06 March 2018


by Blake Allen

Two important events in the US financial landscape took place last week: JP Morgan’s (JPM’s) annual investor day, and Jerome Powell’s testimony before congress. Powell expressed an optimistic assessment of the US economy, and largely reiterated the US Federal Reserve’s (Fed’s) previous guidance for interest rate hikes and balance sheet normalisation. Yet the content of his presentation suggested a slightly more hawkish Fed, reflecting continued confirmation of improving growth and inflation dynamics. He stated, for example, that “We have seen some data that will, in my case, add some confidence to my view that inflation is moving up to target.” Such statements, at the margin, indicate yet another step or half-step towards “normalisation.” And this was reflected in a rise in the market’s implied probability of the number of rate hikes in 2018 going from three to four. The shift also rippled through the equity markets, reasserting an emerging theme of 2018: the return of volatility.

That both equity and bond markets sold-off in tandem thereafter reflects the risk that if rates rise too rapidly they could start to weigh on the equity market by compressing PE multiples. This would entail both pillars of the classical diversified portfolio – bonds and equity – simultaneously being under pressure from rates. Thus, the apparent serenity of the beautiful normalisation of 2017 is now slightly more vexed. Although rates have recently increased somewhat more rapidly than we had anticipated earlier in the year, and the yield curve continues to flatten (typically a negative signal for risk assets), global markets are still within the broad parameters of our pro-growth thesis for 2018, reflected in overweight equity/ underweight bonds allocations. This also involves an overweight position in Banks.

Global Banks, in general, are an attractive asset class at present. After almost a decade of extreme headwinds, many of these pressures are turning into tailwinds: while banks have struggled for years to build sufficient capital, many now have excess capital; and while the regulatory environment was becoming increasingly onerous and draconian in the post-global financial crisis (GFC) years, banks are now largely on top of regulation, with the pile of GFC litigation largely behind them, and the regulatory tide is actually turning towards deregulation.

Further, valuation multiples are still quite modest; even while Banks are now far less risky businesses – having curtailed such business units following the GFC, and due to much higher capital requirements; and yet ROEs are trending upwards and reaching now quite attractive levels.

Banks are one of the few asset classes whose valuations tend to benefit (up to a point) from rising interest rates, and this is likely to remain a major theme for the remainder of the year. Yet, for reasons to be discussed below, the earnings boost from rising rates in 2018 and beyond is likely to be lower than it was last year.

These developments, generally bullish as they are, aren’t equally bullish for all banks. The tech drive seen amongst the large banks will probably allow them to continue taking market share from smaller players. JP Morgan is a particularly well-positioned large bank, and the above-noted economic developments were evident at its investor day held last week.

On the macro front, JPM presented a characteristically bullish picture of the US economy and its own prospects (the US is 80% of their business; rest of the world only 20%). Yet, it must be noted that the operational outlook was quite mixed, with some profit drivers a little uninspiring. The negatives are, in our view, more than counterbalanced by the positives, such as their continued strategic and technology-related investments, excess capital and continued buyback program, and the profit-boosting effects of US tax reform. Here are some of the details of JPM’s guidance and expectations:

  • Core loans to grow at a slower pace in 2018, at 6-7% (excluding the CIB division). This compares to the 2014-17 CAGR of 13%. This is mildly concerning, as soft core loan growth in tandem with a Fed Balance Sheet unwind paints a less bullish GDP outlook. In the medium term, however, JPM still presented an attractive earnings growth outlook, as the company continues to invest heavily in growth (especially in technology), and plans to enter 15-20 new markets over the next 5 years. That JPM has the right sort of strategic DNA in its decision making processes – the company relentlessly focuses on investing for long-term opportunities, and has tended to avoid the traps of short-termism – is part of the reason we continue to favour the stock.
  • Net Interest Income (NII) to grow by about 6% in 2018 ($54-5bn in 2018, vs $51.4bn in 2017); which is merely in line with core loan growth. JPM does expect a further $2.5bn rise in NII to come from rising rates until the “neutral rate environment” is reached; but this is rather lacklustre, representing only 4.9% of 2017’s NII. This relatively underwhelming number could be traced to a few factors, including: rising money-market rates will diminish the lag, and discount factor, with which banks reprice deposits (i.e. the “deposit beta” will rise); the US yield curve is flattening, thus reducing the interest differential banks can earn through maturity transformation. Such factors are evidently weighing on the outlook for NII growth; and indeed JPM noted that in the longer term, “NII growth will be driven mostly by balance sheet growth and mix” (as opposed to NIM ratcheting higher).
  • Non-interest Revenue is expected to grow at 7% in 2018, and roughly 3% p.a. thereafter. Again, this is roughly in-line with BS growth in 2018, and rather lacklustre in the following years.
  • Expenses are expected to rise by about 6% in FY18 (adjusted for changes in Accounting standards w.r.t. revenue recognition). Although this is in line with revenue growth in 2018, we think the currently high investment in tech will allow an improving cost/income ratio beyond 2018.
  • Credit costs: JPM expects 2018 net charge offs (NCOs) to remain “relatively flat” in 2018, and “relatively benign” in the medium term. With the exception of Auto lending, they expect NCOs to rise in every lending category in the medium term (see table below).

JP Morgan’s estimates of net charge off rates:

This is however consistent with their judgement that current levels are at record lows. Thus, beyond 2018, one would expect credit costs to be a headwind to ROEs as credit costs rise from record-low levels.

  • Medium-term ROTCE was raised from 15% to 17%. Perhaps surprising in light of the above guidance. The number is 200 bps higher than their previous guidance, and reflects the effects of US tax reform (up to 300 bps tailwind), as well as the fact that, given increasing regulatory clarity, JPM is evidently overcapitalised and can return excess capital to shareholders (thus reducing the BS). This is being effected through higher dividends and buybacks, and JPM now expects the net payout ratio to rise from 90% (2017 guidance) to 100%. (Note that the net payout ratio reflects all returns of capital, i.e. both dividends and buybacks).

In short, JPM appears to be in good shape, and is investing proactively for medium-term growth. We think the company will continue to gain market share from its peers. Although there are some headwinds to 2018’s earnings growth, these should be more than offset by the effects of US tax reform; thus JPM should still grow EPS in FY18 by c. 25%. As we expect GDP growth to continue at healthy levels in 2019, we still expect reasonable, though somewhat lower, EPS growth beyond 2018 (supported by a reduced share count following JPM’s buybacks). At a roughly 12.5x forward PE (FY18), we still think JPM is an attractive investment.



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