martes, marzo 31, 2015

MAYDAY / THE ECONOMIST BUTTONWOOD COLUMN

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Buttonwood

Mayday

Financial markets have not priced in Britain’s shaky politics

Mar 28th 2015 
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THE British political system is noted for producing strong, stable governments. But that is changing fast. May’s general election may generate a chaotic result—something financial markets are being slow to recognise.

As in other European countries, voters are turning away from the mainstream parties. Britain’s first-past-the-post electoral system moderates the impact of this change. But the polls nonetheless suggest that both the Conservatives and Labour, the two parties that have dominated British politics for a century, will fall well short of a majority—as they did at the last election in 2010.

An average of four electoral models, along with the odds offered by Ladbrokes, a bookmaker, produces the following result: Conservatives 280 seats, Labour 273, Scottish Nationalist Party (SNP) 46, Liberal Democrats 25, UKIP 4 and others 22. With 650 seats in total, 326 are needed for an outright majority although, since five Sinn Fein (Irish nationalist) MPs tend not to turn up, 323 would be enough.

On those numbers, the current coalition of Conservatives and Liberal Democrats would not have enough seats to form a majority government, nor would a Labour/Lib Dem combination.

A formal Conservative/SNP deal would pass the numerical test but not a practical one: neither party would agree to it. Both Labour and the SNP have ruled out a formal coalition, which would in any case require the support of other parties (the Greens and the Welsh Nationalists, for example) to secure a working majority.

The most likely outcome, then, is that a minority government would take power, attempting to pass legislation on a bill-by-bill basis. The party with the most seats (on current betting, the Conservatives) would get the first chance to rule. But it would probably find it impossible to push through a financial plan that resembled its latest budget; indeed, Alex Salmond, the likely leader of the SNP at Westminster, has just said he would vote down any Conservative legislative programme.

Given that the SNP may well have the casting vote (it, too, benefits from first-past-the-post), Labour may end up in charge. But its programme would also be hostage to the SNP. Mr Salmond has made it clear he would be opposed to further austerity (as well as demanding an expensive high-speed railway line to Scotland). Either way, the creation of a minority government would lead to considerable doubt about the government’s fiscal position.

The last time a minority government took office was in 1974; a second election was called quickly. But the rules have changed since then. Now another election will take place only if a government loses a confidence vote (and no alternative can be formed) or if two-thirds of MPs vote for a new poll. That process (requiring many MPs to vote for early unemployment) would be another source of uncertainty.

Even if chaos is avoided, the results will not necessarily be market-friendly. If the Conservatives win, they are committed to a referendum by 2017 on exiting the European Union. That creates the potential for further uncertainty as the vote approaches. Some businesses may wait to invest in Britain until the result is clear.

A Labour victory would probably avoid a referendum, but investors would be worried about a perceived anti-business agenda of higher taxes and more regulation. The most market-friendly result might be a grand coalition of Conservative and Labour, but that is highly unlikely.

Ramsay Macdonald, the only previous Labour leader to agree to such a pact in peacetime, is reviled in party lore as a class traitor.

All this might not matter if the British economy did not have some significant weaknesses. Recent growth may have been strong (GDP rose by 2.6% in 2014) but the foundations look shaky.

Productivity is a big concern: output per hour is 2% below its pre-crisis peak. Andrew Haldane, the Bank of England’s chief economist, has suggested the next move in interest rates might be down, not up—hardly a sign of a buoyant economy. Britain’s current-account deficit, an annualised 6% of GDP in the third quarter, is equal to its highest level since 1955, making the country dependent on foreign capital.

As yet, markets show no sign of alarm. The FTSE 100 share index recently passed the 7,000 mark for the first time. Ten-year gilt yields, at 1.5%, are very low by historical standards. And though sterling is close to its lowest level against the dollar since 2010, it has held up well in trade-weighted terms, thanks to the euro’s weakness. All that may change abruptly in May.

Heard on the Street

Bond Funds’ Liquidity Presents Market Concern

Bond funds may be relying increasingly on investors who can take their money out at any time, creating another risk for financial markets

By Paul J. Davies 








Across all asset classes, the total amount in funds that can be withdrawn on a daily basis has grown 76% since 2008, the study found. Funds with daily redemption now make up 46% of the global investor base compared with 43% in 2008. In U.S. credit the numbers are more stark: global mutual funds offering daily liquidity have almost doubled their share of that market from 11% in 2005 to 21% at the end of 2014.

At the same time, the pattern of what companies are issuing to the market has changed in this world of very low interest rates. Risker companies can borrow more easily, but also safer companies can borrow for longer for less.

