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:
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.
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.