Bank earnings kick-off with good underlying trends
admin | October 12, 2018
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
With each passing quarter there is a degree of apprehension around what kind of unexpected setbacks could hurt the banks. Yet with the 3Q18 earnings season now in full-swing, another quarter passes without a big theme for concern among the domestic banks. We remain cautious with a number of big challenges ahead such as Quantitative Tightening and CECL, each of which will impact banks negatively, but to what extent is difficult to estimate. Thus far we see no reason for results to effect credit spreads in the near-term.
The following are some of the primary themes that are credit-drivers have come from the JPM, C, WFC earnings:
- Margins – while the revised tax code has clearly been the biggest driver for positive valuation moves for the banking sector the past couple years, the next driver is expected margin expansion. The markets have been watching the rise of the 10-year Treasury as a signal for higher NIM for banks, but the flattening yield curve means benefits have been muted. NIM for JPM expanded 2 bp Q/Q, but is flat from 4Q17. Similarly, WFC reported anemic NIM growth of 1 bp Q/Q to 2.94%, which begs the question: when will higher rates help the banks? We have a cautious view in this regard given the effects of Quantitative Tightening (QT) have yet to even bear any impact on banks’ funding. As JPM management pointed out on the 3Q18 call with investors, QT has the potential of taking $1 trillion of deposits out of the market. If that comes to fruition, the cost of funding will be materially higher for banks, and that will have a detrimental effect on NIM.
- Asset quality – This is clearly a concern for some point in the future given the borrowing binge among corporates as well as consumers. For now the issue is still moot as JPM, WFC and Citigroup each reported good asset quality trends among the major lending lines. In fact, WFC posted a reserve release of $100 million in 3Q18. The first test that will put banks under some earnings pressure will be in 2019 when CECL requirements initially come in to practice. Thus far we have not seen clear guidance from any of the banks – either from a cost of lending, nor a view on decreased demand for lending – given any elevated borrowing costs due to CECL requirements.
- M&A – When Jefferies reported its broker/dealer fiscal 3Q18 results a month ago, the company posted IBD revenues that were down 2% Y/Y, but down 7% on a sequential basis. That trend seems to be a bit mixed among the others who have reported. JPM posted 40% higher equity underwriting Y/Y for the 3Q18 period, but an 11% decrease for debt issuance fees. Advisory fell 6% Y/Y. The decline was a bit more pronounced for Citigroup with underwriting down 17% Y/Y in equities and down 9% in debt. Conversely Citigroup actually saw advisory revenues increase 9% Y/Y, but that is not enough to offset the nominally larger underwriting business.
- FICC and Equity Trading – In 2Q18 the big banks reported pretty durable results for FICC revenues, which was in strong contrast with the smaller brokers where FICC dropped 20-40% Y/Y. Given the seemingly positive results at JEF in their fiscal 3Q18 results for FICC, the same was generally expected for the bulge-bracket firms. JPM posted a 10% decline in FICC, but adjusted for FTE it was only down 6%, which puts a question mark next to other results given lower tax rates. And again we saw Citigroup post a different direction; FICC revs were actually higher for Citigroup, up 9% Y/Y and showing that the market is not equal for all big participants.
- Capital & Funding – Neither capital nor funding present a challenge for banks in our view for the foreseeable future. CET1 ratios still hover around 12% for the big banks, however regional banks are somewhat lower as seen with PNC at 9.3%.
If banks are “printing money” then why the equity sell-off?
The period of economic expansion in the US has been historic in length and proportion. However with some of the recent valuation the market has been under pressure. Firms in the banking space continue to trade at high multiples of book, but driven by high earnings. Asset managers have been under more pressure and have been a source of continued consolidation. Retail money has been flowing out of ETFs, which in our estimation is to blame for the recent market correction. This could be short-lived as banks are showing that the economy is still on track and borrowing is still happening despite the continued rise in rates. Nevertheless it should remain a reminder that the markets have short memories and can be hair-trigger in response to even minor concerns.