In Europe, for example, the share of investment grade corporate bond issuance with a maturity of more than 10 years has grown from 6.4% in 2011 to more than 25% at the end of 2014 and an incredible 38% so far this year, according to Société Générale. Longer-dated debt tends to be less liquid than shorter-term bonds.

Asset managers aren't like banks: they don't put their own capital at risk in the same way, but only deliver the results of market performance to their investors. Also, bonds should always be easier to sell than bank loans.

However, mutual fund investors are like the depositors of the capital markets, only they don’t have the safety net of national insurance schemes to protect and therefore pacify them. That means volatility could more easily become real turmoil.

Saudi battle for Yemen exposes fragility of global oil supply

OPEC's oil giant has daggers drawn with Iran, is encircled by enemies, and now faces a failed state on its southern border

By Ambrose Evans-Pritchard, International Business Editor

8:41PM GMT 26 Mar 2015

Houthi fighters ride a patrol truck in Sanaa

Houthi fighters ride a patrol truck in Sanaa  Photo: REUTERS/Khaled Abdullah
 
 
The long-simmering struggle between Saudi Arabia and Iran for Mid-East supremacy has escalated to a dangerous new level as the two sides fight for control of Yemen, reminding markets that the epicentre of global oil supply remains a powder keg.
 
Brent oil prices spiked 6pc to $58 a barrel after a Saudi-led coalition of ten Sunni Muslim states mobilized 150,000 troops and launched air strikes against the Iranian-backed Houthi militias in Yemen, prompting a furious riposte from Tehran.
 
Analysts expect crude prices to command a new “geo-political premium” as it becomes clear that Saudi Arabia has lost control over the Yemen peninsular and faces a failed state on its 1,800 km southern border, where Al Qaeda can operate with near impunity.
 
Over 3.8m barrels a day (b/d) pass through the 18-mile Bab el-Mandeb Strait off Yemen, one of the world's key choke points for crude oil supply. While there is little likelihood of disruption to tanker traffic, Saudi Arabia is increasingly threatened by Shiite or Jihadi enemies of different kinds.
 
Shiite Houthi rebels have already seized Yemen’s capital, Sanaa, and pose a potential contagion risk for aggrieved Shia minorities across the Saudi border in the kingdom’s Southwest pocket, never an area friendly to the ruling Wahhabi dynasty in Riyadh.

The Houthis are well-armed with rocket-propelled grenades and surface-to-air missiles that were either caputured or came from Iran. They have been trained by the Lebanese Hezbollah.

“I don’t think air strikes are going to do the job, and it is not clear whether Saudi Arabia is really willing to put boots on the ground,” said Alastair Newton, head of political risk at Nomura and a former intelligence planner for the first Gulf War.

“Nor do I have much confidence in the ability of the Saudis to wage a successful campaign against the Houthis, despite their massive superiority on paper. Yemen is very difficult terrain, as the British learned in the Aden crisis,” he said.

The Saudis face an impossible dilemma. The harder they hit the Houthis, the greater the danger of a power vacuum that can only benefit Al Qaeda and Islamic State groupings that already control central Yemen. They are among the most lethal of the various Al Qaeda franchises. A cell from that area was responsible for the Charlie Hebdo attack in Paris.



The last 120-strong contingent of US military advisers has been evacuated from the country, while Yemen’s own security apparatus is disintegrating. It is now much harder for the US to coordinate drone strikes or harass Al Qaeda strongholds.

"There is a real risk that the Saudis will keep doubling down in Yemen and in so doing will overstrain themselves—politically, militarily and even economically,” said Kenneth Pollack from the Brookings Institution in Washington.

Mr Pollack said the Saudis are being squeezed by low oil prices and the “exorbitant” costs of welfare spending and subsidies to stabilize the region after the Arab Spring. “The Kingdom cannot afford to get dragged deeper into a Yemeni quagmire it cannot stabilize on its own,” he said.

Saudi Arabia’s new king, Salman, has been spreading largesse in “a manner reminiscent of Caligula and Nero” to smooth his succession, he said, backed by police coercion to keep the lid on dissent. “Ultimately, repression and fear of civil war can only produce a (false) stability for so long,” he said.

Diplomats says the Saudis are more alarmed than at any time since Saddam Hussein’s invasion of Kuwait in 1991, with the added worry this time of luke-warm support from the Obama Administration in Washington.

Alireza Zakani, a key ally of Iran’s Ayatollah Khamenei, recently boasted that Iran now controls four Arab capitals through proxy Shia-oriented movements: Baghdad, Damascus, Beirut, and Sanaa. It is an exaggeration. None of these regimes take orders from Tehran.

Yet it is true enough to fan the worst fears of the Gulf’s royal dynasties. The ultimate nightmare for Saudis would be a revolt by the Shia majority in the Eastern Province, home to the giant Ghawar oil field and most of the kingdom’s crude output.

