Portfolio manager Margaret Samuel looks at two global bank stocks as potential investments against a backdrop of rising interest rates.
The pandemic has created a level of forced savings not seen since World War II. The market is looking forward to more normal activity levels, and we expect that pent-up demand will be expressed in accelerated consumer and business spending including inventory building.
Although central banks project accommodating policies for some time in the future, the longer end of the bond market reflects this expectation of future spending with increasing rates, albeit from historically unprecedented low levels.
Increasing yields, especially with a steepening curve, can benefit financial stocks to the extent that their yields on longer-duration loans exceed their interest-rate obligations on shorter-dated deposits. In addition, with oil prices rising, the prospects for Western Canadian energy companies to repay loans to banks may improve.
Let’s look at a US bank and a competing major Canadian bank as potential investments against the backdrop of rising rates.
JP Morgan Chase & Co. (NYSE—JPM)
JPM is a financial holding company engaged in investment banking and financial services with 2019 revenue of $119 billion USD and it operates in four segments.
The first is Consumer and Community Banking, responsible for $56 billion USD revenue in 2019, and which operates bank branches, automated teller machines, telephone banking, mobile banking and online banking to offer services to consumer and business clients. With an ROE of 31 per cent, this segment serves 63 million US households, has 9.3 per cent of the market share of retail deposits, and is the top sales-based credit card issuer. In addition, more than three-quarters of its checking households use it as their primary bank. Rising rates, especially with a steepening yield curve, may benefit this segment that generates much of JPM’s revenue.
JPM’s second segment is Corporate and Investment Banking, generating $38 billion USD revenue in 2019 and which generates a 14 per cent ROE. It offers treasury and securities products and services, prime brokerage, market-making, and investment banking services to municipal entities, government organizations, financial institutions, investors and corporations. More than 80 per cent of Fortune 500 companies do business with this segment in over 100 markets around the world. This segment ranks first globally in markets revenue and investment banking fees, processes the greatest volume of USD payments, and is the second-largest custodian with $27 trillion USD in assets under custody.
The third segment, Commercial Banking, created $14 billion USD revenue in 2019 and provides asset management, investment banking, treasury services and lending solutions to about 18,000 commercial and industrial clients, and approximately 34,000 real estate investors and owners. With 30 international locations and 142 locations in the US, this segment generated $2.7 billion USD of investment banking revenue in 2019 and an ROE of 17 per cent.
The fourth segment, Asset Management, was responsible for $9 billion USD of the corporation’s revenue in 2019. This segment was the top private bank generating an ROE of 26 per cent in 2019 with $2.4 trillion USD in assets under management providing wealth management and investment management services for 59% of the world’s largest central banks, sovereign wealth funds, and pension funds.
With its broad diversification, JPM benefits in a challenged environment. For example, lower rates are offset across its businesses such as mortgage trading and mortgage origination. As another example, in 2019 a slowing European economy was offset by robust global growth, given JPM’s geographical diversification, and strong consumer sentiment in 2019 that offset weaker corporate sentiment due to JPM’s diversity of clients.
As CEO Jamie Dimon stated on December 8, 2020 “we want to run an efficient business while investing for the future. So, we spend more time in the present while investing for the future. We’re always doing both.”
Not only can a large part of its business benefit from rising rates, but this quote suggests that JPM is led by wise management as well.
Royal Bank of Canada (TSX—RY; NYSE—RY)
RY has approximately 17,000,000 clients with more than 86,000 employees, operates in about 36 countries and, on the basis of market capitalization, is the largest bank in Canada and one of the ten-largest global banks. While most (59 per cent) of its revenue is generated in Canada, 25 per cent is US and 16 per cent international.
In its presentation for the fourth quarter of 2020, RY reports a strong financial profile, including resilient earnings of $11.4 billion in 2020, 14.2 per cent return on equity, a strong capital position of 15.5 per cent, including 12.5 per cent Tier 1 common equity, and high credit ratings on its debt. With a goal of maximizing shareholder returns, over the last ten years RY has increased its dividend every year and has a conservative average dividend payout ratio of 47 per cent.
Deposits and lending, which benefit from a steep yield curve, are reflected in Personal and Commercial Banking, which accounts for about 45 per cent of RY’s earnings. In its Personal and Commercial Banking segment, 95 per cent of which is Canadian, RY builds digitally-enabled relationships to focus on serving clients by resolving problems and providing advice, on accelerating client growth, on delivering digital solutions, and on becoming more agile and efficient. This strategy has resulted in solid volume growth in loans and deposits over the last four years, as well as top 2 market share ranking in key categories, including personal lending, deposits and GICs, credit cards, mutual funds, and business loans.
Having diversified over the years from this interest-rate sensitive business segment, RY generates 24 per cent of its earnings in Capital Markets, 19 per cent in Wealth Management, seven per cent in Insurance, and five per cent in Investor and Treasury Services. In the Capital Markets segment, with more than half its revenue generated in the US, RY is the 12th-largest global investment bank, and is strategically positioned in large financial centres.
In Wealth Management, RY targets growing in global markets, deepening digitally enabled and data-driven Canadian client relationships, accelerating growth in the US, and attaining top-tier status in the British Isles and in Asia.
The bank’s Insurance segment similarly aims to deepen client relationships through providing a full range of insurance solutions. This segment also focuses on improving distribution with technology solutions, on digital initiatives for simplicity and innovation, and on expanding international business optimized by selection and risk management.
The Investor and Treasury Services segment also employs technology and data insights to solve clients’ challenges, to attract Canadian insurance companies, pension funds, investment counsellors and asset managers with high risk-adjusted returns, robust service, and risk controls.
RY has a disciplined approach to risk management, including scenario analysis and diversification by product and region, to anchor its credit quality. Its presentation for the fourth quarter of 2020 suggests that RY is proud of the ability of its technology platforms to help clients exceed expectations, and of its ability to attract top employees, to lead ESG initiatives, and to partner with other organizations that enhance value for all Canadians.
Margaret Samuel, MBA, LL.B., CFA is President, CEO and Portfolio Manager of Enriched Investing Incorporated. She can be contacted at info@enrichedinvesting.com. She or clients of Enriched Investing™ may hold positions in the securities mentioned. The information provided is general in nature and does not represent investment advice. It is subject to change without notice and is based on the perspectives and opinions of the writer only. It may also contain forward-looking statements that may not prove to be accurate. Every effort has been made to compile this material from reliable sources; however, no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please consult an appropriate professional regarding your particular circumstances.
This is an edited version of an article that was originally published for subscribers in the March 2021, First Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.
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The MoneyLetter •4/25/21 •