Banks Offer First Glimpse Into the Fourth Quarter Economy

By TRG Advisors on January 18, 2023

Kicking Off the Q4 Earnings Season With Banks

Banks often kick-off earnings season; Wells Fargo (WFC), JP Morgan (JPM), Bank of America (BAC), Morgan Stanley (MS) and Goldman Sachs (GS) represent most of the heavyweight banks that have
reported Q4 earnings in recent days. The financial services sector can be complex, and banks derive revenues through a variety of different services, including retail banking, commercial banking, investment banking, wealth management and trading. Financial services tend to be, along with other cyclical sectors, correlated with market and economic growth.

During the 2008 Great Financial Crisis, the world experienced first-hand the power that financial services giants held within the global economy. As a consequence, over the past decade, laws were
made to ensure banks are properly regulated and stress tested. Throughout the past few months, with great anticipation of a global recession, banks have become out-of-favor for many investors. After all, a market downturn and economic contraction are not good for banks – let alone any business.

The divisions within these giant banking corporations generate profits from economic spending and business activity, but the complexity within banks also offers diversified revenue streams and opportunities. Not to mention, the low expectations and out-of-favor sentiment offers low valuations in the current environment.

With most banks’ Q4 earnings now public, we’ve taken the opportunity to digest and share some key themes and takeaways.

Net Interest Income: A Beneficiary of Elevated Interest Rates

As expected, a higher interest rate environment is supporting better net interest income (NII). JP Morgan recorded a record NII figure of $20 billion, which represented +72% y/y. Wells Fargo reported NII +45% y/y and Bank of America reported +29% y/y.

The yield curve remains significantly inverted – the 3-month/10-year spread is -117 bps. Banks tend to generate higher interest income when the yield curve is elevated and normal. Today, it’s elevated and
inverted, but it’s allowed banks to generate much higher income than most of the past decade’s lowrate environment. Morgan Stanley’s CFO said that the bank’s NII has not peaked.

Chart 1: Higher Net Interest Income Across the Major Banks¹

If/when the yield curve becomes un-inverted and normalizes, banks should benefit.

Provision for Loan Losses vs. Nonperforming Loans

Companies are raising their provisions for credit losses – and we applaud this prudent action to prepare for unknowns – but good credit quality and the benign growth in nonperforming loans continues to underscore an easier credit environment for businesses and consumers alike. Conditions have become easier over the past few months in large part because inflationary costs, labor tightness and supply challenges have improved for those receiving the loans.

All major banks covered here are reporting lower non-performing loans compared to a year ago. Bank of America highlighted that their nonperforming loans and leases, as a percent of total loans and
leases, is much lower than a year ago for both their consumer and commercial programs. This trend is true for many of the major banks.

Credit Quality Strength

Goldman Sachs highlighted in their earnings call that, “the overall credit quality of our wholesale lending portfolio remains resilient.” Wells Fargo said, “loans grew in both commercial and consumer portfolios and charge-offs have also continued to increase, but credit quality remained strong.” They also shared, “customers have remained resilient with deposit balances, consumer spending and credit quality still stronger than prepandemic levels.”

Bank of America pointed analysts toward their higher originations in consumer home equity loans, consumer vehicle lending and new credit card accounts.

Low Fees and Elevated Expenses

Employee costs continued to be a headwind in Q4. Expenses are higher overall, but manageable. While compensation costs increased in the quarter, for Goldman Sachs and Morgan Stanley, compensation expenses were lower than 4Q21. JP Morgan and Wells Fargo both indicated lower revenue-related compensation for employees, in an effort to cut costs. Across all sectors, employee costs and wages continue to be an inflationary headwind for companies.

Piling onto their higher compensation struggles, banks are charging lower fees. Goldman Sachs’ investment banking fees were down -48% y/y and Bank of America’s fees “declined a little more than – 50%” in Q4. JP Morgan investment banking revenues were down -52% y/y and Morgan Stanley’s banking business fell -49% y/y. Volatile markets and less capital markets activity drove the lower fees
and revenue declines for investment banking divisions. Despite the decline in banking deals, pipelines remain active and there will be upside when market volatility eventually does settle. We could be seeing a trough in fees and deal flow within investment banking.

Trading revenues, particularly fixed income, have managed to pick up some of the slack from lower banking fees. Morgan Stanley trading revenues were up +26% y/y. Trading revenues are expected to
continue amid the volatility and client repositioning. Wealth management businesses also tend to have more steady returns and offered revenue growth for some banks, including Morgan Stanley, which reported +6% y/y net revenues in the space.

Banks continue to provide conservative guidance, given the uncertain macro environment. A pickup in second-half activity will have favorable y/y comparisons.

Shareholder Return Programs and Valuations

Banks are indicating continuation for near-term buyback activity. JP Morgan announced that their currently suspended buyback program expects to resume this quarter with approximately $12 billion in share buybacks.

The S&P financials sector has a higher aggregate dividend yield today, compared with its 10-year average. We like opportunities to invest alongside companies at cheap valuations with positive upside
opportunities/catalysts.

Chart 2: Markets Pricing Some Stocks Near Their Book Value²