The level of Iranian involvement varies by country. The Qums division of Iran’s republican guard operates directly with Shia militias in Iraq. Elite Iranian units are on the ground in Syria. Prince Turki bin Faisal Al Saud, the former head of Saudi intelligence, recently told a forum in London that the Assad regime in Damascus would collapse within days without Iranian backing.

Iranian aid for Yemen’s Houthi rebels is less direct. It may be a bargaining chip to extract concessions, perhaps to pressure the Saudis to push up the price of oil by slashing production.

Iran needs an oil price of $130 a barrel to cover its budget, making it acutely vulnerable to the current Saudi tactic of flooding the market. Iran's leaders have accused Saudi Arabia of driving down price deliberately to squeeze the Iranian economy.

Yemen does not have a history of deep sectarian divisions, yet the lines of religious cleavage have been hardening. It is the latest country swept up an epic struggle for mastery between the Sunnis and Shias across the Middle East that some have compared to the Catholic-Protestant blood-letting of the Thirty Years War in 17th Century Europe.

The fast-moving events in Yemen are a bad defeat for the US, which had pinned its hopes on the British-trained president Abdrabbuh Mansour Hadi. American diplomats and security officials have had to destroy documents and make a dash for the exits, reminiscent of the final days in Saigon at the end of the Vietnam War.

The dreams of the Arab Spring have died in one country after another. Both Yemen and Libya have collapsed, prey to Jihadi groups in multi-sided civil wars.

Libya’s oil output has slumped by half to 400,000 b/d since late last year as rival militias fight for control, and ISIS spreads its tentacles. Iraq’s output fell to 2.6m b/d in February, partly due to spill-overs from the war against ISIS. This is 700,000 b/d less than planned.

For now the oil market is awash with excess production, perhaps by as much as 1.5m b/d, though estimates vary widely. The US and China have largely filled their strategic petroleum reserves and are running out of room. Traders are struggling to find more empty tankers to store crude. Refinery demand is falling due to the Spring maintenance.

Goldman Sachs expects oil prices to fall back to $40 and languish there through the second quarter before recovering as the growth of US shale output slows and global demand picks up.

Yet the global market of around 90m b/d remains tightly-balanced, prone to violent reversals.

Any sign that Saudi Arabia is becoming embroiled in “Vietnam-style” attrition in Yemen or that it cannot safely secure its porous northern and southern borders against Al-Qaeda/ISIS could upset the fragile psychology of the world’s oil markets in a heart-beat.
 

Editorial

A Dangerous Escalation in Iraq

By THE EDITORIAL BOARD

MARCH 26, 2015

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Tikrit, Iraq, on Thursday. Credit Khalid Mohammed/Associated Press       

                
The strikes are part of a campaign that from the outset has been waged without the authorization from Congress required by the Constitution. Mr. Obama is pursuing the operation at the request of Iraqi officials, who said air power was needed to break a stalemate. His reliance on two Bush-era war authorizations, for Afghanistan and Iraq, are insufficient to embroil the nation in the war against ISIS, which has been underway for eight months and could continue for years.
    
These strikes could further destabilize Iraq if the United States is seen to be siding with Shiite militias — which make up the bulk of the ground forces battling ISIS in Tikrit — over Iraq’s minority Sunnis. Yet in a sign of just how unpredictable the dynamics of the region are, some of the militias see the United States as the greater evil and are so angered by the airstrikes that they have already announced they are pulling out of the fight.
 
Until now, America has left the battle in the hands of a force of about 30,000 Iraqis led by Iran and composed mainly of Iran-backed militias; they are facing a far smaller group of ISIS jihadists. The Iraqi government and its army have been largely sidelined, having lost credibility when the army failed to stop the ISIS onslaught last year. Mr. Obama ordered the airstrikes on Wednesday after the nearly four-week-old ground offensive to retake the city had stalled.
 
Tikrit is a strategic crossroads in the heart of Sunni territory in central Iraq, and its liberation from ISIS control could make it easier to liberate Mosul, Iraq’s second-largest city, which is now also under the control of the Islamic State.
 

The overwhelmingly Shiite ground forces battling ISIS in Sunni Tikrit have become increasingly powerful as the government army has disintegrated. The militias have a brutal record of sectarian bloodletting, including burning and bulldozing thousands of homes and other buildings in dozens of Sunni villages after American airstrikes drove ISIS out of the town of Amerli in northeastern Iraq last summer. If that happened in Tikrit, the United States would be blamed for helping to trigger yet another cycle of horrific sectarian violence.
 

