Banks report earnings in the coming week and investors have a lot to sort through. Guidance on all of the incredibly negative aspects of current fundamentals, namely loan loss provisions, will be key.
Some Catch-Up on Banks:
Friday, bank stocks were rallying, with the Invesco KBW Bank ETF KBWB up 3% by midday. That fund is comprised of roughly 70% regional banks and about 30% widely followed large caps.
It’s down about 30% from its June 8 level, a bear market. June 8 was the fund’s high off of the March 23 low for the broader market. The yield curve has compressed, with the spread between the 10-Year Treasury and 2-Year Treasury moving to around 45 basis points from north of 60 in mid-June. Banks borrow short and lend long, so a lower spread equals lower profitability. Regional banks, more sensitive to the yield curve and less diversified businesses, may see a harsher shock to earnings than larger banks may see. The yield curve compression has come with a broader risk-off move in financial markets, which has seen money driven into growth stocks, not value, and into safe bonds since mid-June.
Bank stocks are now trading at incredibly inexpensive valuations in one sense. Many large cap and regional banks are trading at below their book value per share. Historically, banks usually trade at a very mild multiple of book value, so the valuation indicates investors are a bit uncertain on the growth environment for banks going forward. JPMorgan is an exception, trading at a just over 1 times book value, low for the bank, although JPMorgan usually fetches a valuation premium versus peers. Jamie Dimon and company are known for having an excellent ability to diversify, scale, invest in new banking platforms and widen out profit margins. Earnings multiples on depressed next 12 months’ projections are rich though, as a May rally in banks and other cyclical sectors expanded multiples while earnings estimates were still falling.
But even if the market were to assign a normal valuation to banks on a sustained basis, some banks -- not all -- would still take a little while to reach 2020 highs, as several years of earnings forecasts have been decimated by the virus-induced drop in loan demand, a minuscule spread on rates and high loan loss provisions. That’s cash set aside as an expense, in order to absorb losses on non-performing loans. For most large cap banks, full-year 2022 earnings per share will still be roughly 20% below 2019 levels, according to FactSet consensus estimates, although book value per share will come close to pre-virus levels. The book value outlook is stock-price positive, although investors do need to see the earnings stream come in with strength. And that's especially true when it comes to supporting dividends and buybacks.
Currently, JPMorgan (JPM) - Get JP Morgan Chase & Co. Report and Bank of America (BAC) - Get Bank of America Corporation Report are trading at 30% and 34% below their 2020 highs. Wells Fargo (WFC) - Get Wells Fargo & Company Report is trading at less than half its 2020 high of $53 a share.
Earnings for Two Heavy Hitters:
When JPMorgan and Bank of America report, investors will be paying attention to the outlook on loan loss provisions.
“Earnings next week are going to focus a lot on guidance for loan losses,” Jon Curran, Senior Bank Analyst and Senior Investment Manager at Aberdeen Standard Investments told TheStreet. “I don’t think they’re [banks] going to be able to put hard numbers around eventual losses,” he added, saying he will watch the language and tone on the prints. Curran is a manager of bond funds for Aberdeen.
Investors will be looking for cues that management teams think they will see moderating loan loss provisions in the near future. For well-capitalized banks, which most large cap banks are, these increased provisions may be a longer-term positive, as they restore liquidity while trading off strength in near-term earnings. But as Curran put it, that’s an immediate positive for bank bondholders, as it ensures the ability to easily repay debt, while it’s a murkier outcome for equity holders.
After having no loan loss provisions in last year’s second quarter, JPMorgan is expected to set aside $7.5 billion this Q2, with that amount diminishing each quarter in 2020, leading into a clean 2021. That’s also according to FactSet.
The slightly smaller Bank of America is expected to also see more than $1 billion in loss provisions, with improvements leading into a 2021 of no provisions.
But the defining factor for these two heavy hitters and likely the other heavy hitters: the non-lending businesses. Both JPM and B-of-A are expected to see year-over-year growth in most areas of capital markets, underwriting and investment banking revenue. For JPM, total revenue is actually expected to grow 4% year-over-year.
On diversification, $1 trillion in new investment corporate grade debt issuance in May -- against just $975 billion in all of 2019 -- was likely a huge positive for underwriting revenue. That issuance happened as the Federal Reserve pulled out its entire toolbox and then some to keep bond yields (borrowing costs) low. This could conceivably enable banks to beat estimates for the reported quarter. But with the virus, stimulus and economic outlooks so uncertain, Curran emphasized investors will care much more about forward looking indicators, rather than backwards looking ones.
Diversification aside, in aggregate of large cap banks, "We expect 2Q20 earnings to fall 69% year-over-year, as continued strength in capital markets and the benefit of larger balance sheets is more than offset by larger reserve builds and rates near 0%,” wrote Goldman Sachs analyst Richard Ramsden in a note. These dynamics are decimating operating margins and return on equity, metrics that aren’t expected to return to pre-pandemic levels for a few years.
Earnings for Wells Fargo:
Wells Fargo is expected to post a net loss for the quarter.
And loan loss provisions -- expected at $3 billion for the year, over nothing last year, are expected to moderate to $720 million in 2021.
Wells Fargo is a slightly less diversified business than the heavy hitters are, and it is very weighted towards lending. The stock is trading at about a third of book value, but 30 times next year’s earnings.
Other banks to report soon:
Morgan Stanley (MS) - Get Morgan Stanley Report, Goldman Sachs (GS) - Get Goldman Sachs Group Inc. (The) Report and regional banks will soon show investors what their businesses are shaping up to be in the pandemic environment.
The point: investors need to see in the guidance and language from management that banks are on a path back towards pre-virus lending revenues, operating margins, return on equity (hit hard even through 2022) and earnings. The good news: there isn’t enormous downside -- though there is some -- for bank stocks in the near-term.
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