Downtown Association with a hawkish tone. Dudley kicked the “financial conditions targeting” door back open in our view. He said the FOMC with an eye on FCIs should be able to remove accommodation with low inflation.

“Even though inflation is currently somewhat below our longer-run objective, I judge that it is still appropriate to continue to remove monetary policy accommodation gradually,”

New York Fed’s Bill Dudley

“I expect that the U.S. economy will continue to perform quite well, with slightly above-trend growth leading to further gradual tightening of the U.S. labor market,”

New York Fed’s Bill Dudley

A Q&A focused on Harvey and Irma

In the Q&A, the sleepy event became far more interesting. Governor Dudley opened the door to inflation shock concerns with an eye on the two historic hurricanes with a meaningful impact on the U.S. economy this season.


(Insured losses understate the fiscal policy rebuilding/infrastructure funding needed from Washington – $220B for Harvey and Irma in our view).

The colossal rebuilding projects concentrated on greater Miami, Tampa, greater Houston, and Beaumont will require hundreds of thousands of new workers.

Keep in mind, Texas and Florida represent 12% of US GDP.  Dudley mentioned labor market in construction is “tight” in those states.   According to the National Association of Home Builders – over 75% of its members report acute shortages in the latest survey.

Bond Yields and Cat 4+ Hurricanes

Our latest Bear Traps Report takes a look at bond yields and category 4+ hurricanes in the U.S. – the data is impressive.  Each time, bonds rally into the tragedy – (GDP growth worries) on near term economic risk concerns.   What comes next is a mind blower. 

It’s clear, any substantial fiscal policy changes coming out of Washington will have a meaningful impact (wages, average hourly earnings, cost push inflation). The colossal rebuild (as high as $220B in our view) comes with wage inflation risk in Q4 and beyond.

The Road Ahead

Today, many U.S. economists are asleep at the switch again.  They’re far too focused on “Goldilocks” calm U.S. inflation data, NOT global Inflation Pressures, Irma and Harvey.   Hello, BIG MISTAKE. In a dramatic reversal, the global inflation picture could very well force the Fed into surprise rate hikes, NOT cuts this time around.

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U.S. Manufacturing’s Best Result since 2011

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Friday’s ISM data showed U.S. factories surged in August to the fastest pace of expansion in six years, largely powered by an employment uptick.

  • Factory index climbed to 58.8 (est. 56.5) from 56.3 in July.
  • Employment gauge jumped to 59.9, highest since June 2011, from 55.2.
  • Economists polled expected a reading of 56.8%. Any reading above 50% indicates improving conditions.

Friday’s jobs report in the U.S. displayed the strongest month for manufacturing hiring since August 2013.  Manufacturing and construction accounted for an additional 64k new jobs.

U.S. 10 Year Treasury Bond was 3.73% the last time ISM Data was this Strong

Inside the data, the measure of new orders fell to 60.3 from 60.4; order backlog gauge rose to 57.5, matching a three-year high.   The August PMI is at its highest level since August 2011, when it touched 59.1. And the August PMI is 3.4% above the 12-month average of 55.4 and 2.1% above the 2017 average of 56.7.  ISM noted, 14 of the 18 manufacturing sectors contributing to the report expanded in August.  It’s clear, bond yields are being suppressed by U.S. political and global geopolitical risks – not economic growth data.

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North Korea and President Trump, High Drama

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Breaking: Japan’s Topix falls 1.4% as yen firms in face of rising North Korea tensions.

On Tuesday, the CBOE Volatility Index surged nearly 12% percent after President Trump was quoted saying further threats from N Korea would be met with “fire and fury.”

One Month Look at Stocks in Japan

Overall, stocks in Japan are 3% off their recent highs.

Earlier reports of a Defense Intelligence Agency analysis indicating Pyongyang has successfully developed a miniaturized nuclear warhead that could fit onto its missiles sent a chill through markets.  The yen surged with gold, while crude dipped below $49 a barrel.

First Time – Long Time

For the first time since June, S&P 500 futures drop greater than 1%.  Per CNBC, the Dow Jones industrial average climbed for 10 straight days, through Monday, for its second winning streak of 10 days or longer this year (after its 12-day win streak in February). That means that 2017 already marks the first year in which the Dow has had two winning streaks of 10 sessions or longer since 1959.  Geopolitical risk is now poised to upset this apple cart.

We believe the Pentagon is considering a request from South Korea to allow it to develop more powerful ballistic missiles as tensions with North Korea continue to escalate.

“There is currently a limit on the warhead size and missiles that South Korea can have and yes, it is a topic under active consideration here,” Pentagon spokesman Capt. Jeff Davis told reporters at the Pentagon, as reported by Reuters.