In the fight against ISIS, the United States and Iran, bitter enemies for decades, share the goal of defeating the group. American officials insist they are not cooperating with Iran, but the two governments communicate, through the Iraqis if not directly, and their operations have often been complementary. Many of America’s Sunni allies are concerned about Iran’s growing influence in the region, including in Iraq.
 
The administration may hope that a victory in Tikrit will bolster the standing of Iraq’s prime minister, Haider al-Abadi, who has made some strides in restoring Baghdad’s credibility after the disastrous tenure of his predecessor, Nuri Kamal al-Maliki. There was also hope of ensuring that the Americans, not the Iranians, would be the dominant foreign force in any coalition that attempts at some point to retake Mosul.
Before ordering the airstrikes, Mr. Obama reportedly insisted that the Shiite militias move aside so the Iraqi Army could play a larger role, and on Thursday Iraqi special forces were reported to be advancing on Tikrit. Maj. Gen. Qassim Suleimani, the commander of the Quds Force of Iran’s Islamic Revolutionary Guards Corp, who had been advising forces around Tikrit, reportedly left the area on Sunday.
 
The core problem is that if ISIS is expelled from Tikrit, the Americans and Iraqis will need to bring security and ensure there is a government that respects the rights of all citizens. That should involve reaching out to leading Sunnis and assuring them that they will be central to rebuilding, securing and governing their city. It has long been apparent that no amount of American military assistance alone can save Iraq if the country’s leaders continue to marginalize the Sunnis.
 
Relief aid, including electricity and water, should be delivered immediately to Tikrit. The militias must be marginalized or their fighters integrated into Iraqi institutions like the army and the police so that they serve the state rather than a warlord or faction. Grand Ayatollah Ali al-Sistani, the senior leader of the Shiite world, can have an important function in making the case for a more inclusive government. So can Iran, whose fitness for rejoining the international community will be judged by its willingness to cooperate on security in the region.

Lots to Worry About but Nothing to Fear?

By: Michael Ashton

Thursday, March 26, 2015


As we tick towards the end of the quarter, the news feeds are starting to look like they occasionally do when we are having a big spike in volatility.


We have the Greece deadline coming up. I don't think anyone knows exactly when Greece's finances will hit the wall, but it is going to be soon. And, compared with prior incarnations of this exact same crisis, there doesn't seem to be nearly as much optimism about the probability of a "positive" resolution to this crisis. By "positive," I mean in the sense that the status quo remains more or less preserved: Greece gets money, and pledges reforms, but nothing actually happens except that Greece's depression continues. I don't at all mean positive from the standpoint of the Greeks (I continue to think they will be better off in the medium-term to exit the Eurozone and default on Euro-denominated debt), or even from the standpoint of the Euro (assuming the single currency survives, the departure of Greece will be an important test case for the ramifications of re-shaping the currency bloc to a sturdier subset of countries that intend to move towards fiscal union). Interestingly, and in contrast to prior iterations of the exact same crisis, both sides appear to understand that Grexit does not mean disaster, and to perceive the possibility that it might make sense to let this happen - since, in any event, it is inevitable. There seems to be little urgency to craft a real deal, and the panicky increase in market volatility is missing this time.

The Middle East is increasingly in flames. What I call the "black I's" of Iran, Iraq, and ISIS are as unstable as ever, but now Yemen is in civil war with the existing government fighting Iranian-backed rebels and today Saudi Arabia plunged into the fight as a counterweight to Iran's influence. The comments that this should be only a short-term influence on crude oil prices because "the market remains oversupplied" make two assumptions that are possibly questionable here.

One is the technical point that the oil market is oversupplied (true), but that this means current prices should not react to disruptions to future supply. Of course, that is wrong: if it was suddenly discovered that all oil in the world was scheduled to evaporate on January 1st, 2020, you can bet your bottom petrodollar that prices today would (and should) react, even though that date is far in the future. Efficient markets reflect not only spot supply and demand, but also discount expectations for future changes in supply and demand (at least, for commodities that are storable at a reasonable cost).

The second assumption that may be questionable is whether the battle over Yemen is just a skirmish over a country with a small oil production footprint. Indeed, that may be the case.

However, the appearance of Saudi Arabia into the fray does make one wonder whether the Saudi Kingdom does see a bigger conflict at play here. To the extent that Yemen is an opportunity for Sunnis (most of the Arab world) and Shia (Iran, most of Iraq) to engage indirectly, it signals rising structural tensions in the region and the possibility for much wider conflict. An analogy might be the Cold War phenomenon of the US and the USSR engaging in conflict by proxy; that conflict never emerged into a hot war but that didn't make those of us hiding under our desks any more confident in the stability of the situation.

