The Long and Short

A stellar earnings season for big banks

| January 22, 2021

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.

Another quarter of strong trading and investment banking revenue, coupled with reserve releases, produce record US bank earnings. Credit investors should maintain a market-weight on the domestic bank sector and exploit relative value opportunities in the intermediate part of the curve where some risks and outperformance do not appear fully priced in.

US Bank Earnings Recap

JP Morgan (JPM: A2/A-/AA-) reported record earnings for the fourth quarter of 2020, with earnings per share (EPS) of $3.79 beating the consensus estimate of $2.62. Top-line managed revenue was $30.2 billion for the quarter, up +3% year-over-year and well ahead of the consensus estimate of $28.7 billion. JPM released $2.9 billion in reserves in the fourth quarter, against $1.1 billion in net charge-offs for a net benefit of $1.9 billion to earnings. The release is a good sign for not only JPM, but the industry at large, as a possible indication that prior provisioning for Covid-related losses was more than sufficient to cover the economic downturn. The bank recorded a similar, smaller reserve release in the prior quarter as well. CEO Jamie Dimon did caution against reading too much into the big numbers, as the releases are highly temporary in nature. He also highlighted that reserves are still very high (>$30 billion) reflecting the operating uncertainty on the immediate horizon. Meanwhile, loan growth remains extremely tempered as average loans were up just 1% versus a massive +35% jump in average deposits. Once again, the biggest line items for earnings and top-line performance were the massive results in trading revenue. Total trading revenue was up 20% year-over-year with fixed income (FICC) increasing +15% to $3.95 billion and equities up +32% to $1.99 billion – both well ahead of the consensus expectation. Investment banking revenue also saw huge year-over-year gains versus the fourth quarter of 2019 and helped bolster the record-breaking performance in the quarter. IB fees were up +34% year-over-year to $2.56 billion. Equity underwriting fees jumped +88% year-over-year to $718 million, while debt underwriting fees were up +23% to $1.01 billion and M&A advisory increased +19% to $835 million.

Bottom-line: We recently revised our sector weighting view on domestic banks to a market-weight from an overweight to begin 2021, reflecting tighter valuation in spreads and still present headwinds in the industry, such as low rates, constrained loan demand, and the relatively flat yield curve. As the nation’s largest lender and premiere franchise among US money center banks, JPM remains a core holding within the segment. While JPM is trading tight to peers, the bank’s “fortress balance sheet” and extraordinary capital position, as well as its continued strong performance in the challenging operating environment, dictate its leading stature among US money center banks.

Exhibit 1. We maintain our preference for JPM intermediate paper, as there does not appear enough additional spread available in WFC to compensate for lingering reputational and regulatory risk

Source: Amherst Pierpont, Bloomberg/TRACE G-spread Indications

Wells Fargo’s (WFC: A2/BBB+/A+) fourth quarter results were highly reminiscent of the prior quarter, as costs related to the bank’s ongoing turnaround once again continued to negatively impact overall performance. WFC reported the fourth quarter EPS of $0.64, ahead of the $0.60 consensus estimate, while top-line revenue of $17.9 billion missed expectations of $18.1 billion. The bank booked another $781 million in restructuring charges, plus an additional $321 million in charges toward continued customer remediation. Those followed charges in the third quarter of 2020 of $718 million and $961 million, respectively. The earnings impact of the charges was somewhat offset by a $757 million reserve release related to the sale of the student loan portfolio. The net negative impact to EPS of all three items was $0.06 per share. Average loans dropped 6% in the quarter, as deposits rose just 4% versus the massive influx we are observing at peer banks. Among the more disappointing line items for the bank was its efficiency ratio (all in costs as a percentage of revenue), which was up to 83% for the fourth quarter of 2020 from 81% in the prior quarter, missing expectations of 79%, and still well above industry standards.

Bottom-line: Once again, the equity market is reacting negatively to the results, with WFC shares down about 4-to-5% at the open, despite the fact that management committed to the resumption of share repurchases after the Fed gave the greenlight at the end of 2020. WFC bond spreads seem less affected with intermediate spreads appearing mostly unchanged, in-line with the rest of the peer group. In the fourth quarter of 2020, WFC’s difficulties were once again magnified relative to peers, and without the benefit of outsized trading gains to help offset the weakness. WFC is still working toward repairing its severely bruised reputation, and is struggling to make headway amidst the difficult operating environment. We have remained buyers of WFC credit on short-term operational or headline related weakness. Bonds currently appear properly priced relative to peers, and we continue to monitor longer-term progress against the difficult operating backdrop.

