The last Wall Street bear market ended nearly a year ago and a new bull market began in June, though it’s flagging. But one prominent sector hasn’t participated, raising numerous eyebrows as earnings season approaches.
Whichever sector index you choose, all show the same thing: Bank stocks remain down year over year even as the broader market is up about 17%. From mid-October 2022 through early October 2023 period, the S&P Banks Select Industry Index ($SPSIBKT) fell 18%.
“This is the first time in nearly 100 years that the market is off a major low for this long and the banks are still down,” said Kevin Gordon, senior investment strategist at Schwab.
It’s unusual not just because it’s been so long since a similar scenario but also because banks often lead rallies off of major lows. A bull market in stocks generally reflects a robust economy, and a healthy economy shows up in the banking industry because more consumers and businesses borrow to expand or upgrade their homes or factories, there’s more hiring that leads to more investing, and new companies launch shares on Wall Street to participate in the growth. All this activity tends to help banks, at least in a normal recovery.
The fact that bank stocks aren’t up despite economic growth, which some economists peg near 3% for Q3, is puzzling and suggests that perhaps the growth we’re seeing isn’t wide in scope or lifting all boats equally.
Most of the biggest U.S. banks aren’t exceptions to the general downturn in the financials sector, and they begin their quarterly reporting period this Friday, October 13, when JPMorgan Chase JPM, Citigroup C, and Wells Fargo WFC are expected to open their books to investors. Goldman Sachs GS and Bank of America BAC are expected to report October 17, followed by Morgan Stanley MS October 18.
“Loan loss provisions, revenue growth, and lending standards are key to watch,” Schwab’s Gordon said.
Loan loss provisions are funds banks put aside in case loans go bad and detract from earnings. They’ve been a near-constant drag on bank results since banks began adding to them during the pandemic.
Headwinds from all sides
The atmosphere ahead of Q3 bank earnings is very different than it was heading into Q2 reporting season three months ago. At that point, the overall market had been climbing for a month, and investors generally felt bullish. There was growing belief that the Federal Reserve was nearing the end of its rate hikes and that cuts could come as soon as early-to-mid-2024, giving the economy and companies an additional boost.
This month, the benchmark 10-year Treasury note (TNX) yield topped 4.8% for the first time since late 2007, up from spring lows near 3.3%. The Fed projects rates remaining higher for longer into 2024, and worries are growing that an extended period of high borrowing costs could put banks under more pressure as old loans expire and customers flinch at new, more onerous rates. Housing sentiment also suffered recently as the average 30-year mortgage approached 8%, which could hurt banks in the home and mortgage loan businesses. Mortgage applications fell to levels last seen in the mid-1990s when the population was 20% lower.
There was a burst of initial public offering (IPO) activity in late summer and early fall, but potential IPOs might get pushed back if executives put their finger to the wind and sense a declining stock market and rising costs. This could potentially hurt the largest Wall Street investment banks that have seen their IPO and mergers and acquisitions (M&A) businesses suffer lately amid high rates.
In sum, these are tough times for banks across the spectrum, something likely to be reflected when we hear from executives of the largest financial institutions over the next week. Bank earnings often set the tone for the entire reporting season, and banks are closer to the heartbeat of most industries, so their results and observations merit a close look.
“Banks have been trading quite poorly of late, and it’s not just the regionals,” Schwab’s Gordon noted. “Given some of the mega-cap banks have been weakening, the focus now shifts to what executives say regarding their outlook for lending standards. It would make sense to see more tightening since that’s what the Senior Loan Officer Opinion Survey (SLOOS) on bank lending has been telling us.” That survey, out four times a year from the Fed, tracks banks’ willingness to lend.
The focus this quarter is likely to center around credit quality and loan volume as banks continue to struggle with a high interest rate environment and emerge from last spring’s industry turmoil that saw several regional banks fail. When the big banks report, keep an eye on the general level of loan activity and the quality of their existing loans. The main thing to watch is how much, if anything, they added to provisions for credit losses. More capital set aside for that indicates increased fears of default, which would also weigh on earnings.
Credit check
After staying relatively steady most of the summer, credit conditions appear to be tightening for consumers and businesses under the strain of rising rates. This is another example of the tough environment for banks, which need to be more careful who they loan to when rates are high.
