06.02.22: When the CEO of America’s largest bank says “brace yourself” for an economic “hurricane,” investors should take notice. While Jamie Dimon is not an elected official, he is a de facto economic policymaker. That’s because Mr. Dimon controls JP Morgan (JPM), the largest bank in the United States, the world’s largest bank by market capitalization and the world’s fifth-largest bank ($3.744 trillion in total assets). On Wednesday Dimon warned investors that JPM will be “bracing ourselves and we’re going to be very conservative with our balance sheet.”
JP Morgan caught our attention on April 13 when the bank raised its loan loss provisions by $1.4 billion in Q1, reversing five consecutive quarters of reductions. The move stood in stark contrast to Wells Fargo, which reduced its Q1 loan loss provisions by over $700 million. Other large banks also raised their loan loss provisions, but not nearly by the same magnitude as JPM. We expect the big five banks to hike their loan loss reserves in Q2.
Tighter lending standards among our nation’s largest banks holds obvious implications for credit markets in general. To date, the yield premiums corporate bond lenders require to extend credit to investment-grade borrowers and below have remained relatively stable. Historically, corporate credit spreads follow lending standards, since tighter standards restrict the supply of available funds, particularly among corporate borrowers. Dimon’s remarks suggest loan loss provisions will likely rise in Q2. We expect corporate bond lending spreads to widen as a result, putting additional downward price pressure on lower-quality bonds.
Triple-C-rated “junk” bond prices have tracked those of higher-quality bonds through April, falling as interest rates rose. The default risk premiums have remained stable, however. Lower-quality bonds underperformed their higher-quality counterparts for most of May and rebounded in tandem with equities. High-yield investors have not raised their default risk premiums to the extent that equities would suggest. Perhaps lenders believe higher inflation will enable weaker borrowers to pay back their loans with cheaper dollars. We expect tighter financial conditions and slower growth will eventually weigh on lower-quality corporate bonds.
Corporate bond yields stick out relative to equities also, appearing overly optimistic, as Cresset’s equity valuation model suggests. The BBB bond yield is a critical component of our model. Historically, the markets’ earnings yield, the reciprocal of its forward price-earnings ratio, mirrors the investment-grade bond yield. The S&P 500’s forward earnings yield is nearly one percentage point higher than the 10-year, BBB bond yield, suggesting that spreads could widen by nearly one percentage point without having an impact on equities. If equity investors are correct, and Jamie Dimon’s “hurricane” makes landfall, corporate bonds – particularly the lower quality variety – are vulnerable.