I don't have a strong opinion on whether either assumption is warranted, but it strikes me that markets for implied volatility ought to be somewhat more bid on either possibility, not to mention what is happening in Greece. And yet, they're not. The two charts below (source: Bloomberg) show the VIX and the MOVE (for bonds). Neither seems to be displaying much alarm at this point. It feels like we should be having a spike in volatility, but we are not. To me, this makes the buying of protective puts an attractive alternative to consider.

VIX 2008-2015
MOVE Index 2008-2015
 

Gold And Silver - What Moved Price? Bab el-Mandeb And Uranus Square Pluto. What?!

By: Michael Noonan

Saturday, March 28, 2015



So many "experts" have so much to say in correlating the current prices for gold and silver with factors like how much gold China and Russia have been accumulating, the shortages of and demand for physical PMs, hypothecating, rehypothocating [aka stealing] of gold by Western Central Banks, the record sales for gold and silver coins, world-wide, etc, etc, etc.

Yet, with all of the pinpoint accuracy in reporting, backed by statistics, graphs, charts with arrows drawn in to show the next direction [always wrong] for PMs, there has been little demonstrable cause and effect relations between events and prices. We have two.

The easy one first, yet the one hardest for most people to accept: planetary influences on the real world, found in the expression, "As above, so below." What happens above, in the planets, is manifested on earth. We do know for a fact that W D Gann was an astute astrologer, and he incorporated planetary movements very successfully in his work. "Wheels within wheels," as he would say. Planetary orbits within each other relative to earth.

Now, before dismissing this notion out of hand, consider this: Most people in the world believe a Federal Reserve Note [FRN], is actually a dollar. If you are one of the many who happens to believe this massive lie as a fact, you have your facts wrong and should not be so judgmental of other facts. As an aside, a Federal Reserve Note is a debt instrument issued by the U S Treasury. That is a proven and known fact. Where it breaks down is in the mistaken belief that debt is money. Debt is the opposite of money, but this is not an article on what is and what is not money.

The lawful definition of a dollar is found in the Coinage Act of 1793, Section 20. This Act has never been overturned and is recognized as law to this day. It is the corporate Federal government that chooses to ignore the law and pretend Federal Reserve debt is money.

Moving on.

A Uranus square Pluto conjunction occurs when the planets are 90 degrees apart from each other. From 2012 through 2015, Uranus has squared Pluto seven times, the last on 18 March, a few weeks ago. What happened to gold during these events? When the Sun transits [moves across] the mid-point of the square, a change in trend is indicated. The October 2014 squaring was somewhat of a non-event, but there was a brief opportunity, and one need not have suffered loss exposure. Plus, nothing is perfect.

For all of those who utilize fundamental analysis, even conventional technical tools, none have been as on target as the one from "Above."

Gold Weekly Chart


Back to earth. Where on earth is Bab el-Mandeb, and why did it affect the price of gold?

It is the purported shipping "choke point" for oil tankers, the 4th largest in the world. The strait is located between Yemen, Djibouti, and Eritrea, and it connects the Red Sea with the Gulf of Aden and the Arabian Sea.

Middle East Map

Saudi Arabia just pulled an Obama and began bombing Yemen back into the Stone Age.

Why? Ostensibly, the Saudis want to ensure the Bab el-Mandeb Strait is kept open for oil tanker passage. There is an unfounded "fear" that the Houthis of Yemen will cause major disruptions. Exactly who are the Houthis? Excellent question.

They are a purely Yemeni localized group, Shia, that want to keep Yemen free of government corruption. They are anti-American, no surprise there given the US history of destruction in the Middle East and the phony war on terror, but all the Houthis want is to be respected and not discriminated against by the government. They are not a warring faction and have no military capability, per se, and they have never been known to be a threat outside of Yemen.

They are being labeled as "rebels" by the mainstream press because the Obama administration wants that kind of rhetoric in order to shape public opinion about them.

The Houthis have had some backing by Iran, and therein lies the rub. It is really the Arab Sunnis against Iranian Shias. One brand of Muslims against the other. The bombing of Yemen is a proxy war to get to Iran, just like the US-led coup in Ukraine has been a failed proxy war against Russia, in fact, one that has back-fired badly on Obama. After three days of intense bombing by the Saudis, the entire military structure of the legitimate Yemeni government has been destroyed. No one is being held accountable. Obama is backing the Saudis on yet another war bringing yet more destruction to innocent people.

This Saudi action prompted a sharp rally in gold and silver. The threat to any blockade of the Bab el-Mandeb Strait is a fiction, yet oil and gold rallied because of it. By Friday, the tenor of the gold/silver rally had abated.

What could be interesting, as an aside, is to see if China steps in and tells the Saudis to back off.

China has a military presence near that strait, but the reason for a potential intervention is not that, rather, China has had its fill with the Obama administration administering destruction wherever it chooses to go.

