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Large Cap Financials & Asset Inflation

February 26, 2018

New York | None other than Warren Buffett of investment fame started off the week complaining to Becky Quick of CNBC that there’s not enough big things to buy.  Railroads? Airlines? Not even Wells Fargo & Co (NYSE:WFC) suffices to satiate Mr. Buffett's hunger for assets.

 

With over $120 billion in cash burning its way through his trouser pocket, the best that the Sage of Omaha can come up with is buying one of the most overvalued stocks of all, namely the computer cult led by Apple Computer (NASDAQ: AAPL). 

 

Sure sounds like inflation to us.  Too much cash chasing too few goods or at least good opportunities? 

 

 

Of note, we’re scheduled on CNBC WorldWide Exchange this Tuesday at 5:50 ET with Wilfred Frost to talk about the outlook for JPMorgan (NYSE:JPM) and other financials. In a year with rising volatility and slow loan growth, valuations for large banks are back to 52-week high but with virtually no change in the outlook for earnings save from changes in corporate taxes.

 

In 2017, the only two loan categories at JPM that grew were real estate and agriculture, including some festering CRE multifamily exposures we can see out the office window here in Midtown Manhattan. 

 

As we’ve noted previously, the gross yield on JPM’s loan book was only 4.57% through the end of Q3 ’17 vs. 6.9% for Citigroup (NYSE:C) due to the subprime consumer and credit card book. But the gross yield on Citi’s commercial loan book is half JPM’s, illustrating the extreme competition for assets in the world of large commercial bank credits.  

 

Once you net out 100bps of SG&A, getting to the Street's 6% revenue growth rate for JPM obviously depends on the trading and advisory side of the bank.  Indeed, Street analysts have JPM growing revenue 6% in Q1 and ~ 4% for all of '18.  Positives are rising interest rates in terms of NIM and a positive mark on the bank's MSRs.  Net interest income was up mid-teens for JPM in 2017.

 

Negatives include slowing loan growth, still modest trading/FIG volumes, and a soft residential loan market.  JPM, Wells Fargo & Co (NYSE:WFC), and Bank America (NYSE:BAC) are paying up big time for jumbo mortgages in major MSAs, a large but unprofitable business for years to come.  Same goes for C&I loans and CRE, which really peaked in terms of volumes in '16 and have been slowing every since. 

 

Like WFC, big negative for JPM is size.  The bank's yield on earning assets is in the bottom decile of large bank peer group. The bank’s overall results are boosted by trading/asset management, which is half of the bank, but precious little vigorish is coming from the loan book. 

 

The same shortage of assets that so vexes Warren Buffett is putting enormous downward pressure on bank loan yields and even relatively inaccessible assets such as GNMA MSRs, which are changing hands around a 9% unlevered yield according to our friends at Mountain View.  This is half the yield seen for GNMA MSRs back in 2012, another indication of the tightness of asset markets.

 

So on Tuesday as former Fed Chairs Janet Yellen and Ben Bernanke are celebrated at Brookings Institution in Washington, we will no doubt hear some cautious discussion about rising risks of inflation.  But in fact Chair Yellen and her colleagues on the Federal Open Market Committee have already baked double digit inflation into asset prices.  This type of thinking apparently prompted Goldman Sachs (NYSE:GS) to issue a report suggesting a stock market collapse if the 10-year Treasury bond reaches 4.5% yield.

 

We take some comfort that bond spreads have not moved significantly even as the yield on the 10-year has backed up three quarters of a point from the 2016 lows (see chart below).  But the latest CBRE report on cap rates for commercial real estate shows record tight spreads in multifamily.  And we keep wondering if the systemic shortage of investable assets will cause another bond rally such as followed the 2016 election.

 

Now the slow increase in interest rates and, dare we say, volatility will eventually boost the possibility of revenue growth on the trading side of banks like JPM and C.  Our former colleague Mike Mayo has triple digit growth targets for earnings from JPM and Citi over the next three years. 

 

But to hit those generous levels of earnings growth, the FOMC needs to figure a way to lighten the system portfolio and increase trading volumes on the Street.  With rates rising and the “economic cycle” showing signs of maturity, it is hard to see where we can grow volumes in the large banks to fulfill those sort of bullish earnings estimates.  

 

Indeed, the biggest risk to the overheated equity markets is the Fed.  If Fed Chairman Jerome Powell is true to form during his two congressional appearances this week, look for him to continue speaking forthrightly about things like inflation and deficits.  Powell also may surprise everyone and scold Congress for again raiding the Fed's capital to "pay" for the most recent spending bill.

 

The Federal Reserve Chairman is the nation’s banker. He has a duty to speak up when Congress and the Executive Branch are so badly wrong on so many issues.  He can start by explaining to members of Congress why the Fed and Treasury are alter egos and why remittances from or the assets of the Fed are not valid sources of new public revenue.

 

None of this is particularly good for the markets. Powell is the most intelligent, forthright and decisive Fed Chair we've seen in many years -- and he is not an economist.  We think Chairman Powell is likely to break the golden rule of Washington, which is to never tell the truth in public.

 

 

 

 

 

 

 

 

   

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