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Taking the Pulse of the Big Banks

Earnings season for the fourth quarter of 2019 kicks off with the big banks this week.

Their earnings are influenced by many factors – Federal Reserve policy, net interest margin compression and trading revenue, to name a few.

And if trade wars were the biggest story in finance in 2019, the Federal Reserve was a close second.

Let’s look at the pros and cons that should impact big bank Q4 earnings…

PRO: Organic Balance Sheet Growth

After repeated hawkish commentary throughout the fourth quarter of 2018 contributed to the largest S&P 500 correction since the 2008 financial crisis, Chairman Powell did an about-face (i.e., “dovish pivot”).

In early January, he suggested that the balance sheet reduction program was no longer on autopilot. This meant that the Fed planned to pause its sale of assets it bought during the financial crisis to keep the economy afloat.

In fact, Powell said the Fed would like to “organically” start growing its balance sheet again – mainly through the purchase of short-term Treasurys.

This is good for banks because it should inject more cash into the economy. And more cash means more consumer spending.

CON: Narrow Yield Curve

But in the ensuing months, trade war rhetoric, falling inflation expectations, weakening economic data and curve inversion drove the Fed into a mid-cycle adjustment of three 25-basis point rate cuts commencing on July 31.

Most of Wall Street rejoiced at the 2019 rate cuts. Big banks did not.

Bankers really want to see a steepening yield curve. It’s a pretty good indicator of a growing economy when long-term rates drastically outweigh short-term ones.

And a growing economy means that more people will be spending money and taking out bank loans.

Although falling rates took some of the inversion off the yield curve, the damage had been done…

We’ll see that in fourth quarter earnings reports.

CON: Net Interest Margin Bottoming

For the most part, Wall Street feels that net interest margin – a big bank’s average net income from assets – is in the process of bottoming.

This is because the Fed is again “on a pause” – and unlikely to take action in the short term to adjust rates.

This means that the big banks have to pay the piper in the fourth quarter of 2019 (even if in the long run we could see a comeback in the financial sector).

PRO: Surge in Trading Revenue

But it’s not all bad news for big banks… Trading revenue has been a saving grace for them during times of disappointing net interest margins.

For one thing, when the stock market is rising – as it was for most of 2019 – individuals and institutions like to trade. And trading revenue for most of the big banks will be up by double digits for the fourth quarter of 2019.

The other reason for double-digit trading revenue growth?

Fourth quarter stock market performance in 2018 was abysmal – and capped by a December whose performance was the worst for that month since the 1930s.

That helped set lower comparisons for 2019 and fuel that double-digit rise in trading revenue.

On the positive front, there’s great growth in trading revenue due to giddy stock market investors in 2019 and low-bar comparisons for 2018. We also have the Fed starting to buy up some Treasurys and adding some cash reserves back into the system.

On the negative side, we have a narrow yield curve and low net interest margins…

And it’s finally time to watch it all untangle.

Three Key Players to Watch

S&P Global Market Intelligence expects earnings growth of 10.5% for the financial sector.

The only area projected to see a bigger jump from the fourth quarter is the utilities sector.

Stock price growth usually follows earnings growth in the long run, so if the financial sector can keep up this momentum into 2020, it could be a very good buy for equity and fixed income investors alike.

Three big banks kicked off earnings season with reports on Tuesday, January 14…

JPMorgan Chase (NYSE: JPM) beat analysts’ estimates for earnings and revenue.

As expected, increased trading revenue was a big part of that jump. However, even revenue in consumer and community banking – where net interest margin compression would be felt – was up slightly.

Citigroup (NYSE: C) also beat analyst estimates for earnings and revenue.

Like JPMorgan, Citi saw a big increase in trading revenue and minimal gains in areas of the bank most affected by net interest margin compression.

Wells Fargo (NYSE: WFC), on the other hand, beat revenue estimates but lagged on earnings.

The bank reported that net interest margin compression was the biggest culprit in the earnings miss.

But this 4.1%-yielding Fortune 500 Conestoga isn’t spinning its wheels…

Just like JPMorgan and Citigroup, Wells Fargo is likely poised for a rebound in 2020 as net interest margin compression eases.

This means that – should any of these banks’ share prices follow weaknesses in earnings – it could be a buying opportunity.

As earnings continue, I suspect to see similar mixed reports from big banks – though overall the pros should outweigh the cons.

Good investing,

Rob


About

Bond Expert Rob Morgan is a former financial advisor who led firms such as Sethi, Fulcrum Securities, Janney Montgomery Scott, Fulton Financial Advisors and Fifth Third Bank.

During his time at Fifth Third Bank, he managed a $160 million taxable bond fund.

He holds a CFA designation.

An MBA recipient from Vanderbilt University and submarine veteran of the U.S. Navy, Rob has made more than 700 media appearances on national networks, including CNBC.

He is also a Contributing Editor for Wealthy Retirement.

You can follow Rob on Twitter @RealRobMorgan.

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