While all eyes are focused on China's enormous build-up of physical gold, the anticipation that perhaps that country will use their gold to initiate a "gold reset" using the Yuan, and the eventual destruction of the Fed's fiat "dollar," [really, just a FRN, a debt instrument], hardly anyone was paying attention to another Uranus square Pluto, and few had ever hear of the Houthis or the Bab el-Mandeb Strait. Both were pivotal, albeit temporary, forces on gold, last week. We knew about the squaring, but not about the square off in the Arabian Gulf.

The month does not end until Tuesday, but we will include the monthly charts just to take a peek on how they may end and if they may show anything going into April. There is nothing conclusive that says the correction from the 2011 highs has ended. Rallying and staying above 18 is the first hurdle silver must meet.

Silver Monthly Chart

Going by previous patterns, last week we indicated this week's activity had a higher probability of being a small range bar, which is exactly what developed. The location of the close suggests more selling may enter the market next week, and that would be in keeping with price activity in a down trending market. The onus for change is on buyers, and they have not yet met that burden.


Silver Weekly Chart


The increased volume on the rally high, the mid-range close location on that bar, and the overlapping of the last 4 bars says sellers were meeting the efforts of buyers, creating a balance.

From balance comes unbalance and odds favor a correction, although anything can happen.

Two areas of support are the 16.60 to 16.37 area, to as far as the D/S bar [Demand over Supply] low, the 16.10 area. In a down market, price usually makes greater inroads into a D/S bar. The character of the bars on any decline, along with volume, will determine if identified supports will hold.

Silver Daily Chart


Regardless of where price closes for March, there is still a lot of effort required to turn this trend around.


Gold Monthly Chart


The developing market activity speaks for itself. Typical action in a down trending market.

There is still no evidence of a turn in the offering.


Gold Weekly Chart 2


After an $80 rally, there is room for a normal correction to develop over the next few weeks.


Gold Daily Chart

Barron's Cover

JPMorgan Rising

JPMorgan came out of the banking crisis stronger, but shares haven’t caught up. They could rise 30% in a year, not including the 2.9% yield.

By Andrew Bary

March 28, 2015

 
After five years of leading JPMorgan Chase through epic regulatory struggles and legal settlements, Jamie Dimon has cemented his position as the world’s top banker. As other big banks floundered in the wake of the financial crisis, he used JPMorgan’s strong financial position to push to the fore in investment banking, credit cards, and asset management. And with some $2.6 trillion in assets, JPMorgan is the country’s largest bank.
 
The bank’s strengths should soon become visible in earnings, which could climb to $24 billion, or $6.50 a share, next year, from an expected $5.76 a share this year and $5.29 in 2014. Investors, however, have yet to catch on. At a recent price of $60, JPMorgan’s shares (ticker: JPM) are valued at just over 10 times this year’s earnings, one of the lowest price/earnings ratios among big U.S. banks. At an undemanding 12 times 2016 estimated earnings, the stock could approach $80 next year -- a 30% gain. That still would be a steep discount to the Standard & Poor’s 500’s P/E of 16 times.
 
Based on a recent dividend boost, to an annualized $1.76 a share, the stock yields 3%, tops among its peers.
 
The bank showcased its key businesses and management team at its annual investor day last month. CEO Dimon spent time trying to demolish the idea floating around in recent months that the bank might be better off in pieces. The breakup idea gained currency thanks to the bank’s low P/E and the notion that parts would carry a higher combined value than the whole, due in part to lower capital requirements.
 
Dimon countered that JPMorgan is an integrated company with four “unbelievable” franchises that derive $18 billion of annual revenue and cost benefits from being together. He added that the bank can absorb increased capital requirements and still deliver impressive returns and higher earnings.
 
“If there was a theme to investor day, it was Taylor Swift’s song, Shake It Off,” says Mike Mayo, a banking analyst at CLSA Securities. “The message to the regulators was: Throw at us what you will; we still can generate a 15% return on equity.” The bank’s return on tangible equity last year was 13%, and its goal is 15%.

“We were tried, tested, and true during the worst of times,” says JPMorgan’s Jamie Dimon. Photo: Jason Alden/Bloomberg News

 
First-quarter results due next month could be strong. One encouraging sign: The bank said in late February that its trading results since the start of the year were running ahead of last year’s pace. The consensus estimate is for $1.40 a share of net income, up from $1.28 a year ago.
 
Mayo added that the bank and Dimon have an “unstated goal: to become a national champion.”

That’s not a label normally associated with big banks, given negative public perceptions and the massive charges for legal fees and regulatory settlements that the industry has taken in the past five years for a host of misdeeds leading to the 2008-09 mortgage crisis and other activities. Bernstein analyst John McDonald estimates the total charges at a stunning $123 billion for the largest banks since the crisis.
 