Cost of Default Protection in South Korea Continues to Surge

This year, Asia’s stock and credit markets have been flashing bullish signs. Per Bloomberg, outside of Japan it costs less to insure Asian corporate and government debt than at any time since before the financial crisis – see the white line above.  Meanwhile, the MSCI AC Asia Excluding Japan Stock Index is near a 10-year high.   On the other hand, geopolitical risks coming at markets from North Korea are raising the cost of default insurance on countries like South Korea – see the orange line above.  Markets depend on continued economic growth and the importance of the region in global debt markets supports stability in CDS prices – but geopolitical risks could turn all the goodwill upside down.  As you can see above, for much of the last five years the cost of default protection in Asia rose with South Korea – high correlation was the name of the game.  In recent months, as Asia credit risk has improved – South Korea continues to deteriorate at an alarming pace.

Council on Foreign Relations

North Korea is believed to have between fifteen to twenty nuclear bombs and has successfully tested a series of different missiles, including short-, medium-, intermediate-, and intercontinental- range, and submarine-launched ballistic missiles. In July 2017, the regime conducted two intercontinental ballistic missile (ICBM) tests capable of carrying a large nuclear warhead. The Pentagon confirmed North Korea’s ICBM tests and analysts estimate that the new missile has a potential range of 10,400 kilometers (6,500 miles) and, if fired on a flatter trajectory, could be capable of reaching mainland U.S. territory. U.S. analysts and experts from other countries are still debating the possible nuclear payload that the ICBM could carry.  “Prior to these tests, North Korea had conducted five nuclear tests: in October 2006 and May 2009 under Kim Jong-il; and in February 2013 and January and September of 2016 under Kim Jong-un’s leadership. Future nuclear tests are anticipated. North Korea possesses the know-how to produce bombs with weapons-grade uranium or plutonium, the primary elements required for making fissile material—the core component of nuclear weapons.” CFR

The Bear Traps Report

We still believe Beijing has a prominent role to play.  Behind the scenes, the US is likely attempting to delegating the North Korea regime change to China.  As a colossal trading partner, China has substantial leverage over North Korea’s generals.   Of course, China likes idea of having buffer in peninsula facing the West, she won’t sacrifice that even if Kim Jong-un is a madman.  Ahead of their coveted 19th Congress this October – war is not in China’s interest at all.  North Korea knows this, helps explain their elevated and annoying resolve.

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Plunge in Auto Sales, is it Cyclical or Secular?

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Car sales in America are rolling over at the fastest pace since the great recession.   There’s debate about whether the downshift is due to normal economic cycles or indications of secular or structural change.

Large auto makers – Ford, General Motors and Toyota, have reported meaningful sales contraction in the first half of the year.

Automakers are reporting substantially weaker than-expected sales for the month, with some companies posting double-digit declines in business.

General Motors sales fell 15.5 percent compared to July of last year when industry sales were close to a record high. While some of the decline at GM can be attributed to a deliberate pullback in fleet sales to rental car companies, the automaker’s retail sales at dealerships came in almost as weak, falling 14.4 percent. – CNBC

Forecasters expect US sales to fall to about 17 million this year – off 500,000 from last year’s pace.

Earlier this year we addressed these risks- The Bear Traps Report with Larry McDonald; A Turn in the Credit Cycle for clients.

U.S. Auto Inventory Build, 1970 – 2017

It’s clear – the inventory levels of unsold cars are at recession levels. As we can see above – unsold automobiles are piling up at the fastest pace since the great recession.   In recent years, sales growth was supported by unusually low borrowing costs and pent-up demand, as cash-strapped households delayed purchases during the economic downturn around 2009.  Credit growth is contracting in the auto-lending sector at the fastest pace since 2008 – this is having a big impact on sales.  On the other hand, as more Americans move to urban areas – the Uberization of transportation is creating significant structural challenges to the U.S. auto industry.




Lurking Beneath the Surface, Global Reflation

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Updated July 30, 2017

Breaking: *IRON ORE FUTURES IN SINGAPORE SURGE 5.9% AFTER CHINA PMI DATA, 9:27pm ET.    PMI came in solid, above its 12-month average. The China’s yuan fixing was set at the strongest level since October – a sign the PBOC doesn’t see any major growth concerns around the corner. 

It was a picture perfect week in Manhattan.  Dry air, a light breeze, the birds were chirping in central park and we witnessed a high of just  72 degrees in late July?  It was a treasure to behold.

No Stress, Relax

St. Louis Fed’s Financial Stress Index is right on five year lows.  Since February 2016 – just as the Fed arrested the U.S. dollar’s vicious accent – month after month financial conditions have eased.  Which begs the question?  From 2014-2016, as the strong U.S. dollar contributed to global dis-inflation – lower commodity prices – won’t the weaker dollar contribute to a surprise burst of global inflation?  Central bankers think they can contain the beast inside the market, but he’s in there – the unintended consequences are a plenty.

All is calm, but something is lurking beneath the surface of the financial markets.  Investors expect no surprises from the Federal Reserve this summer – this week the chances of a September rate hike fell below 10%.  It’s motionless seas as far as the eye can see.

How Low is the Bar?

In recent weeks, Fed rate-hike expectations have plummeted given the market’s myopic focus  on the Fed’s long promised balance-sheet normalization kickoff.  The odds a December rate hike are now priced at less than 35%, down from 70% just six weeks ago.

