The following article, originally published at 1:38 p.m. on Monday, Jan. 9, 2017, has been updated with Citigroup's downgrade of Goldman Sachs.
Trump's Nov. 8 victory prompted speculation that imminent tax cuts and higher government spending will spur faster inflation, sending U.S. Treasury-bond yields on a rapid runup from record lows. Investors and corporations scrambled in November and December to readjust their bond portfolios and interest-rate hedges -- thus showering trading firms with juicy commissions.
Then in December, the Federal Reserve raised interest rates for the first time in 2016, creating another surge in bond trading and bolstering the dollar against most global currencies. The end-of-year flurry in bond and currency transactions is likely to push banks' earnings above analyst expectations as the firms release fourth-quarter results starting Friday.
Fixed-income trading volumes in the quarter through Dec. 21 surged 19% from a year earlier, led by U.S. government bonds, according to Deutsche Bank.
It's the third straight period in which big U.S. firms have profited from idiosyncratic political and economic developments, capping a year that started abysmally when oil prices plunged and fears grew that China might undertake a big currency devaluation. In the second quarter, banks reaped a windfall as traders reacted to the U.K.'s surprise vote to exit the European Union. And in the third quarter, they profited from market volatility amid rampant speculation over the timing of Fed rate increases.
"You've got this high level of volatility because of the expectation that Trump will make the economy grow and that interest rates would have to go higher," said Dick Bove, an analyst at Rafferty Capital Markets with five decades of experience. "All of a sudden, balance sheets of corporations all around the world have to be restructured."
The earnings reports may provide a catalyst for further increases in bank stocks, which rallied in 2016 on speculation that Trump would usher in a new era of deregulation and soften stiff rules that were implemented in the wake of the 2008 financial crisis and bailouts. Trump also has pledged to slash corporate tax rates, a move that would provide an additional boon to net income for both banks and their clients. The president-elect's promise to increase spending on infrastructure such as highways could help to accelerate loan growth.
"All-in, lower taxes and less regulation should set the stage for our bull case," Morgan Stanley analyst Betsy Graseck wrote in a Jan. 6 report. An additional tailwind would come as rate increases by the Fed fatten banks' lending margins, especially at Bank of America.
Large U.S. bank stocks on average surged 19% in 2016, their best performance in 13 years. And, according to Graseck, about 40% of respondents in a Morgan Stanley survey said they expect financial stocks to be the best-performing industry group in 2017.
That said, bank stocks have already reached lofty valuations relative to their historical averages; currently they're trading at 15.9 times 2018 earnings, according to Graseck.
And there's a host of potential risks that could upend investor hopes for the securities. Trump's promised rollback of regulations could easily get bogged down in agency rulemakings or watered down by Congress. The Fed might opt to put off rate increases expected in 2017. The independent research firm CFRA predicted in December that escalated conflict in the South China Sea might roil capital markets, sending stocks plunging.
"The group still appears quite expensive," Graseck wrote.
The big banks' own stock-trading divisions probably didn't benefit during the fourth quarter as much as the fixed-income business, partly because the post-election rally in equities pushed some investors to the sidelines, on concern that valuations might be getting too rich, Bove said. Trading in U.S. stocks was roughly flat versus a year earlier.
Morgan Stanley (MS) probably had the biggest jump in total trading revenue, at 23% versus a year earlier, based on estimates by Deutsche Bank analyst Matt O'Connor. JPMorgan and Citigroup likely registered 21% increases in trading revenue, followed by Bank of America at 20% and Goldman Sachs (GS) at 19%.
Even with that growth, Goldman's stock may have climbed to a higher price than it can sustain, given investors' historical expectations for growth in returns, Keith Horowitz, an analyst with Citigroup, said in a note to clients.
"While we expect Goldman will see improved trading revenues going forward, the path is relatively uncertain and the bar is relatively high," wrote Horowitz, who downgraded his rating on the bank to sell from neutral on Tuesday.
Commodities trading, which most U.S. banks include in their fixed-income revenue, surged along with prices in the fourth quarter, with average daily volume in U.S. crude-oil futures climbing 24% from a year earlier, based on Deutsche Bank's tally.
Compared with the historically strong third quarter, trading revenue was probably lower, ranging from 18% at Citigroup to 28% at JPMorgan, according to RBC.
The fourth-quarter's results also may reveal whether U.S. firms were able to steal market share from European banks that have retrenched amid investor concerns over their financial strength. Citigroup CFO John Gerspach said in October that his firm might have benefited from a retreat by Deutsche Bank (DB) in the government-bond and currency-trading businesses.