WHAT INVESTORS MAY NOT fully recognize is that JPMorgan has built several market-leading companies, including the country’s No. 1 credit-card company, based on outstanding loans; the No. 1 investment bank, by revenue; the top private bank; and the third-largest asset manager, behind BlackRock (BLK) and UBS Group (UBS). Dimon says that JPMorgan plays a vital role because multinational companies need a global bank for lending, foreign exchange, derivatives, underwriting services, cash management, among other services.
 
Mayo, a onetime JPMorgan skeptic who turned bullish in late 2014, carries a Buy rating and $70 price target. Street analysts like the bank, with 30 of 40 rating it a Buy and none carrying a Sell. “In addition to a discounted valuation, JPMorgan has adapted to the changing landscape, grown its market share, and reinvested back in the business,” says Barclays analyst Jason Goldberg, who rates it Outperform with a $73 price target.
 
“JPMorgan is a high-quality bank that has competitive advantages relative to everyone else. That should be worth a premium multiple,” says Ross Margolies, founder of Stelliam Investment Management, which holds JPMorgan shares. Dimon makes the same case, although he has said a premium valuation could take several years to obtain.
 
Current profits, moreover, may meaningfully understate its earnings power. At its investor day, JPMorgan laid out a bullish scenario in which it could earn $30 billion in 2017, up from $21.8 billion last year. That translates into $7.50 of earnings per share.
 
The $30 billion is based on a simulation, and thus isn’t a forecast. A key assumption is an increase in interest rates of more than two percentage points -- something a cautious Federal Reserve may not undertake. However, some increase in rates is a good bet, and JPMorgan calculates that its profits will rise nearly $2.9 billion, or about 50 cents a share, for a one percentage point rise in rates.
 
The dividend, meanwhile, is likely to go higher over the next five years. Dimon said at investor day that the bank’s dividend-payout ratio (dividends divided by earnings per share), now about 30%, ultimately could get to 50% if regulators allow it. That might mean an eventual doubling in the dividend.
 
Dimon, 59, regularly talks about the bank’s “fortress balance sheet.” While that may be an overstatement, since the bank still has considerable financial leverage, JPMorgan’s capital base and ample liquidity make it one of the most formidable financial companies. A key capital ratio has doubled since the financial crisis.
                 
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At its investor day, the company produced a slide showing its resiliency over the past five years. It generated $97 billion in net income, despite $22 billion of after-tax legal expenses and $13 billion of regulatory and control costs, including the expense of adding 16,000 employees in recent years to deal with the bank’s regulatory and legal burden. Over that span, tangible book value grew to $44.69 a share from $27.09, an impressive 11% annualized increase.
 
No wonder that Dimon gets frustrated sometimes, telling reporters on a January call that banks are “under assault” from regulators. “We have five or six regulators or people coming after us on every different issue. It’s a hard thing to deal with.” At other times, he’s more conciliatory, saying last month, “Let’s get it done, no whining, set the highest standards, meet our regulatory commitments, and not make excuses.”
 
JPMorgan likely has dealt fully with the mortgage liability stemming from its own activities and those of companies it purchased during the financial crisis. Remaining legal costs probably stem from a foreign-exchange trading inquiry and the Libor rate-setting scandal. Bernstein’s McDonald estimates that JPMorgan will add $2.2 billion to its legal reserves this year, down from $11 billion at their peak in 2013.
 
SO WHY DOES JPMorgan trade so cheaply? For starters, investors want to see an end to a seemingly never-ending series of legal settlements and penalties. The entire group of mega-financials -- Citigroup (C), Bank of America (BAC), Goldman Sachs (GS), and Morgan Stanley (MS) -- trade for 10 to 12 times estimated 2015 earnings. Wells Fargo (WFC), which has a higher return on equity, commands a P/E of 13. The large financials could be one the biggest pockets of value in the stock market, where it’s tough to find any major group of stocks trading at close to 10 times earnings.
 
SOME INVESTORS VIEWJPMorgan as a black box -- simply too big and complicated to understand. Dimon’s response is that the bank resembles a big regional in most of its activities and that the perceived trading and derivative risks at the investment bank are overblown. The bank doesn’t take big trading positions, he argues, focusing instead on generating profits from making markets on a large amount of customer activity. “We’re the Wal-Mart of fixed income,” Dimon told Barron’s. “We have huge economies of scale.”
 
The bank maintains that one scary figure -- some $63 trillion in notional derivatives exposure -- vastly overstates the risk because of offsetting positions and other factors. It puts the credit risk of those positions at about $59 billion, and almost 90% of that is exposure to high-grade companies.
 