At this week’s Federal Reserve Open Market Committee meeting, there were a few developments lifting  eyebrows on Wall St.  Officials removed references to inflation declining “recently” and being “somewhat” below their 2% target in a portion of their eager monitored statement.

Five Year Look at the Dollar Index DXY

After lofty promises, uncertain fiscal policy out of Congress and the White House has laid a beating on the dollar.  After a post election surge to 104, she touched 93 this week.  A weak dollar is fueling the reflation trade globally – commodities and emerging markets have been major beneficiaries.  The CRB (Commodity Research Bureau ) index is nearly 10% higher over the last year, while the $EEM (iShares MSCI Emerging Markets ETF) is 25% higher since January.

There’s something on Janet’s (Fed Chair Yellen) mind. Commodity prices are rising at the fastest pace in five years.  The global reflation picture is nearly on the Fed’s doorstep.  In our view, there’s a surging probability the Fed gets thrown off track in 2H 2017, they are behind the curve.

Calm Inflation Expectations?

What’s copper telling us about inflation expectations here?  Believe it or not, one of the keys to 2H equity market stability is a sustainable path of sleepy inflation expectations.  Wall St. has taken their inflation outlook lower and lower in recent months.  Any surprises to the upside – in inflation expectations – would motivate the Fed to put forth a more aggressive withdrawal of policy accommodation (employ more rate hikes).  This outcome would be would be fairly disruptive in our view – signal that the Fed is behind the curve. 

Majority of Rate Cuts Globally are coming from Emerging Market Central Banks

Central Banks Globally in 2017

Rate Cuts: 43*
Rate Hikes: 20

*majority from emerging markets

Central banks in Brazil and Colombia cut rates again this week – despite many developed market central banks signaling less accommodative (Canada, U.S., U.K., ECB) monetary policies looking ahead, emerging market central banks still have the punchbowl in “fill’er up” mode.  So we have a large group of EM central banks easing monetary policy  with the U.S. dollar in the middle of its sharpest decline in five years – how do you spell “over-heat” risk?  Developed market central banks are “trying” to remove accommodation while EM bankers are adding at a 2-1 pace (see above)?

Coal’s 24% Surge Since June 1st, Hello Janet… Can you Hear Me Now?

Calm CPI (inflation data) in the U.S.A. has the Fed in relax mode but when you look around the world – other forces are driving prices higher.

This week, copper surged to the highest level in more than two years on expectations that demand in China will fuel a global shortage.  There were even plans in the country to curb metal-rich waste imports reinforcing a bullish outlook.  Benchmark three-month prices rallied as much as 2.8% to $6,400 a metric ton, the highest since May 2015, and were at $6,296 at 11:09 a.m. in London. That’s a fourth day of gains, and adds to Tuesday’s 3.3% jump, Bloomberg noted.

An Unsustainable Divergence, Global Pressures are Coming at the Fed

2012 through 2017

Yesterday’s news? U.S. PCE Inflation – the orange line above – the Federal Reserve’s preferred measure of inflation has declined for three straight months, to 1.4%, from 2.1% in February.   Tomorrow’s news – the global inflation backdrop is a major problem for the Fed – there’s far too much attention focused on the sleepy U.S. inflation picture.

Strong infrastructure investment in the first five months of the year is helping China reflate their asset bubble in desperate search of maintaining 6.5% growth rate in 2017.   The question remains – did those ten “mad men” in a room in Beijing put too much pressure on the gas pedal this time?

Over the Last Year

Iron Ore +50%
Copper +30%
Oil +16%
Gold -6%

Bloomberg data, July 29 2016 to July 29, 2017

Oil: Best Month in 12 Years

Total petroleum deliveries moved up 2.6 percent from June 2016 and were up by 1.0 percent from May to average 20.3 million barrels per day in June. These deliveries were the highest this year and the best month in since 2007.  For the second quarter, total domestic petroleum deliveries increased 3.0 percent compared to the second quarter 2016. For year to date, total domestic petroleum deliveries increased 1.6 percent compared to the same period last year. API Data

Lessons from 2014-2016

If we look back at the 2014-2016 regime and ask what did the Wall St.’s economists get most wrong in trying to read the Fed?  Far and away the answer to this question lies in global economic (disinflation) pressures. Back then, U.S. economists we far too focused on “robust” domestic economic data and were looking for 12 (yes twelve!) rates hikes (2014-2016) while ultimately the Fed only delivered two. Economists were blinded by the positive U.S. data and couldn’t see the deteriorating global macro risk factors tied to the U.S. dollar’s violent surge.  Global economic weakness was a drag on Fed policy – eventually forced the central bankers to lay down on their loudly promised rate hikes.

Today, many U.S. economists are asleep at the switch again.  They’re far to focused on “goldilocks” calm U.S. inflation data (see the orange line above).   In a dramatic reversal from 2014-2016, the global inflation picture could very well force the Fed into surprise rate hikes.   That picture perfect view over the Manhattan skyline could very quickly turn to darkness.  If the Fed is forced to take Mr. Punchbowl away too quickly, the global reflation revival could be the a summer spoiler.

