Financials Sector Earnings Loom with Microscope on Credit Quality

When you think back to the earliest days of the COVID-19 pandemic, a few things probably come to mind: masks, stay-at-home orders, bleach wipes, and, of course, loan loss reserves (LLRs).

OK, maybe LLRs weren’t part of your personal pandemic prep, but they certainly were for major U.S. banks, which put aside billions of dollars in 2020 to steel themselves against possible defaults on outstanding loans after businesses screeched to a halt for COVID-19.

Entering the financials sector’s Q3 2022 earnings season, it’s shades of 2020 again. With interest rates at multi-year highs thanks to a hawkish Federal Reserve trying to tame inflation, the fear is that once again borrowers could find themselves struggling to pay back their debt.

Will big banks have to expand their reserves to protect their own health?

That’s just one question as the biggest U.S. banks prepare to report later this week and early next. Such reserves could take a bite out of their earnings if they do go that route. But there are other questions too, including:

• How was loan volume in Q3, and what are banks’ forecasts for loan volume in Q4 and beyond?

• How did asset volatility in currency, interest rates, and equities play out over the past three months?

• Do banks see any liquidity restraints that might be problematic?

• What does credit quality look like now?

How the banks address these questions and their own earnings results are likely to be influential on Wall Street. Their narrative is likely to set the tone across industries for the rest of the Q3 earnings season.

Preparing for the Worst

LLRs are not one of the things investors want to hear when it comes to the banking sector because they take a direct hit on profits. Bank profits dropped 22.2%, or $17 billion, between the first quarter of 2021 and 2022, according to Banking Dive, a news outlet covering the banking industry. Banks piled up reserves during the pandemic. But thanks in part to the Fed and Congress providing a pandemic lifeboat for businesses, most of the feared defaults never happened.

Banks had reduced loan loss provisions by $14.5 billion during the first quarter of 2021, according to the Federal Deposit Insurance Corp. (FDIC). But it began increasing them again in the first quarter of 2022 by about $5 billion as inflation and recession risks rose along with chances for rate hikes. “Banks increased loan loss provisions in the first quarter (of 2022) due to heightened uncertainty, which lowered industry net income,” the American Bankers Association said in a statement.

LLRs rose again in the second quarter of this year by about the same amount as in Q1, according to the FDIC. The question now is how much they climbed in Q3. A big jump would probably reflect an industry even more concerned about loan quality. And that would raise questions about the overall economic health.

For banks that are tied to a lot of loan activity, LLRs will be an important number to focus on in the coming weeks of Q3 earnings season. This means regional banks and Wells Fargo WFC but, to some extent, big conglomerates too. JPMorgan Chase JPM is one of the largest and most diversified banks in the U.S., so seeing where loan loss provisions change in areas like commercial banking and other areas of their loan portfolios may be something to focus on.

When the big banks report, it’s also important to keep an eye on the general level of loan activity and the quality of their existing loans. If the quality of their loan portfolios is starting to deteriorate and people are having trouble with payments, that could be a sure sign of economic weakness.

Concern about loan losses is arguably industrywide, but there could be some divergence in how financial companies are doing across different lines of business. Corporate dealmaking is getting hit because the cost of deals has risen throughout the year and the economic outlook is still very uncertain. Still, it’s possible that the recent rate and currency volatility could be propping up some of the major banks’ trading activity, or the capital markets parts of their business.

That’s why it’s important to understand the financial sector heat map below showing various subsectors. Banks that play heavily in the capital markets like Morgan Stanley MS and Goldman Sachs GS might see results diverge from diversified banks like Bank of America BAC and JPM that are more closely tied to the consumer economy.

FIGURE 1: Financials Beat: Over the past three months, the S&P 500 Financial Select Sector (IXM-candlesticks) slightly outpaced the S&P 500® Index (SPX), though both lost a bit of ground. Incoming Q3 earnings data may provide more insight which direction they’ll go next. Data Source: S&P Dow Jones Indices. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Setting the Seasonal Tone

It’s probably a good thing that the largest U.S. banks report in the vanguard of earnings season. According to Briefing.com, these firms are uniquely attuned to the nuts and bolts of the economy and can set the stage for how the quarter really went for consumers and industries as earnings season progresses. That’s why it’s worth paying extra attention to what executives from the largest banks have to say.

