Jamie Dimon’s annual letter to shareholders (which doubles as an open letter to the entire universe penned by one of said universe’s masters) is out and as usual, it’s serving as clickbait fodder for every financial media outlet and market-focused web portal on the planet.
I never know whether to cover these kinds of high-handed screeds because really, who cares? 50 pages of pronouncements emanating from the desk of a titan are ostensibly “notable”, but it’s not always clear why.
The commentary on the bank itself is obviously important for investors (and for the economy more generally, given how systemically important JPMorgan is) and I suppose it’s possible for shareholders to extrapolate something about the bank’s strategic imperatives from Dimon’s broader musings about politics, the global economy and the balance of risks.
But for the rest of us, these letters are little more than a taste of what you would get if you were to find yourself in a free-wheeling discussion with Jamie about current events.
Take the following passage, for instance, pulled completely at random from page 36:
But maybe the most crucial privacy issue of all relates to protecting our democracy. Our First Amendment rights do not extend to foreign governments, entities or individuals. The openness of the internet means that trolls, foreign governments and others are aggressively using social media and other platforms to confuse and distort information. They should not be allowed to secretly or dishonestly advertise or even promote ideas on media and social networks.
Duly noted, and everyone will appreciate it if Jamie wants to tell lawmakers his opinion on those issues in the hope that his clout can help prevent attacks on America’s democracy, but if I were inexplicably inclined to read all 51 pages of Dimon’s letter, I imagine I’d be asking myself how, 36 pages in, I ended up listening to Jamie preach about internet trolls.
Anyway, there are some passages worth highlighting (which isn’t necessarily a testament to Dimon’s profundity, but rather speaks to the idea that if you write a 51-page manifesto once a year, you’ll surely say something that’s worth saying eventually, even if it’s just by accident). The bits that are grabbing headlines on financial portals are the following excerpts, with regard to liquidity and the “new normal”:
The fourth quarter of 2018 might be a harbinger of things to come.
Going into the final months of last year, optimism about the global economy prevailed, and this was reflected in the stock and bond markets. But in the fourth quarter, growth slowed in Germany; Italy repudiated European Union rules; Brexit uncertainty remained; and fear spiked around America’s trade issues with China. Among other geopolitical tensions, the U.S. government shutdown began. In addition, more questions arose about interest rate increases in the United States and the effect of the reversal of unprecedented quantitative easing, particularly in this country.
These issues, which reduced growth forecasts and increased uncertainty, should legitimately cause stock prices to drop and bond spreads to increase. However, stock markets fell 20%, investment grade bond spreads gapped out by 36% and certain markets (like initial public offerings and high yield) virtually closed down. Even at the time, these large swings seemed to be an overreaction, but they highlight two critical issues. One, which we never forget, is that investor sentiment can veer widely from optimism to pessimism based on little fundamental change. And second, for the fourth or fifth time in this recovery, there were excessive moves in the market with rapidly increasing volatility accompanied by steep drops in liquidity.
Market reactions do not always accurately reflect the real economy, and, therefore, policymakers and even companies should not overreact to them. But they do reflect market participant views of changing probabilities and possibilities of economic outcomes. Thus, policymakers (and banks), particularly the Fed, must necessarily (because they need to think forward) take an assessment of these issues into account.
At the risk of extrapolating too much re: whether Dimon reads the analysis that comes out of his own house, that second paragraph is basically a reiteration of Marko Kolanovic’s assessment of the December rout.
Kolanovic variously lamented the interplay between “collapsing” confidence among investors and the liquidity-volatility-flows feedback loop. Recall, for instance, this passage from Kolanovic’s March 21 note (more here):
Figure 1, below, shows the Q4 2018 market selloff (starting 9/20) and recovery, as well as the last 5 selloffs (since 2008). One can see that the duration of past corrections is consistent with the current recovery and market reaching new all-time highs in 1-3 months. What is drastically different with the Q4 selloff relative to other selloffs in the past decade is the market liquidity (market depth). This is shown in the table in the inset. Specifically the average liquidity during the last selloff and recovery was less than 1/3 of the liquidity in previous episodes (and about half of the worst liquidity drawdowns of the last decade).