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Central Bank Deleveraging Leads to Colossal Bank Deposit Outflows

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– Assets under management $5.69 trillion, estimate $5.61 trillion
– 2Q iShares net inflows $73.76 billion vs $64.48 billion q/q

Lets look over a few important developments clients were talking about this week – focus was on the J.P. Morgan investor (quarterly) conference call.  As the largest bank in the United States – it’s important to dig through the data, trends and themes found in the transcript below.

Our Takeaways

FOMC's Bal SheetThe relationship between the Fed’s balance sheet and equity prices is clear – the question is, how will stocks react to central bank deleveraging? 

As most investors know – Wall St. expects the Federal Reserve to initiate a reduction in their $4.4 trillion balance sheet this September.  J.P. Morgan made some startling forecasts this week relative to the impact of the Fed’s planned actions.

Deposit Outflows

Federal Reserve deleveraging will lead to loss of deposits at banks, somewhere between 50%-66% of reduction.   Looking forward, $1.5T Fed SOMA (balance sheet) reduction would result in $750B – $1T of deposit outflows from the banks.

From Marianne Lake, JPMorgan Chase & Co. – CFO and EVP

“The Fed is communicating clearly and has every intention to make this gradual and predictable, things can change, and we should just be prepared for that. Not to say that, that would have a particularly significant impact necessarily on JPMorgan but that, that would just be a downside risk, not a probability. So on the balance sheet, it’s still the case that we expect to start seeing normalization in the balance sheet in September.  We’re still actually calling for the next rate hike in December; the market is calling for March of next year. And as we said, the communication has been pretty consistent and pretty clear across the Fed space, which is to say that it’s mostly priced into the market at this point as far as we can tell. And so based upon what we’ve understood, all things equal, we would see the balance sheet shrink about $1.5 trillion over about the next 4 years. So that would ultimately slow growth, not stop growth.  If we saw $1.5 trillion come out of the Fed’s balance sheet, empirical evidence would suggest that we don’t see dollar-for-dollar reduction in deposits. So if you just pick a point between $500 billion and $1 trillion of deposit outflows, at our 10% market share, that would be about $75 billion over 4 years.”

Doing some work here is a necessity – the unintended consequences of central bank policy actions are many and will be disruptive.  As new supply – U.S. treasuries which need to be sold to fund government spending – comes to market, without the FOMC there cash will pour out of the U.S. banks.

Money Flow into Stocks, Former Scared Money Coming Back

In the second quarter, JPM witnessed $8B leave deposits into stocks.  We have not seen this type of shift into equities in a long time.  This is a positive for BlackRock / Pimco’s of the world – as bank deposits shift into ETFs and asset management products, they are the big winners.

BlackRock, Pricing in Some Central Bank Love

BLKOver the last year the Federal Reserve has been buying $20 to $35B a month of Treasuries and Mortgage Backed Securities.  As bonds mature, the Fed has been reinvesting the proceeds – QE (asset purchases) has been very much alive and well.   As the Fed steps away from reinvestment – there will be more treasuries for investors to buy.  J.P. Morgan is anticipating substantial bank deposit outflows, these assets should make their way over to the portfolio managers at companies like BlackRock.  As you can see (top right above), just as the Fed signaled balance sheet reduction, BlackRock equity is up 17% since the March FOMC meeting.  Over the same time, the XLF (Financial Select Sector SPDR Fund) is only 6% higher – BlackRock investors have been pricing in some central bank love.

Balance Sheet Winners

As the Fed takes DOWN their balance sheet – BlackRock and Pimco will be the net Treasury buyer.  In other words,  the Fed’s planned $1.5T reduction its balance sheet – a lot of these assets get reallocated over to BlackRock and Pimco, 20bps on $1.5T is real money.

J.P. Morgan CEO Jamie Dimon on Washington Policy’s Economic Overhang

“Since the Great Recession, okay, which is now 8 years old, we’ve been growing at 1.5% to 2% in spite of stupidity and political gridlock because the American business sector is powerful and strong and is going to grow regardless — when they wake up in the morning, they want to feed their kids, they want to buy a home, and they want to do things. It’s the same with American businesses. My — what I’m saying is that it would be much stronger growth had we made intelligent decisions and were there not gridlock. And thank you for pointing it out because I’m going to be a broken record until this gets done. We are unable to build bridges. We’re unable to build airports. Our inner city schoolkids and are not graduating. I was just in France. I was recently in Argentina. I was in Israel. I was in Ireland. We met with the Prime Minister of India and China. It’s amazing to me that every single one of those countries understands that practical policies that promote business and growth is good for the average citizens of those countries, for jobs and wages, and that somehow this great American free enterprise system, we no longer get it. And so my view is it — and corporate taxation is critical to that, by the way. We’ve been driving capital and bringing it overseas, which is why there’s $2 trillion sitting overseas, benefiting all these other countries and stuff like that. So if we don’t get our act together, we can still grow. I would say it’s unfortunate, but it’s hurting us. It’s hurting the body politic. It’s hurting the average American that we don’t have these right policies. And so no, in spite of gridlock, we’ll grow at — we can grow at 1.5% or 2%. I don’t buy the argument that we’re relegated to this forever; we’re not. And if this administration can make breakthroughs in taxes and infrastructure, regulatory reform — we have become the most — one of the most bureaucratic, confusing, litigious societies on the planet. It’s almost an embarrassment being an American citizen traveling around the world and listening to the stupid (expletive) we have to deal with in this country. And at one point, we all have to get our act together or we won’t do what we’re supposed to do for the average Americans. And unfortunately, people write about the thing like it’s for corporations. It’s not for corporations. Competitive taxes are important for business and business growth, which is important for jobs and wage growth. And honestly, we should be ringing that alarm bell, every single one of you, every time you talk to a client.”

