Despite the high valuation and decline in its stock price after reporting fourth-quarter and full-year earnings for 2021, I still believe JPMorgan Chase (JPM -0.40%) is a best-in-breed banking stock with its fortress balance sheet and ability to perform well in just about every area of banking. After all, America's largest bank by assets did generate more than $125 billion of revenue on a managed basis in 2021. Nevertheless, the bank may struggle to generate the type of returns that investors have become accustomed to in recent years due to some near-term headwinds. Here's why.
Measuring the bank's returns
One way to measure JPMorgan's performance on a quarterly and annual basis is through return on tangible common equity (ROTCE), which is the technical rate of return on shareholder capital after removing preferred stock, goodwill, and intangible assets. That's certainly a strong number given the complexity of the bank and the amount of regulatory capital it must hold. In recent years, despite the lumpiness, JPMorgan has largely exceeded the 17% target.
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In 2019, before the coronavirus pandemic and when the federal funds rate was higher, which tends to benefit banks, JPMorgan Chase reported a 19% ROTCE. In 2020, the bank reported a 14% ROTCE and then a 23% ROTCE in 2021. But both ROTCEs in 2020 and 2021 were heavily impacted by reserve capital. In 2020, JPMorgan had to set aside a ton to prepare for potential loan losses, which significantly hurt earnings. In 2021, after realizing those loan losses would not come to fruition, JPMorgan released that reserve capital back into earnings, which significantly raised the ROTCE. When reserve capital was stripped out in 2020 and 2021, JPMorgan generated a 19% and 18% ROTCE, respectively.
How were those numbers so good with such little loan growth and low interest rates over the past two years? Well, the bank's corporate and investment banking (CIB) division had outstanding years, first in its capital markets businesses and then in investment banking in 2021. But with revenue in CIB expected to normalize this year and interest rates still relatively low, all things considered, the 17% target becomes more difficult.
2022 net interest income guidance
I believe that most of the sell-off following JPMorgan's earnings report on Jan. 14 came from the bank's guidance, which was a bit confusing and also seemed to imply less-favorable results this year and possibly next as well.
One of the main things that banks will typically provide guidance on is net interest income (NII), which is the money banks make on loans and securities after covering the cost of funding those assets. When the Federal Reserve raises its benchmark overnight lending rate, the federal funds rate, banks tend to make more NII because more yields on their assets, such as loans and securities, reprice higher with the federal funds rate than the rate on their liabilities, such as deposits. JPMorgan does expect to see more NII as a result of rising rates. NII from loans and securities in 2021 was roughly $44.5 billion. With projected rate hikes this year, some loan growth, and deployment into securities, JPMorgan expects to see that amount rise to about $50 billion in 2022.
But JPMorgan also generates NII from the bank's CIB markets division, largely through the bank's fixed-income capital markets business through activities such as holding bonds and doing some lending and financing to clients as well. That NII was very strong in 2020 and 2021, coming in at $8.4 billion and $8.2 billion, respectively, but it is now expected to normalize as rising rates also push up the cost of funding fixed-income assets. In 2019 during a more normal economy, CIB markets NII was only about $3.1 billion. So even though JPMorgan is expected to benefit nicely from higher rates, NII may actually be offset some by the drop in CIB markets NII, although this NII can be more difficult to predict.
2022 expense guidance
JPMorgan's expense guidance also seemed to catch analysts by surprise. After expenses came in just shy of $71 billion in 2021, management expects expenses to hit roughly $77 billion this year, which is not an insignificant increase. Roughly $2.5 billion of that increase will be put toward employee compensation and the normalization of travel and entertainment spend, with roughly $3.5 billion being put toward investing back into the company for things like tech capabilities, expansion, and marketing.
As analysts on the conference call following earnings pointed out, this kind of expense increase will likely make it difficult for JPMorgan to generate positive operating leverage this year and potentially next year as well, which is when revenue growth outpaces expense growth.
But CEO Jamie Dimon said that achieving a 17% ROTCE is not out of the question in 2023, depending on things like the performance of fixed-income capital markets and the deployment of excess cash, which the bank has been conservative about. Investors also seem to be somewhat frustrated because JPMorgan has been significantly increasing investments in the company for the last few years, so they want to see those investments show up in the returns.
Headwinds ahead on the road to success
JPMorgan's stock has run up to a pretty high valuation and does face some headwinds in the coming years. At this point, there is likely the potential for much better returns in stocks like Citigroup and Wells Fargo, which are in turnaround mode. But there is also more risk involved with those two, whereas I still feel confident that JPMorgan management is prudently running the company and investing in order to deal with all of the competition in the banking space now and in the future. I still believe in the bank's ability to generate steady and consistent returns for investors, even at its high valuation.