After a highly tumultuous third quarter earnings report that pushed Citigroup (C: A3/BBB+/A) onto the defensive, the bank delivered a more normalized set of earnings results in the fourth quarter of 2020, as outgoing CEO Michael Corbat’s tenure comes to a close. In the previous quarter, Citi’s recent regulatory lapses were on full display in the wake of consent orders from the Fed and OCC and a regulatory fine of $400 million in the third quarter of 2020. There were no additional regulatory charges in the fourth quarter. The bank reported the fourth quarter EPS of $2.08 on earnings of $4.6 billion, well ahead of the consensus estimate. Top-line adjusted revenue was $16.5 billion, falling just shy of expectations. Results were bolstered by a reserve release of $1.5 billion for the quarter. End of period loans fell 3%, while deposits had increased by 20%. Investors appeared disappointed by trading revenue, particularly after the big numbers posted by JPM earlier this morning. Total trading revenue increased +13% year-over-year to $3.9 billion. Equity markets revenue grew +57% year-over-year off a particularly weak 4Q19 to $810 million, while fixed income increased +7% to $3.1 billion, though both were down substantially off the prior quarter. The market was expecting slightly better results from FICC, while equities came in ahead of expectations. Meanwhile, investment banking fees fell 5% year-over-year, as debt underwriting fell 16% to $617 million and M&A advisory fees dropped 38% year-over-year to $232 million. Those weaker performances were offset by a +83% year-over-year gain in equity underwriting fees to $438 million.

Bottom-line: Once again, Citi’s performance in trading and I-banking was far less impressive when measured alongside JPM. Still, it was a sequential improvement as the bank took a step toward normalcy after the regulatory issues that plagued management in the prior quarter. Shares are down modestly in reaction to the results, while Citi credit spreads remain largely unchanged along with the rest of the peer group. Despite industry headwinds and the recent events that led to Corbat stepping down, Citi remains among the preferred risk/reward picks in the big bank peer group, within the context of our recently assigned market-weight for domestic banks within the IG Index.

Exhibit 2. There continues to be better risk/reward in Citigroup intermediate paper over Bank of America

Source: Amherst Pierpont, Bloomberg/TRACE G-spread Indications

Goldman Sachs (GS: A3*+/BBB+/A) delivered a monumental $12.03 EPS for the fourth quarter of 2020, topping the $7.31 consensus estimate, and capping four consecutive quarters of surprise earnings beats driven by strong execution across its various business platforms. The results represented the highest net income reported by GS in a decade. While trading revenue carried the performance over the past several quarters—and was still well ahead of expectations in the fourth quarter of 2020—it was an outsized result in investment banking that was the real surprise in the fourth quarter. Net revenue from I-banking jumped 27% year-over-year to $2.6 billion in the fourth quarter of 2020, and +24% for the full year to $9.42 billion. Equity underwriting rose a staggering 195% off a fairly weak 4Q19 to $1.12 billion, offsetting a 12% year-over-year decline in debt underwriting revenue to $526 million. For the full year, equity underwriting revenue grew 130%. Advisory fees were up 28% year-over-year to $1.09 billion in the fourth quarter of 2020. On the trading front, global markets revenue was up 23% in the fourth quarter of 2020 to $4.27 billion, capping a 43% gain for the full year. Equities trading revenue grew 40% Year-over-year to $2.39 billion, versus a more modest gain of 6% to $1.88 billion in debt trading for the fourth quarter of 2020. GS booked just $293 million in credit costs for the quarter. Meanwhile, for the year, GS booked $3.42 billion in charges for litigation and regulatory proceedings, as the firm sought to turn the page and move past the regulatory stain of the 1MDB scandal. While there remains an overhang, and the prospect of additional, perhaps unrelated, global regulatory issues arising in the near-term, it does appear the largest elements of the scandal have been settled.