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J.P. Morgan CEO Jamie Dimon

Good morning, everyone. I’m going to take you through the earnings presentation, which is available on our website.

The firm reported record net income of $7 billion, EPS of $1.82 and a return on tangible common equity of 14% on revenue of $26.4 billion. Included in the result is a legal benefit of approximately $400 million after tax from a previously announced settlement involving the FDIC’s Washington Mutual receivership.

Other notable items, predominantly net reserve changes and legal expense, were a small net negative this quarter. So underlying adjusted performance was really strong. And highlights for the quarter include: average core loan growth of 8% year-on-year, reflecting continued growth across products; double-digit consumer deposit growth; strong card sales, up 15%, and merchant volume, up 12%; #1 Global IB fees, up 10%; and we delivered record net income in both Commercial Banking and in Asset & Wealth Management.

Some more details about the quarter. Revenue of $26.4 billion was up $1.2 billion or 5% year-on-year, with the increase predominantly in net interest income, up approximately $900 million, reflecting continued loan growth and the impact of higher rates. Fee revenue was up $300 million year-on-year, but adjusting for one-time items in both years, was down modestly, with lower Fixed Income Markets, Mortgage and Card revenues, all as guided, being offset by strong fee revenue growth across remaining businesses.

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Adjusted expense of $14.4 billion was up a little less than $400 million year-on-year, with auto leases being the biggest driver, but also including the impact of the FDIC surcharge and broader growth being offset by lower compensation.

Credit costs of $1.2 billion were down $187 million year-on-year on [lower] reserve builds as a net reserve build in Consumer of a little over $250 million, driven by Card, was offset by a net release in Wholesale of a little under $250 million, driven by Energy.

Anticipating you may have questions, given the recent stress in oil prices, I would emphasize that we guided to expect reserve releases, given we started the year with $1.5 billion of energy-related reserves. And with oil prices having found a lower but seemingly stable level, we feel appropriately reserved.

Shifting to balance sheet and capital.  We ended the quarter with binding fully phased-in CET1 of 12.5% under the standardized approach, with the improvement being primarily driven by capital generation, offset by net loan growth. We’ve been hovering around the inflection point under the Collins Floor for a while now and expect standardized to remain our binding constraint from here. Given that, we’ve replicated this page under standardized rules in the appendix for you to read.

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Balance sheet, risk-weighted assets and SLR all remained relatively flat from the prior quarter.  I would also note that we remain compliant with all liquidity requirements. We were pleased to announce growth repurchase capacity of up to $19.4 billion over the next 4 quarters. And the board announced its intention to increase common stock dividends 12% to $0.56 a share effective in the third quarter. In addition, we recently submitted our 2017 resolution plan, which we believe fully addresses outstanding regulatory feedback.

Consumer & Community Banking: CCB generated $2.2 billion of net income and an ROE of 16.5%. We continue to grow core loans, up 9% year-on-year, driven by strength in Mortgage, up 12%; Card and Business Banking were each up 8%; and auto loans and leases were also up 8%, driven by strong lease performance from our manufacturing partners.

Deposit growth continues to be strong, up 10% year-on-year, with household retention remaining at historically high levels. We saw improvement in our deposit margin, up 16 basis points. Sales growth in Card was very strong again this quarter, up 15%, as new accounts mature. And merchant processing volumes grew double digits, up 12%.

Revenue of $11.4 billion was flat year-on-year. But recall that last year included a net benefit of about $200 million, principally driven by the Visa Europe gain. So excluding that revenue, it was up modestly.

Consumer & Business Banking revenue was up 13% on both strong deposit growth and margin expansion. Mortgage revenue was down 26% as higher rates drove higher funding costs, which, together with lower MSR risk management and lower production margins, put pressure on mortgage revenue year-on-year. In addition, revenue included a reduction of approximately $75 million to net interest income related to capitalized interest on modified loans.

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And Card, Commerce Solutions & Auto revenue was down 3%, but if you exclude the noncore items I mentioned, was up 2%, with NII growth on higher loan balances and higher auto lease income, predominantly offset by the continued impact of investments in Card new account acquisitions. Expense of $6.5 billion was up 8% year-on-year on higher auto lease depreciation, higher marketing expense and continued underlying business growth.

