Update: The Bull Case for US Financials

September 8, 2022 | Premium Service | In this issue of The Institutional Risk Analyst, we check in on US financials after the markets essentially gave back the gains made over the summer during the month of August. The two best performers in our surveillance group remain Raymond James Financial (RJF) and Charles Schwab (SCHW), just proving that quality is not quite dead in the land of stock investing. What’s next for financials as we head into the end of Q3 2022?

In general, the mid-quarter updates from the small to medium size banking institutions are strong, with loan growth starting to appear and deposit rates remaining very low. We continue to expect the financials to report better, less volatile results in Q3 2022, but that may not impress institutional investors. The universal banks are going to suffer going forward as AUMs and new securities issuance falls sharply.

The same people who were buying large caps at 2x book value a year ago are now running away from bank stocks just as the fundamentals are starting to improve for Main Street lenders. The Buy Side is generally 6 to 12 months late when it comes to the financials, in part because they focus on volatile reported earnings rather than more meaningful fundamental measures of bank profitability.

We wrote about RJF and SCHW last month (“Universal Banks | Morgan Stanley, Goldman Sachs, Charles Schwab, Raymond James & Stifel”), but we think it is notable that some of the lowest risk platforms in the business are outperforming the largest names, by a lot. RJF is the only name on the list that is still up for the full year. Our surveillance list follows below.

Source: Bloomberg (09/07/2022)

The general selloff in financials starting in July tracked the increase in interest rates after the mini-rally from mid-June through most of July. The 10-year Treasury is again above 3% but the market is moving 10-15bp per day either way, adding to the cost of hedging and the general level of uncertainty about prices. On Friday September 2nd, for example, the Treasury market fell 10bp in yield going into the Labor Day holiday.

Right behind RJF and SCHW in terms of recent performance is Morgan Stanley (MS), another one of universal banks in our surveillance group that is outperforming the large money centers. With all of these names, a major positive in terms of valuations is the relatively small role that credit plays in earnings. The universal banks gather assets and occasionally make loans, creating a low-risk franchise that is being rewarded by risk averse investors.

That said, we are increasingly cautious about the trading and investment banking side of the equation, one reason why MS is trailing the more focused advisory plays like RJF and SCHW. The large declines in debt and equity underwriting in 1H 2022 has led a number of analysts to issue “sell” ratings for some names, including Goldman Sachs (GS). Dick Bove at Odeon noted with respect to MS, GS and Citigroup (C):

“These companies are facing severe problems as business dries up. Moreover, moves by the Federal Reserve to shrink its balance sheet suggests that the current tough times will extend through 2023.”

With the FOMC reducing the size of the system open market account (SOMA) by $50 billion per month, the bid for Treasury debt and agency mortgage-backed securities might seem to be softening, but recession fears are likely to offset the exit of the Federal Reserve Bank of New York from the bond markets.

We expect to see reasonably strong earnings for smaller banks as loan yields slowly rise, but the transaction side of the house is likely to be weak, hurting MS, C, GS and JPMorganChase (JPM). In the chart below from SIFMA, new securities issuance through July is plummeting, good news for lenders but very bad news for the wider financial markets and the economy.

Note that the Fannie Mae current coupon MBS is now +150bp to the blended yield on the Treasury 5-10 year securities, the widest spread in many weeks. Treasury yields in general are at the highest levels in 12 weeks going back to mid-June, another reason why we expect to see higher loan yields when banks report Q3 earnings.

One name to watch in Q3 2022 will be Wells Fargo & Co (WFC), which is in the process of dramatically shrinking its balance sheet. Improved earnings in Q3 2022 may be a catalyst for this long-underperforming name. As we noted in our Q2 2022 pre-earnings setup, a modest improvement in operating efficiency at WFC, which has been in the 80% range, could be quite meaningful for the stock.

The alternative to common shares that we have long followed is to purchase the preferred shares of the largest banks when they are cheap, one reason why we enjoy value shopping when the markets are choppy. We have been adding to our preferred positions through the selloff and are looking to establish some new positions as market opportunities arise.

We will be writing more extensively about the outlook for earnings in Q3 2022. Suffice to say that the results for smaller Main Street lenders are likely going to be a surprise, but worries about future credit losses will probably dampen the party in terms of share prices in the near term for large cap names.

Disclosures | Long: CVX, CMBS, NVDA, WMB, JPM.PRK, BAC.PRA, USB.PRM, WFC.PRZ, WFC.PRQ, C.PRN, WPL.CF, NOVC, LDI

The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.