Starting Gun: Earnings Season To Start With Banks Amid Rate Worries

With Financial sector earnings season looming, a shot got fired across the bow last week when Tim Sloan, CEO of Wells Fargo & Co WFC announced his retirement. This unexpected move created some drama in a sector where it’s mainly been an interest rate game for the last year.

Sloan’s retirement, which follows the company’s 2016 fake account scandal, received applause from some industry analysts who said a new CEO could help the bank’s reputation. However, a new CEO for Wells Fargo won’t necessarily be enough to help lift what’s been a lagging Financial sector in the face of a dovish Federal Reserve and a slowing economy. The sector did rally early in April when Treasury yields ticked higher, but still faces challenges.

Big bank executives typically have the ear of many investors when they step up to the earnings plate and deliver their views of the latest economic developments and where they think things are headed both for the industry and the world outlook as a whole. Their words might get an even closer watch this time around, especially with rates tumbling and divisive issues like Brexit and China trade still in the headlines.

Defensive Unit on Field

Banks enter Q1 earnings season playing a bit of defense, and the sector really hasn’t been all that strong for the last year. The big boost some analysts had expected for banks from last year’s rise in rates never really came, and meanwhile U.S. and overseas economies appear to be slowing, which could hurt banks’ ability to generate loans and suppress trading activity, another source of income for many big banks.

The Fed’s about-face on policy in Q1 with its forecast that it’s not likely to raise rates again this year—abruptly halting five straight quarters of rate hikes—put pressure on bank stocks in Q1. The S&P Financial Select Sector Index (IXM) fell more than 6% from its March high in the days after the Fed announcement, losing much of its Q1 recovery. 

Financial stocks had been edging upward since getting beaten up in  Q4, and the pace accelerated on the first day of April. The sector is now up more than 10% year-to-date. However, that lags the S&P 500 Index (SPX), and it’s been a rocky road for the sector. (See figure 1 below.) Smaller regional bank stocks, in particular, appear to be taking a hit from the interest rate situation, as they have more exposure to interest rates. This so-called “second tier” of bank stocks, however, might get some interest from investors if China tariff talks start to look rocky, because they might be shielded more from overseas dangers.  However, they are also the most susceptible to continued lower rates.

FIGURE 1: DOVISH FED PRESSURES BANK STOCKS. After falling along with the broader market at the end of 2018, the S&P Financial Select Sector Index (IXM – candlestick) rebounded quickly, but fell again after dovish comments from the Federal Reserve. Since then the sector has lagged the S&P 500 Index (SPX – purple line). Data source: S&P Dow Jones Indices. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

The five biggest bank stocks fell in the mid-to-high single digits after the Fed’s March meeting. Remember that bank financials have a strong arbitrage relationship with interest rates. When rates rise, it often encourages consumers and businesses to deposit money in their bank accounts to collect the interest. The banks then take those funds, lend them out at higher interest rates, and potentially can ring up profits.

With the Fed’s decision to hold off further elevating rates in the near-term, that puts pressure on bank margins—and, consequently, their bottom lines.

Possibly more troubling for banks is that the Fed noted that consumers and businesses were putting the brakes on spending. “Growth of economic activity has slowed from its solid rate in the fourth quarter,” the Fed said. “Recent indicators point to slower growth of household spending and business fixed investment in the first quarter...overall inflation has declined.”

The financial technology space might be a bright spot. Mobile payments are past the point of novelties as more and more consumers adopt the technology to cover costs on everything from beers with friends to bigger retail and household purchases. And it’s not just Millennials who no longer carry cash. Analysts are widely expecting companies in the mobile payments space to turn in strong results.

One interesting development along those lines came with Apple Inc's AAPL announcement last week that it’s teaming with Goldman Sachs Group Inc GS on a credit card. It’s the first credit card for GS, and a sign of technology companies and banks working together on business ventures that could potentially benefit both.

The Flattening Yield Curve

Yield curve inversion appears to be all the rage now as market pundits speculate on what it means when the 10-year Treasury rate falls below the three-month Treasury rate.

When that happens—as we’ve seen in recent weeks—short-term interest rates lie at or just above long-term rates, typically an indication that investors believe that growth will be weak, which the Fed mentioned.

And if the mortgage market is any indication, it might be a good idea to keep tabs on rates for home loans and pay close attention to what bank executives think about that impact on their bottom lines. Mortgage rates tumbled last week to their lowest level in 14 months and saw the biggest weekly point slide since 2009. 

Flattening yield curves have historically foreshadowed a recession ahead, according to researchers at the San Francisco Federal Reserve, who note that an inversion has preceded the last seven downturns. Given that, it will be interesting to hear what bank executives have to say in their forecasts.

Two important points: A recession is a part of a normal business cycle, so one will eventually come. However, historically, no one has had too much luck predicting recessions, and the Fed still sees 2.1% U.S. economic growth this year. That said, are banks starting to see a slowdown in lending? What do they see ahead on the mortgage-lending front? Lower interest rates might typically spur home buying, but the tight inventory on housing might still be a deterrent. These are among the questions that might get answered during Financial earnings season.

Also, investors might want to consider listening for bank executives’ views on Brexit and its possible impact. The latest Brexit deadline is now April 12, and it looks more and more likely that a “no-deal” Brexit might be in the works. Remember, London is a world banking capital. What happens to the banking sector worldwide and in the U.S. if there’s a mess in the U.K.? Perhaps bank executives can give some insight. The China tariff situation also remains fluid, so they might be asked to address that as well.

On the more positive side, the initial public offering (IPO) market has picked up lately, which may be a source of profit for many of the big banks.

Getting back to where we started, with the Wells Fargo & Co WFC CEO question, shares of WFC ended up pulling back Friday from a strong start as a little concern appeared to filter in on the news. One analyst noted that banks often groom their CEOs from within, but WFC has said it wants to hire from outside. That might be causing worry among some investors about the company’s future course, because hiring from outside might add a bit of mystery to where the business is headed.

Q1 Earnings Season

Though overall Q1 earnings for S&P 500 companies are expected to fall more than 2% year-over-year, the Financial sector is one of the few that might see earnings growth in Q1.

Financial sector Q1 earnings are seen growing 1.6% in Q1 year-over-year, CFRA said. That’s a pretty hefty slowdown from 17.1% in Q4, but also could reflect tougher year-over-year comparisons. For the full year 2019, CFRA sees Financial earnings rebounding and climbing more than 8%.

Upcoming Earnings Dates

JPMorgan Chase & Co. JPM and Wells Fargo & Co WFC are expected to report before the session begins on Friday, April 12.

Citigroup Inc C said it will report before the market opens on Monday, April 15

Bank of America Corp BAC, Morgan Stanley MS, and Goldman Sachs Group Inc GS are all expected to report earnings the week of April 15.

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