Markets can't ignore the real economy for much longer

published 15 October 2009

Traders in Wall Street cheered and clapped as the Dow breached 10,000 yesterday.

Not so long ago, they were casually shrugging and sitting on their hands as it stormed past 14,000. But that was in another era, before the Great Recession. Now we're in the Great Recovery, and the mere feat of getting back to five figures on the Dow is worthy of applause.

So what's coming next? 11,000 or 9,000?

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Yesterday's news demonstrated very well the vast disconnect between the financial economy and the 'real' economy. Of course, they're all part of the same thing, which means that one can't disconnect from the other for very long. The big question right now is, will the real economy catch up with the financial one? Or will the financial world be dragged back to grim reality?

Where did JPMorgan's money come from?

Let's have a look. One reason for the market's jubilation was third quarter results from JPMorgan Chase. The bank hammered analysts' estimates by churning out $3.6bn in net income for the three months to 30 September.

Guess where the money came from. Was it the credit card unit? Of course not. Your average man and woman in the street are either paying off their credit cards, or have already defaulted. That particular unit made a $700m loss. Debt write-offs are rising, accounting for 10.3% of outstanding balances. And as Ian King points out in The Times, the picture is deteriorating, not improving. JPMorgan chief executive Jamie Dimon reckons credit card losses could be "north of $1bn the first and second quarter."

What about other forms of consumer lending? Forget it. That division had a net loss of $1bn, worse than last year. It now expects write-offs to hit $3.8bn, compared to earlier provisions for around $2bn. Total retail loans outstanding fell by 3% - in other words, people repaid more than they borrowed. And corporate lending has fallen too.

No, the lion's share of the money came from investment banking where profits more than doubled due to heavy trading in the fixed income markets and a flurry of corporate deals. And it's little wonder given that the third quarter was the best ever for many capital markets around the world that it's made a lot of money. The group made $1.3bn from trading on its own account a figure which it warned will fall sharply "as markets normalise" in coming quarters. It also was able to "write up" various once-toxic securities by $400m.

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The problem with the Western financial system

Now bear in mind that JPMorgan, of all the banks in the West, is one of the ones that handled the financial crisis most adeptly. But as Lex points out in the FT, "JPMorgan's fundamental problem is an overexposure to arguably one of the big themes of the next decade: the deleveraging of western households and companies after years of extension anything to do with lending to consumers or companies, by JPMorgan's own admission, looks grim indeed."

And this is pretty much the problem with the entire Western financial system. It's all very well for a financial company to make decent profits when markets have an unusually good quarter. But while markets can detach from the underlying economy for periods of time, they do, in the end, depend on the underlying performance of the companies within them. And that, in turn, depends on the health of the real economy.

If consumer credit and therefore spending is falling, and company borrowing and therefore spending is falling too, then companies can only boost their profits by cutting costs. That'll do nicely for a short while. It could certainly be more than enough to make this third quarter earnings season look very good indeed to investors with low expectations. But after that, you need sales to pick up, and some sign that companies are planning to expand and invest.

However, if consumers are still picking up the pieces from being made redundant, and fretting about repaying their debts, then that's easier said than done. Particularly as the boost that consumers have had from lower prices and lower interest repayments looks as though it might be reaching an end.

For example, the price of crude oil has been shooting up again, helped by a weak dollar and, no doubt, the amount of money sloshing around the markets. A high petrol price both here and in the US is not great for consumer sentiment some analysts have even blamed the spike in oil prices for causing the crash in 2008. We wouldn't go that far, but another oil price spike certainly wouldn't help consumers.

Where investors should be putting their money now

I wouldn't short the Dow from here there's too much risk it could go higher as more companies beat low-ball expectations. But in terms of investing over the longer term, as the comments in Lex suggest, investors would be better to look to 'emerging' (or as David Fuller on Fullermoney calls them, "progressing") markets, rather than rebounding Western ones. My colleague Cris Sholto Heaton keeps an eye on events in Asia in his free weekly email, MoneyWeek Asia if you don't already get it, sign up for MoneyWeek Asia here.

Just before we go, a reminder about the World MoneyShow, coming to London at the end of this month. It's a convenient way to get to hear from investment experts from across the world, including the likes of Marc Faber of the Gloom, Boom and Doom report. I'll be there too, along with Paul Hill and Dominic Frisby from the MoneyWeek team. The show takes place at the Queen Elizabeth II conference centre on Friday 30 and Saturday 31 October I hope you'll come along. Find out more about the World MoneyShow here.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.