The recent annual regulatory review of JPMorgan’s capital adequacy produced a mixed result. After the Comprehensive Capital Analysis and Review process, which involves a stress test seeking to measure banks’ ability to weather an economic downturn, JPMorgan was given the green light to lift its dividend by 10%, in line with expectations. However, it plans $6.4 billion of share repurchases over the next five quarters, below prior estimates of about $8 billion. The combined capital return -- dividend and buybacks -- is about 50% of earnings, below that of Wells Fargo, which is closer to 70%.
 
Look for JPMorgan’s total payout ratio to go higher in the next few years. In the meantime, it should build plenty of capital.
 
“We were tried, tested, and true during the worst of times,” says Dimon. “We’ve built four outstanding franchises, each with great prospects. Legal and regulatory issues should abate over time.”
 
The four business units are consumer and community banking, corporate and investment banking, commercial banking, and asset management. The credit-card business, for instance, has been overhauled since 2008 to focus on more-affluent consumers, and the success of the bank’s upscale offerings, like Sapphire, and co-branded cards with the likes of United Airlines, account for some of the competitive pressure on American Express (AXP). JPMorgan even has a superhigh-end offering in its Palladium card that it believes is better than AmEx’s exclusive Centurion or Black card.
 
The corporate and investment bank is the industry leader in investment-banking revenues, which include advisory fees and underwriting revenues. It also sets the pace in controlling costs with employee compensation last year, accounting for just 30% of revenues, versus 37% for Goldman Sachs. There’s a growing moat around the business as global banks scale back or eliminate their trading operations.
 
Investors also get the services of Dimon, the country’s top banker and a champion of both JPMorgan and the industry, in a difficult political and regulatory environment. Mayo says Dimon could be “a character from a Hemingway novel, with all his bravado and hubris.” Dimon, who’s healthy after treatment for throat cancer last year, talks about staying another five years at the helm.
 
The outspoken Dimon can also come across as the smartest guy in the room, ruffling regulators and politicians. He brings experience, passion, strategic vision, and a familiarity with minute details of the bank’s vast operations. No major financial company is so closely identified with its leader.
 
The investor day also highlighted the bank’s bench amid concerns about CEO succession. Possible successors to Dimon include Marianne Lake, the chief financial officer; Matt Zames, the chief operating officer; Gordon Smith, the head of the consumer and community bank and former chief of the credit-card operations; and Mary Erdoes, the head of asset management. Dimon, like Berkshire Hathaway’s Warren Buffett, seems intent on leaving his company in such strong shape that his successor won’t need a commanding presence.
 
Dimon sees JPMorgan as a national asset, and that it would be a loss to the country if regulators ever force a breakup of the bank. “America has been the leader in global capital markets for the last 50 or 100 years,” he said on the January earnings call. “It’s part of the reason this country is so strong. I look at it as a matter of public policy. I wouldn’t want the next JPMorgan to be a Chinese company.”
 
U.S. bank regulators are concerned about the risks with the largest banks, and one result is that JPMorgan may need to carry the U.S. industry’s highest capital cushion to reflect its size and complexity. While final rules have yet to be set, JPMorgan might have to maintain by 2019 an 11.5% ratio of Common Equity Tier 1 to adjusted assets, 4.5 percentage points above the minimum of 7%. JPMorgan is the top U.S. bank in assets at $2.6 trillion, versus $2.1 trillion for Bank of America, $1.8 trillion for Citi, and $1.6 trillion for Wells Fargo.
 
JPMorgan is well on its way toward reaching that 11.5% capital goal, as its Tier 1 ratio stood at 10.2% at year-end 2014, double the 2007 level. It aims to hit 11% by the end of 2015 and 12% by 2018.
 
THE CAPITAL RULES ARE prompting JPMorgan to take a hard look at all of its businesses and activities to see whether they can stand up to the higher capital standards. It is moving to shed $100 billion of non-core deposits by the end of this year. JPMorgan is also telling hedge funds and other prime-brokerage clients to boost their business with the bank to justify the capital-heavy nature of their relationships.
 
Rivals like superregional U.S. Bancorp (USB) see opportunity because their simpler business model means lower required capital and thus an ability to underprice the giants on loans and still earn adequate returns.
Dimon is unfazed by the capital issue, saying the bank has long carried more capital and liquidity than its rivals and still maintained its competitiveness.
 
One of the chief complaints among big investors is the difficulty in finding good growth stocks in the current market. As a result, Facebook (FB), Under Armour (UA), and other fast-growing companies trade for lofty valuations. With a tail wind coming from higher rates, JPMorgan could emerge as an exciting growth story in the next few years, and it’s available now for just 10 times forward earnings.