Bottom-line: Goldman had been subject to quarter-to-quarter fluctuations in performance in recent years, but the past year has demonstrated tremendous execution in volatile markets, which is a traditional, long-term hallmark of the GS credit. We had maintained our view that those quarterly fluctuations remained mainly an equity story more than an actual credit concern, but it had built some disparity versus the more consistent results that had been coming out of peer Morgan Stanley over the past few years. The playing field does appear to have been leveled over the past few quarters.

Exhibit 3. Spreads have gotten very tight between GS and MS, but we still prefer the spread pick-up in GS where available in the intermediate part of the curve

Source: Amherst Pierpont, Bloomberg/TRACE G-spread Indications

For a second consecutive quarter, Bank of America’s (BAC: A2/A-/A+) earnings results did not quite live up to the lofty expectations created by its closest peers. In particular, trading results fell short of expectations and did not match up to the sizable year-over-year gains observed at the other US money center banks. BAC reported fourth quarter 2020 adjusted EPS of $0.59 on $5.5 billion in net income, edging out the $0.55 consensus estimate, while the top-line revenue decreased 10% year-over-year to $20.1 billion, short of analysts’ expectations. On a positive note, provisions for credit costs declined to $53 million for the quarter, resulting in a $828 million reserve release. That follows a better-than-expected net reserve build of just $400 million in the prior quarter. Reserves had been built out by about $7.6 billion in the first two quarters of the year, which at the time investors expressed concern that the efforts might not be enough to fully weather the economic downturn of the global pandemic. Total trading revenue increased just 7% year-over-year to $3.06 billion versus substantially larger gains at peer banks. FICC revenue fell 5% year-over-year to $1.74 billion, offset somewhat by the 30% gain in equities revenue to $1.32 billion. Meanwhile, total investment banking fees were more on par with the peer group, increasing 27% year-over-year to $1.86 billion, led by improved equity underwriting and M&A advisory fees.

Bottom-line: BAC’s balance sheet and capitalization remain well-positioned to weather the near-term economic downturn and further deterioration in credit. Investors in BAC credit remain properly compensated for the risk, particularly given the relative stability of the sector. Our preference between the two names remains with closest peer Citigroup on better risk/reward, although increasing spread pick in BAC vs Citi in the intermediate part of the curve is leveling this view to a degree.

Morgan Stanley (MS: A2*+/BBB+/A) reported strong results in the fourth quarter of 2020, capping off a record-breaking year for FY2020 in terms of both top-line net revenue ($48 billion) and net income ($11 billion). Adjusted EPS in the fourth quarter of 2020 was $1.92, well ahead of the $1.20 consensus estimate, as top-line revenue grew 26% year-over-year and also finished well ahead of market expectations. MS saw a 32% increase in trading revenue in the fourth quarter, among the best year-over-year performances in the peer group. MS once again retained the honor of the top producer in the industry in overall equity trading revenue with $2.50 billion (vs $2.39 billion at GS), which was up a highly impressive 30% year-over-year. Management highlighted particular strength in derivative products amidst the volatile trading environment. Fixed income trading jumped 31% year-over-year to $1.66 billion, which MS noted was driven by a particularly strong quarter in forex trading and credit products. MS posted tremendous gains in investment banking revenue, also topping the year-over-year performance relative to closest competitor GS. Total I-banking revenue grew 46% to $2.30 billion, anchored by a 137% year-over-year increase in equity underwriting fees to $1.00 billion from $422 million. M&A Advisory fees were also up 26% to $827 million, both offsetting a modest 5% drop in debt underwriting fees to $475 million.

Bottom-line: Shares of MS initially traded up slightly but have leveled off to a flat performance on the day. The bank wasted no time in launching a three-part debt deal almost immediately after the earnings call concluded.   Closest peer GS has probably posted the more impressive trading results for 2020, but it is very hard to argue with the record-breaking performance by MS for the entire year. We also still believe MS maintains the preferred longer-term franchise for retail brokerage, and it will be interesting to monitor how the firm intends to integrate its purchase of E*TRADE to potentially further its edge across these platforms. Furthermore, the acquisition of Eaton Vance should eventually bolster the bank’s expanding presence in investment and wealth management. Both MS and GS remain core holdings for the US banking segment–which we currently view as a market-weight. Our preference has been for the spread pick in GS over MS in the intermediate part of the curve when available, but that gap continues to narrow quite a bit.

Dan Bruzzo, CFA
1 (646) 776-7749

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