Bank Earnings: The Rubber Hits the Road

During the early part of my career, when I served as a press secretary to a U.S. congressman, I learned an important lesson about politicians.

Don’t listen to what they say. Watch what they do.

My observation applies to any elected official, regardless of party affiliation. As the 2020 election looms closer, we’re hearing a lot of overheated rhetoric about the “Big Banks.” Several presidential candidates habitually decry the supposed rapacity of the financial services sector, especially those on the progressive spectrum such as Senators Bernie Sanders (I-VT) and Elizabeth Warren (D-MA).

My advice? Ignore the incendiary tweets, the cable news diatribes, the op-ed pontificating. Second-quarter earnings season is underway. As an investor, that’s where you should focus.

Earnings season is when the rubber hits the road. First out of the gate this week: the heavyweights of banking. Financial services are a bellwether for the wider economy.

Wall Street is closely watching second-quarter corporate operating results, to see if several headwinds, including the global trade war, the Brexit mess, and China’s slowing growth, will significantly hurt earnings and by extension the stock market.

The quarterly reports are starting to pour in and so far, for the big banks at least, the results are encouraging (with caveats).

JPMorgan Chase (NYSE: JPM), the largest U.S. bank by assets, yesterday exceeded earnings estimates but net interest margin fell. A key metric for banks, net interest margin measures the return on investments relative to interest expenses. The overall trend of falling net interest margins is spawning worries that lower interest rates are a drag on bank profitability.

Banking is a “spread” business. Banks profit from the gap between the interest rate they receive on their assets and the rate that they pay on liabilities. Net interest margins fall as loans are repaid at lower interest rates.

Goldman Sachs (NYSE: GS) and scandal-plagued Wells Fargo (NYSE: WFC) yesterday both reported earnings that beat expectations, but WFC’s net interest margin declined. The previous day, Citigroup (NYSE: C) reported the same dynamic: a beat in earnings accompanied by a decline in net interest margin.

Before the opening bell this morning, Bank of America (NYSE: BAC) reported earnings that beat expectations, driven by robust retail banking. But (you guessed it) net interest margin fell.

These earnings results from the major banks highlight a bright spot for lenders: they’re writing more consumer loans as the economy continues to show buoyancy. Higher income from consumer banking is offsetting declines across other businesses.

Big rhetoric over “Big Banks”…

Even Donald Trump bashed the banks in 2016. During that tumultuous campaign, Trump consistently attacked Hillary Clinton for her ties to the banking community and pledged to “drain the swamp.” But then a funny thing happened. He won.

Under President Trump, the banking industry has thrived. From his appointments and policies, Trump has made it clear that the financial services sector has favored status with his administration. Notably, Trump named longtime banker and former Goldman Sachs executive Steven Mnuchin as Treasury secretary.

Over the past two years, the Trump team has rolled back banking regulations loathed by global investment bankers, exemplified by the Dodd–Frank Wall Street Reform and Consumer Protection Act that was passed in 2010 in the wake of the Great Financial Crisis.

Supporters of these banking rules say they were designed to prevent another 2008-2009 financial crisis. Bankers say the rules are cumbersome and unnecessary; they’re glad to see them gutted.

Bankers also were delighted with tax overhaul. The massive corporate income tax cut signed by Trump in December 2017 disproportionately helped banks, because they tend to take fewer deductions than other types of companies.

Bank stocks went on a tear in 2017, in euphoric response to Trump’s surprise election, and then stumbled in 2018 as the escalating trade war weighed on long-term growth expectations. The flattening of the yield curve also stoked fears of a recession.

But an economic downturn is farther down the road, whereas banks benefit from several shorter-term trends.

The consumer remains in charge…

One immediate tailwind for the financial sector is the seasonality that banks typically experience in the autumn, when demand for investment services and tax planning starts to pick up.

The Trump tax cut continues to pay off for financial services. Banks plowed most of their tax windfall into buybacks, which should put a floor under their stocks and propel share prices higher. What’s more, the strong performance of the U.S. economy during the first half of 2019 suggests business growth, which in turn suggests loan growth. Consumer confidence remains high, which translates into higher debt levels that banks can service.

Read This Story: Will The American Shopper Keep the Bull Alive?

The Commerce Department reported Tuesday that U.S. retail sales increased 0.4% in June, greater than the expected 0.1% increase. It was the fourth consecutive month of rising retail sales (see chart).

Source: Commerce Department, Investing Daily

The benchmark iShares U.S. Financials ETF (IYF) has generated a year-to-date return of 22.3%, compared to 21.4% for the SPDR S&P 500 ETF (SPY). Bank stocks are poised to outperform for the rest of the year.

Investors are heartened that bank earnings have so far beaten expectations, because if bearish projections are proven right, the stock market faces tough sledding as S&P 500 profits weaken.

According to research firm FactSet, the S&P 500’s average earnings per share in the second quarter are expected to decline 3.0% from a year ago, following a 0.3% drop in the first quarter. If that projected decline comes to pass, we’ll officially find ourselves in an earnings recession.

China’s woes are dampening corporate profits. The country this week released weak economic growth numbers that unnerved investors.

However, the robust jobs report for June, combined with signs that the consumer remains in a spending mood, continues to underpin the bull market. Investors are still hoping for an interest rate cut this month, although yesterday’s upbeat retail report makes it less likely.

Money in the bank…

Regardless of monetary policy, portfolio diversification is more important now than ever. The “domino crashes” of 1929, 1981, 1987 and the more recent tumbles of 2007-2009 are all examples of situations when investing in only one type of asset was not the wisest course of action.

Several credible research studies have found that asset allocation explains nearly 100% of the level of investor returns. At the heart of asset allocation is the risk-return trade-off. Many investors make the mistake of setting their asset allocation once and then walking away. It’s not a one-time task; it’s a life-long process of fine-tuning.

Based on the trends I’ve outlined above, your portfolio should have exposure to the banking sector. The major banks are trading at attractive valuations, as undue pessimism weighs on their share prices.

For general tips on how to re-balance your portfolio according to current market conditions, read my story: Your Next Moves in This Mixed-Bag Market.

And when a politician says he or she wants to “break up the Big Banks,” rest assured, it’ll never happen, no matter which party is in power. You can take my words to the bank.

Questions about the financial services sector? Drop me a line: mailbag@investingdaily.com

John Persinos is the managing editor of Investing Daily.