“Risk assets appear to be adjusting to the threat of ‘higher for longer,’” noted Collin Martin, director, Fixed Income Strategy at the Schwab Center for Financial Research. “High-yield bond spreads are up more than 50 basis points in less than two weeks, and average spreads are at their highest levels in more than three months.”
When spreads widen between corporate bond yields and Treasury yields, it can reflect a tougher borrowing environment for businesses. In this case, it appears to be affecting those with lower credit ratings on the high-yield side of the market.
Tightening credit might mean banks are growing more reluctant to lend to certain businesses, which could dry up venture capital, commercial real estate, and other businesses dependent on a relatively free flow of funds.
“The move up in spreads has been relatively widespread, but consumer cyclical industries have gotten hit the hardest,” Schwab’s Martin said. “Anything connected to the consumer would be most at risk if the economy slows.”
Regional bank earnings to watch include PNC Financial Services PNC, M&T Bank MTB, U.S. Bancorp (USB), and Regions Financial RF.
Deposit levels also remain a concern going into earnings season and should be monitored by investors. The recent rally to 16-year highs in Treasury yields poses competition for banks trying to attract deposits, and banks continue to raise the interest they pay out on short-term investments as they try to keep cash in the system.
Another issue that didn’t go away is the inverted yield curve, in which long-term U.S. rates remain well below short-term ones. The curve between the 2-year and TNX yields has fallen to 50 basis points recently from over 100 in Q2, but it’s mainly because longer-term yields are rising so quickly. An inverted cure can hurt bank earnings because banks tend to borrow in the short term and lend for the long term.
Many banks have enjoyed nice tailwinds in recent quarters from net interest income, which is the money they make lending minus what they pay to customers. Eventually, those strong results are going to get “lapped,” meaning companies will face tougher comparisons to year-ago earnings performance.
Ask your banker
To get a better sense of how things are going beyond simple top- and bottom-line numbers, here are some questions big bank CEOs might be asked on their earnings calls:
- How was loan volume in Q3, and what are banks’ forecasts for loan volume in Q4 and beyond?
- Are defaults likely to rise and, if so, in which industries?
- How are deposit trends, and are banks paying more interest to keep depositors? If so, what would be the impact on margins?
- Could the M&A market pick up later this year?
- Is a recession likely and, if so, how deep will it be?
- Did banks continue to put aside loan loss reserves in Q3 to protect from possible loan defaults?
- Is the commercial real estate market going to be a big drag on regional banks as many lower-yield loans to those companies expire?
Will banks still beat analysts’ estimates?
Big banks have a long history of exceeding Wall Street’s expectations. It happened again last quarter and injected vigor into the early days of Q2 earnings season. Earnings from the financials sector, which includes banks, rose 7% year over year in Q2, according to research firm FactSet, versus a preseason expectation of 4%. Revenue climbed 11.2% in financials versus a 7.6% estimate ahead of Q2 earnings.
The financials sector is expected to see Q3 year-over-year earnings per share (EPS) growth of 8.7%, according to the latest FactSet projection. That’s down a touch from the September 30 projection of 8.9%. Analysts expect the sector to post revenue growth of 5.3%, a sharp sequential decline.
Digging deeper into the sector to focus on banks alone, research firm CFRA sees “moderate results” for large banks in Q3, with some chance for surprising upside on EPS. Single-digit growth in consumer and commercial loans is likely, CFRA said, and it doesn’t anticipate a big spike in loan delinquencies.
Continued monetary policy tightening and general economic uncertainty that’s hurt mergers and acquisition activity could be a drag on performance of major investment banks, according to CFRA. A weak equities environment for much of Q3 could be another pressure point. Net-interest income remains a catalyst thanks to high interest rates, the firm said, but tough comparisons might make it harder for banks to rely on that for year-over-year earnings boosts.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
Charles Schwab & Co., Inc. (“Schwab”) and TD Ameritrade, Inc., members SIPC are separate but affiliated subsidiaries of The Charles Schwab Corporation. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank.
TD Ameritrade® commentary for educational purposes only. Member SIPC.
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