The banking industry continues its recovery from the financial crisis despite the fact that it is left with tremendous legal costs and slower earnings growth. Also the zero interest rate policy run by the Federal Reserve with the intention of boosting the economic activity initialed a significant net interest margin (NIM) contraction for the last couple of years. However, as the turnaround in monetary economics in the country is getting closer and we will likely see a NIM expansion again from 2015 onwards.
JPMorgan's (NYSE:JPM) CEO Marianne Lake offered a briefing presentation at Morgan Stanley Financial Conference on Jun 11 and pointed that JPMorgan is managing duration for a more normalized rate environment. She stated that the bank's market share in fixed income, currency and commodities trading (FICC) dipped to 15.4% in Q1 and roughly a 20% decline in trading revenue in Q2 is expected. A very well known slump in trading threatens the profit engine of Wall Street banks. This has been one of the most substantial influences on bank stocks for the last several months. On the other hand she mentioned that job and compensation cuts are on the table at the investment bank side due to the slowdown in trading. This would somehow offset the decline in trading revenues. In her presentation Ms. Marianne Lake also added that NIM and net interest income is expected to be relatively stable over the next two years, with the significant upside coming when the Fed takes up front-end rates as well as the bank modeling 2.65-2.75% over the next rate cycle. Excluding the lawsuit costs that would possibly grow, I think the decline in trading revenues and the net interest margin expansion seem to be the major catalysts to be priced in.
First, to be more precise about the impact of declining trading revenues, JPMorgan ranked number one in FICC trading last year by getting $15.5 billion in revenues. The banks also got $4.76 billion from equities. What's more the bank has generated an average 37 percent of its annual trading revenue during the first quarter for the last four years. A 20 percent drop would leave about $2 billion this year. Depressed rates and declining demand for banking services are among the headwinds the bank is confronting at the moment. As the gradual withdraw monetary stimulus starts and rate takes leg up, we will this time likely to see investor sentiment reaching a scary extreme in the fixed income market and driving the transaction volume down. Most probably the fixed income revenue for the bank will be stable over the next two years.
Second, it is absolutely true that within the US banking universe JPMorgan could be more profitable if it had a higher yielding asset mix. The bank reported a net interest yield of 2.20% which is below the average yield of large US banks (see the charts below). Bank of America (NYSE:BAC), Citigroup (NYSE:C) and Wells Fargo (NYSE:WFC) reported 2.36%, 2.90% and 3.20%, respectively. To able to reach its target NIM, the bank is required to have its assets much more geared toward loans. The bank has enough liquidity to stretch its loan to deposit (L/D) ratio. Its relatively low L/D ratio indicates that the bank may not be earning as much as it could be. On the other side the bank has a strong balance sheet and enough liquidity to cover any unforeseen fund requirements such as penalty payments arising out of the financial crisis. But for sure a gradually growing loan exposure will make the bank more profitable without increasing the risk.
Based on the catalysts mentioned above I valued the stock with a 12-month ROE/COE-based capital-adjusted model. The model is set up with four different NIM scenarios in which yield ranges between 2.50% and 3%, and a stable trading revenue after a 20% decline in 2014. The model also incorporates a 4% long-term growth rate and 10% cost of equity.
Numbers suggest that the stock roughly offers an average return of 17% over the next year if the bank reaches its target NIM range. In order to reach this target the bank will have to manage an asset transformation as detailed above. Thanks to its strong balance sheet the bank will do it without raising concerns around its liquidity coverage in my opinion. But the key risks for the stock will be legal costs that already have become a primary factory in stock-price performance. I also would see upside risk to valuations if higher dividend payments or share buybacks are allowed by the Federal Reserve.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.