It’s arguably true now more than ever as the world appears to be teetering on the edge of recession. Back in June, JPM Chairman and CEO Jamie Dimon warned of an economic “hurricane,” saying he didn’t know if it would be minor or a superstorm like Sandy, which made a direct hit in 2012 in New York City where JPM is headquartered. As of today, Dimon’s comment was made three large Fed rate hikes ago.

What he said on Monday during a CNBC broadcast wasn’t much more optimistic, but there was an exception. Dimon thinks balance sheets are in pretty good order.

In what could be seen as a preview of JPM’s earnings call tomorrow, Dimon said Monday that the benchmark S&P 500® (SPX) could fall by “another easy 20%” from current levels, adding that “the next 20% would be much more painful than the first.” He thinks the United States and global economies are likely to fall into recession sometime in the next six to nine months.

With those words, major indexes went lower.

So, the words Dimon chooses Friday will likely be monitored even more carefully by the markets. The same is possible for whatever his cohorts at major banks like GS, Citigroup C, Bank of America BAC, and Morgan Stanley MS say during their respective calls. Others like JPM and WFC may have specific views about the future market for U.S. mortgages, car loans, and other financial trends. Both WFC and JPM are among leading mortgage banks, and WFC is a leader in car loans.

Since Dimon mentioned his June “hurricane,” the weather’s clearly gotten worse. The situation in Ukraine appears even more volatile with Russia’s recent bombings and nuclear threats, and the Fed appears set for a potential fourth 75-basis-point rate hike in November. Earnings growth expectations from Wall Street analysts for Q3 fell from nearly 10% at the end of June to below 3% now, according to research firm FactSet.

As for the entire financials sector, Wall Street’s outlook for Q3 earnings is so weak that even a slightly better-than-expected showing might receive an upbeat response from investors, Briefing.com observed. FactSet projects a year-over-year earnings decline of 13.5%, making it the second-worst sector performance in the S&P. Four of the five subsectors within financials are predicted to show earnings declines, including consumer finance, capital markets, banks, and insurance. Three of those industries could see double-digit earnings declines, according to FactSet. Only the diversified financial services industry is seen reporting year-over-year earnings growth.

That sets up a pretty low hurdle for financials, and we should have a decent idea by the end of the week whether the sector can beat projections. The market will look for any rays of light in a dark tunnel, according to Briefing.com, so it’s possible a financials sector beat of, say, 200 basis points above the FactSet projection could support the whole market at the start of earnings season. Financials sector stocks sport very low price-to-earnings (P/E) ratios, which means buyers could be tempted to jump in on any better-than-expected earnings news.

Investors shouldn’t confuse earnings beats with earnings progress for the financials sector, though. The environment remains very bleak. The initial public offering (IPO) and special purchase acquisition company (SPAC) markets have almost completely dried up after going on a wild tear in 2021.

This year, the global economy is slowing, merger and acquisition activity is down, and the U.S. Treasury yield curve remains deeply inverted.

An inverted yield curve is when near-term yields like those on the 2-year Treasury note are much higher than yields on the 10-year Treasury note (TNX). Recently, that inversion was above 40 basis points. This also hurts banking industry profits and probably won’t improve until the Fed starts to lower rates. That won’t be for a while, according to the latest Fed dot plot of projected rates over the coming years. The median Fed projection is for its benchmark rate to peak at 4.6% in 2023, up from between 3% and 3.25% now.

Also, the Fed expects unemployment to climb back above 4% in the coming year, which is still low historically but up from recent very low levels. Rising unemployment, accompanied by recent 7% mortgage rates and reports of borrowers having to pay $1,000 per month for car loans, doesn’t sound particularly pleasant, not only for banks but for all credit issuers. That includes credit card and payment companies that are also part of the financials sector.

A slowing economy dogged by high borrowing costs helps nobody in this industry, not to mention its customers.

TD Ameritrade® commentary for educational purposes only. Member SIPC.

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