Credit Contagion

charge off rates

U.S. banks are witnessing a significant surge in credit card defaults – something we’re tacking closely.

Finally, on credit performance. Card Services drove higher net charge-offs year-on-year, but still within our guidance for the full year of less than 3%. Net reserve builds were around $250 million, building $350 million in Card, $50 million in Business Banking and $25 million in Auto, in part due to loan growth and in part higher loss rates in Card. This was partially offset by a release of $175 million in Mortgage, reflecting continued improvement in home prices and lower delinquencies.

To touch on consumer delinquency trends, in particular in Card, we are seeing some early signs of normalization, which are generally in line with our expectations and our credit risk appetite. And in Auto, our trends are relatively flat.

Corporate & Investment Bank: CIB reported net income of $2.7 billion on revenue of $8.9 billion and an ROE of 14.5%. In Banking, IB revenue of $1.7 billion was up 14% year-on-year, with strong performance across products but particular strength in DCM. We ranked #1 in Global IB fees and #1 in North America and EMEA. We were also #1 in ECM and DCM globally, in each case gaining share for the first half of this year.

Advisory fees were up 8%, benefiting from a large number of deals closed in this quarter. Equity underwriting fees were up 29%, better than the market, but relative to a weak prior year quarter. With a strong market backdrop and supportive valuations, we saw continued momentum in global issuance, especially IPOs. And debt underwriting fees were up 5% from a strong quarter last year, driven by the high flow volume of repricing and refinancing activity, even with fewer large acquisition financings.

In terms of the outlook, we expect IB fees in the second half of the year to be down year-on-year, given that we had the highest IB fees on record for a third quarter last year. That said, overall sentiment remains positive. ECM issuance is expected to continue, given the stable market backdrop. And the M&A backlog is healthy, with conditions remaining constructive for refinancing activity.

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Treasury Services revenue of $1.1 billion was up 18%, driven by higher rates as well as operating deposit growth. Lending revenue of $373 million was up 35%, reflecting lower mark-to-market losses on hedges of accrual loans.

Moving on to Markets, total revenue was $4.8 billion, down 14% year-on-year. Fixed Income revenue was down 19%, with decent performance across products relative to a very strong second quarter last year, which was driven by higher levels of volatility and activity broadly, including as a result of Brexit. This quarter conversely can be characterized by a lack of idiosyncratic events resulting in sustained low volatility, reduced flows and continued credit spread tightening, all of which impacted activity levels in rates, credit trading and commodities.

Emerging market performance was relatively stronger on a weaker dollar and lower rates as well as some regional events. Equities revenue was down 1%. In derivatives, on the structured side, we did quite well and outperformed. And on the flow end, we held our own in a quiet and therefore challenging environment. Prime was a bright spot as we are realizing the benefit of the investments we’ve been consistently making.

Before I move on, I would also like to remind you that the third quarter of 2016 markets revenue was also a record since 2010. In fact, it was about $1 billion more than the average of the previous 5 years. And so while that isn’t guidance, it is context as this quarter has felt quiet, more like prior years.

Securities Services revenue of $982 million was up 8%, driven by higher rates and higher asset-based fees on higher market levels. And remember, the second quarter benefits from dividend seasonality. Finally, expense of $4.8 billion was down 5% year-on-year, driven by lower compensation expense and the comp-to-revenue ratio for the quarter was 28%.

A look at Commercial Banking.   Another quarter of excellent performance with record revenue and net income and an ROE of 17%. Revenue grew 15%, driven by deposit NII as the rate environment continues to be favorable and on higher loan balances with spreads remaining steady. IB revenue was down due to the lack of large deal activity during the quarter, but underlying flow activity was solid across products as momentum continued and forward pipelines appear strong.

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Expense of $790 million was up 8%, and we expect this to grow modestly in the second half as we continue to execute on the investments in bankers and technology that we outlined at Investor Day.

Loan balances were up 12% year-on-year and 3% quarter-on-quarter. C&I loans were up 4% sequentially, ahead of the industry, on broad-based growth across markets and within specialized industries. CRE saw a growth of 2%, in line with the industry, but below last year’s pace on reduced origination activity as we continue to be selective at this stage in the cycle. Finally, credit performance remained very strong with a net charge-off rate of 2 basis points.

Leaving the Commercial Bank and moving on to Asset & Wealth Management. Asset & Wealth Management reported record net income of $624 million, with pretax margin of 32% and an ROE of 27%. Revenue of $3.2 billion was up 9% year-on-year, driven primarily by higher market levels, but also strong banking results on higher deposit NII. Expense of $2.2 billion was up 4% year-on-year, driven by a combination of higher external fees and compensation on higher revenue.

This quarter, we saw net long-term inflows of $9 billion with positive flows across multi-asset, fixed income and alternatives being partially offset by outflows in equity products. We saw net liquidity outflows of $7 billion, largely due to specific client deal-related cash needs. Record AUM of $1.9 trillion and overall client assets of $2.6 trillion were both up 11% year-on-year on higher market levels. Deposits were flat year-on-year and down 5% sequentially, reflecting the beginning of balance migration into investment-related assets, as expected, and those balances remained with us. Finally, loan balances were up 9% year-on-year, driven by mortgage, up nearly 20%.