And here are some excerpts from our post summarizing Marko’s exposition of the “loop” mentioned above:
Marko establishes the link between volatility and liquidity, where the latter is simply market depth which, as regular readers are acutely aware, has gotten considerably worse over time (i.e., it’s diminished).
Describing the chart on the left in the set of visuals shown below, Kolanovic notes that the relationship “is very strong and nonlinear e.g., market depth declines exponentially with the VIX.” That, Marko underscores, is the crux of the matter. “Given that an increase in volatility often results in systematic selling, this relationship is the key to understand market fragility and tail events”, he writes.
In the right pane above, you can see that negative relationship between volatility and market depth (i.e., liquidity) has become more pronounced (i.e., gotten “worse”) over the past decade.
The real kicker here is when Marko notes that when volatility spikes, the VIX becomes the only thing that matters when it comes to liquidity. To wit:
Figure 3 shows the % of liquidity variation that can be explained with the VIX over time (rolling R-squared). The higher the VIX, the more liquidity is driven by the VIX, and recently up to ~80% of liquidity variations were explained by the VIX.
That’s the context for Dimon’s discussion of “traditional/micro” liquidity which comes later in his letter.
We’ll just go ahead and leave you with the relevant passages on that from Jamie and then embed his entire tome below those passages for anyone who wants to spend the rest of their day perusing Dimon’s thoughts on literally everything under the sun.
The confusion and uncertainty around liquidity are causing some legitimate concerns. Several times in the last few years, including in the fourth quarter of 2018, markets exhibited rapid losses of liquidity, although fortunately, and importantly, the markets recovered in all cases – but that was in the context of a good environment. The ongoing debate around liquidity and short-term losses of liquidity in the market is an important one. We consider it in two ways: traditional liquidity and macro liquidity.
- I call it micro liquidity here, and it generally refers to the width of the bid-ask spread, as well as the size and speed with which securities can be bought or sold without dramatically affecting their price. There is no question that some micro liquidity is more constrained than in the past due to bank capital, liquidity and Volcker Rule requirements. In addition, high-frequency traders generally create some intraday liquidity (within a day), though even this is unreliable in a downturn. Because they rarely take positions interday (day to day), traders do not create real liquidity, but my view is that they increase the volatility of liquidity over time. There is no question that rules and regulations also cause unwanted and unnecessary distortions in money market vehicles, such as repos and swaps, particularly at quarter-end. If you look at liquidity – from before the financial crisis to today – in fairly liquid markets like Treasuries, swaps and equities, there is a noticeable difference. In good markets, liquidity is essentially high and is almost at the same level today as it was before the crisis. But when markets became volatile in the last several years, liquidity dropped much further and faster than it did before the crisis. It is important to remember that this happened in good times. Therefore, it is reasonable to expect that what we have been experiencing is now the new normal of liquidity – and that we should be prepared for it to be even worse in truly difficult times.
- This describes a broader view of financial conditions. For example, is it easy to borrow and lend? Are banks able to increase their lending? Is the cost of borrowing going up? Is the Fed adding or reducing liquidity in the system (essentially by buying or selling Treasuries)? There is no doubt that new regulations, particularly bank liquidity requirements, dramatically reduce the ability of the Fed to increase bank lending today by shoring up bank reserves. In the old days, the central bank could effectively create excess reserves by buying Treasuries. These excess reserves were lendable by the bank. Today, such reserves are often not lendable due to new liquidity rules. So bank lending as a function of deposits is, in effect, permanently reduced. The notion of “money velocity” and in fact the transmission of monetary policy are, therefore, different from the past, and it is hard to calculate the full effect of all these changes. It is extremely difficult for us, and probably even for the Fed, to know when and at what level the removal of cash (liquidity) from the system starts to significantly affect macro or micro liquidity. We will, however, probably know it when we see it