The banks are normally among the first companies to report earnings each quarter. As such, the banks often set the tone for each earnings season. There was added anticipation for bank earnings this time around as the banks, as a sector, suffered a more sizeable correction than the overall market in December, 2018. And because many market strategists look to the banking sector, along with other sectors like the transports, as a key gauge of economic and market sentiment, it was important that the banks show that the operating environment is not as bad as the markets had feared.
To alleviate some of the suspense, bank earnings were not as bad as feared. There were certainly puts and takes, but overall bank earnings were solid and roughly in line with expectations. Perhaps more importantly, the commentary coming from bank management teams was generally constructive. Yes, there will be challenges ahead as we head further into the latter stages of the business cycle. But by and large, bank management teams articulated that there was a big disconnect between the doom and gloom on Wall Street and the optimism on Main Street.
Let’s first look at some of the more promising trends in the quarter:
- We saw a surge in business loans toward the end of the quarter, which most attributed to the volatility in the capital markets;
- We also saw continued strong credit quality, with low levels of loan losses, non-performing assets and delinquencies. Loan loss provisions did increase for most banks, but the increases were attributed to loan growth, in most cases;
- For banks with capital markets businesses, we saw pretty good trading results in Equities as client activity and volatility picked up;
- Investment banking wasn’t too bad on strong M&A fees;
- Expenses were pretty well contained despite continued investments in technology and digital initiatives, cyber-security, marketing and higher labor costs;
- There was obviously a continued benefit from lower tax rates and lower share counts;
- Bank balance sheets remain very well capitalized and able to withstand a fairly intense recession.
On the negative side:
- We saw smaller increases in net interest margins as the short-end of the yield curve continued to rise and the yield curve flattened;
- Bank customers, especially business customers, are increasingly moving their deposits to where they can get better yields, and this is leading to “deposit flight” from the banks;
- We also saw sharply lower fixed income trading revenues, but this has been an ongoing secular shift and was intensified by the volatility in the capital markets in the fourth quarter;
- Mortgage-related income was also weak due to a sharp drop in originations and loan-sale margins;
- Asset management income was a little weaker reflecting the volatile capital markets.
So, putting it all together, the earnings results were okay and supportive of a relief rally in stocks from oversold levels. Investors’ biggest concern going forward, though, is that bank earnings continue to benefit from very low credit costs. If the economy is indeed slowing or even going into recession, credit costs would be expected to rise meaningfully. For now, though, as long as credit costs remain low, we can probably expect decent bank earnings and limited downside from today’s valuations.
The banks’ sensitivity to higher credit costs placed added emphasis on the economic commentary coming from the bank management teams. To reiterate, the comments regarding the domestic economy were fairly constructive, with the usual caveats about trade issues, the government shut-down and other policy uncertainties. The fairly widespread sentiment that there is a disconnect between the capital markets volatility and the “real” economy was music to investors’ ears. Armed with this confidence, investors have been buying bank stocks fairly aggressively, and the sector has rallied much more than the overall market since January 15 (which is the day that JP Morgan reported).