Corporate reported net income of $570 million, which includes the legal benefit I mentioned earlier of $645 million in revenue or $400 million after tax. And a reminder, this is the same $645 million that was publicly announced in August 2016 and represents partial reimbursement for costs that we have previously incurred and paid that remained the responsibility of the WaMu receivership.

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Outlook: starting with the quarter, we guided second quarter NII (net interest income) to be up about $400 million from the first quarter, given the rate — the March rate hike, but you’ll see that the NII for the quarter increased by only $150 million. While we did fully realize the expected benefit of higher rates and continued growth, against that, we had the onetime $75 million mortgage adjustment as well as lower CIB market NII.

These effects, together with modest downward pressure from lower 10-year rates, with all other things equal, point to a full year number of closer to $4 billion up rather than the previous $4.5 billion, but with a potential to be higher if we continue to benefit from tailwinds of lower deposit reprice. So you will see we have adjusted the guidance, but it will be market-dependent. And any near-term forecast is sensitive to a number of factors, none of which changes our conviction that we will ultimately deliver $11 billion plus of incremental NII as rates normalize, and we are well on our way.

On expense, we continue to expect full year adjusted expense of $58 billion. Second quarter was in line with our expectation and our guidance at a little better than $14.5 billion, which is also where we expect the third quarter to come in.

Finally, we have revised our full year core loan growth down to 8% year-over-year, but a couple of comments. First, we are seeing slightly lower growth than we expected coming into the year, it is only modestly lower. And more importantly, we remain encouraged by the consistency and breadth of client demand across products.

Secondly, we noted that mortgage could be a big driver. And with a smaller market and a more competitive environment, fewer loans have met our hurdle rate. And of course, we remain appropriately focused on quality and not quantity of growth. And as such, loan growth is an outcome, not a target.

So to wrap up, we are very pleased with the firm’s performance this quarter, with all of our businesses showing broad strength. We maintained or improved leadership positions [above] delivering the benefits to both clients and shareholders of our operating model and our continued investments. We remain encouraged by the growth outlook for the global economy and expect continued solid growth here in the U.S., which positions us well going forward.

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The Demographics Myth Inside Labor Force “Participation”

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“The Federal Reserve is often the chaperone who has ordered the punch bowl removed just when the party was really warming up.”

William McChesney Martin, Fed Chairman from 1951 to 1970, special thanks to our associate Arthur Bass for this gem.

As U.S. unemployment crept lower in recent years, Federal Reserve Chair Janet Yellen stayed with the slow crawl of policy tightening.  Which begs the question, did the Fed keep interest rates too low for to long?

Jobs at First Glance

Friday’s jobs report showed  payrolls rising 222,000 in June, the biggest increase since February.   At first glance it appears joblessness has fallen further, to 4.4% in June from 4.7% at the end of last year and 5% in December 2015.  Average hourly earnings have risen at an average year-on-year pace of 2.6%, but lets look beneath the data to see what’s really going on.

File_002 (2)A picture says a thousand words – stubbornly low wage growth is being held back by an army of young people still sitting outside the labor force.  Blaming the 2008 financial crisis for this dynamic is the biggest copout in modern economics.  Just look at 2012-16 data, it’s clear this problem is structural NOT cyclical at this point.

Much of the media cheerleading during the Obama years covered up some UGLY data that’s still with us today and had a lot to do with the election of President Trump.

Far from intentional, but hopeful Media and Wall St. “Fed (central bank) cheerleading” has misled investors for years.  Every January like clockwork – from 2012 – on we were promised a “great rotation” out of bonds and into stocks.  Every year, the crowd has called for higher rates and bond yields – only to see them plummet again and again.  Year after year, bonds were panned – but often times were the place to be.

Hope is not an investment strategy – only by digging into the hard facts can the truth be found in the bond market.

U.S. Bond vs. Stock Fund Flows


Bonds: +$825B
Stocks: -$43B

EPFR, S&P Global data, cumulative data

Central bankers globally have created the mother of all asset bubbles here.  The reach for yield is unprecedented.  Interest rates should be used to price risk, today the risk-pricing mechanism is broken, it’s toxic.

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Productivity in Decline


Labor productivity is a measure of economic results – a comparison of the amount of goods and services produced (output) with the number of labor hours used in producing those goods and services. It is defined mathematically as real output per labor hour.  Growth occurs when output increases faster than labor hours – but we’ve seen very little of our long lost friend.  Labor productivity growth can be estimated from the difference in growth rates between output and hours worked.  During the 2012-2016 business cycle – labor productivity grew at a sad annualized rate of 1.1%*.  This growth rate is notably lower* than the rates of the 10 completed business cycles since 1947—only a brief six-quarter cycle during the early 1980s posted a cyclical growth rate that low (also increasing 1.1%).  That’s ugly indeed, but what’s driving this picture?

*U.S. Department of Labor, BLS data

Full Employment with Youth on Strike?

“Men ages 21 to 30 years old worked 12 percent fewer hours in 2015 than they did in 2000.  Nearly 15 percent of young men worked zero weeks in 2015, a rate nearly double that of 2000.”

Young American Men Living at Home with Parents or Relatives

2017: 35%
2000: 12%

National Bureau of Economic Research study, July 2017

Artificial Intelligence AI’s Impact, the Side Effects of Easy Money

There’s a lot going on in labor market data – far more than who led the country at one time or another.  We must ask a few questions?  How much is AI artificial intelligence (robotics) at play here?  By keeping interest rates so low for so long, has the Federal Reserve brought forward billions in venture capital dollars (funding the AI explosion) into a short period of time?  Investments which would have come over 20 years have been accelerated forward in time – displacing millions of workers?  How many jobs across the U.S. retail sector are robots eating each year?

Number of Robots across Fulfillment Centers

2020: 145k
2019: 101k
2018: 67k
2017: 45K
2016: 30K
2015: 20k
2014: 10k
2013: 5k
2012: 2k

Business Insider, Amazon data

Amazon and U.S. Jobs

Since October 2016, employment in the U.S. retail sector has plunged by nearly 160,000 jobs, that’s easonally adjusted, BLS data.

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Artificial Intelligence, the AI Explosion, thanks Janet?

AI Jump

U.S. Full Time Employed

2017: 126M*
2007: 122M
1997: 104M
1987: 92M

*From 2007 to 2017 the U.S. population grew to 325M from 301M.  Only 4m new full time jobs on a population 24m larger?  Yes, as immigration makes up most of the population growth, there are far less full-time jobs to support the influx of people jumping over the border – even less to support middle class Americans.  This helps explain secular stagnation and endlessly low bond yields – the U.S. has been in a productivity depression.

Productivity Depression

Hours Worked

Total hours worked per employee plunged during the Obama recovery – especially 2013-15.

BLS, Bloomberg Data

Real Unemployment Rate is Far Higher than 4.37%

25-54 Year Olds: Labor Force Participation: 81.6%, is down 2% from 2007

Labor Part 2

If you do the math, there’s roughly 20 million relatively young people NOT in labor force, this speaks to the opioid tragedy and income inequality.   The U.S. maintains 5% of the world’s population – but consumes 80% of the opioids produced on earth annually*.  The media blames demographics, but that’s only part of the problem – these are fairly young (25 to 54 years old) displaced workers.  There’s a reason why President Trump turned Michigan, Wisconsin and Pennsylvania red for the first time since the mid 1980’s – it has far more to do with the above data than Russians.

The Opioid Tragedy

Opioid abuse kills more than 100 Americans per day.   There are as many opioid prescriptions written annually in the United States as there are adults.   Over 97m Americans used prescription pain relievers in 2015 – while over 12m persons misused** their prescriptions.

*Angus Deaton, “Economic Aspects of the Opioid Crisis”
** National Survey of Drug Use and Health, Goldman Sachs

Latest Bank of International Settlements Report

Low Rates for Too Long = Misallocation of Capital

File_000 (2)Lots of financial engineering – NOT enough real job creation.  Low rates for too long has created “Zombie firms (top right above).”  Zombie firms are defined as public companies with EBITDA (earnings before interest, taxes, depreciation and amortization) to interest expenses ratio below one. 

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This Decade vs the Last


U.S. Population: +24M
Full Time Jobs: +4M


Population: +22M
Full Time Jobs: +18M

BLS data

Today we’re looking at 125.6m 24-54 Year Olds actually in the Labor Force.  As a percentage of the population – this number has come down over the last decade. 

Bloomberg’s View on the FOMC, our Comments in Bold

Victory? The Fed is Millions Away from that Declaration

Janet Yellen and her colleagues say they’re closing in on full employment, and she’s tiptoed closer to suggesting that slack has been absorbed, though she never declared total victory.

Reasonable Close?  It’s NOT Close at All

She said in January that the labor market was “reasonably close” to the committee’s maximum employment objective, for instance, and that the cyclical element of participation declines had “largely” disappeared.

May have been Lingering on the Sidelines?  Really?

The latest data could vindicate the idea that potential workers may have been lingering on the sidelines. The Fed has lifted rates only slowly, and the effect on the economy has been limited as financial conditions remain easy. Against that backdrop, employers continue to hire rapidly, taking on 222,000 new workers last month.

Finally Scraped Bottom?

It seems they’ve finally scraped bottom when it comes to people who are actively applying to jobs and thus classed as unemployed. Unemployment was 4.4 percent in June, up from a 16-year low of 4.3 percent the month before, and the share of people moving from unemployment to jobs has moved lower.

Sweet Accomplishment??? 

As that has happened, employers have begun to tap sidelined labor pools. The shift has helped to stabilize — and now slightly lift — the labor force participation rate, which measures what share of the population is working or looking for a job. That’s an especially sweet accomplishment for the Fed because it flies in the face of demographic trends, which should be weighing the rate down.


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