Banks gain favor in risk-off environment but earnings uncertainty remains

While rising interest rates have allowed banks to generate more net interest income from loans, fears of economic slowdown have been weighing on the sector as it gets more expensive to borrow money and fewer transactions such as home mortgages get done.

Loan growth is expected to slow, while investment banking remains moribund as initial public offerings and other financing deals cool off.

Goldman Sachs and Morgan Stanley are expected to cut staff after Wells Fargo
WFC,
+0.90%
was the only bank in the third quarter to report a headcount reduction amid a drop in its mortgage business.

Also Read: Goldman sharpens knife on headcount, bonuses along with other big banks

At the same time, banks may divert some income away from the bottom line to build up capital reserves to withstand an economic downturn. Stock buybacks and dividends may be more muted as a result.

The profit parade from the U.S.’s largest banks will come after their stock prices underperformed the overall market as investors wait for a pause in interest rate hikes by the Federal Reserve.

“It’s tempting to get more positive given stocks are already down sharply, inflation seems to be slowing and Fed rate hikes may be coming to an end,” Deutsche Bank analyst Matt O’Connor said in a research note on Friday. “But our gut is that stocks will set new lows and fully (or close to it) price in a U.S. recession suggesting there’s more risk from here.”

Also Read: Wells Fargo has fired an executive accused of urinating on a fellow passenger aboard a flight to New Delhi

During the fourth quarter, digital currency loomed large on Wall Street’s radar screen in the wake of the bankruptcy of crypto exchange FTX. Banks are positioning themselves as providers of regulated banking services and specialists in more stable, government-backed currencies.

J.P.Morgan Chase
JPM,
+1.91%
CEO Jamie Dimon has been front and center on this issue and has referred to cryptocurrencies as “pet rocks” and not part of the real market.

Meanwhile, economic storm clouds are casting a cloud over the banking sector despite a strong December U.S. jobs report.

J.P.Morgan Chase’s annual business leader outlook survey released this week showed that the majority of small and midsize U.S. business leaders anticipate a recession in 2023. Sixty-five percent of midsize businesses and 61% of small businesses expect a recession in the next 12 months.

Against this backdrop, analysts expect JPMorgan Chase to report earnings of $3.11 a share and revenue of $34.29 billion when the megabank reports earnings on Friday, according to estimates compiled by FactSet.

Analysts have become more bullish on JPMorgan’s earnings than the $2.91 a share projection for fourth-quarter earnings on Sept. 30, but less optimistic than the $3.15 a share estimate as of Dec. 30, according to FactSet.

Also on next Friday, Bank of America
BAC,
+1.00%
is on deck to report earnings of 78 cents a share on revenue of $24.3 billion, Citigroup
C,
+1.20%
is expected to post earnings of $1.19 a share on revenue of $17.93 billion and Wells Fargo is seen earning 60 cents a share on $20 billion in revenue.

Among the quartet, Wells Fargo has seen its earnings estimates cut most dramatically in recent weeks from $1.27 a share as of Sept. 30 to 60 cents a share as of Friday.

On Jan. 17, Goldman is forecast to report earnings of $6.03 a share on revenue of $11.02 billion and Morgan Stanley is likely to report a profit of $1.32 a share on revenue of $12.64 a share.

Over the past three months, expectations for Goldman’s earnings have fallen from $7.82 a share on Sept. 30 to $6.03 a share now, while Morgan Stanley’s profit estimates have dropped from $1.65 a share on Sept. 30 to $1.32 a share on Friday.

Brian Mulberry, client portfolio manager at Zacks Investment Management, told MarketWatch that over the course of the coming year megabanks may benefit from an uptick in merger and acquisitions, both for providing debt as well as other banking services, as corporate clients grow accustomed to higher interest rates that are returning to historical norms after a decade of central bank monetary stimulus.

“It’s an interesting period for banks because interest rates have gone up and impacted loan demand, but in a historical context, a 5% Fed funds rate is not a headwind for transactions,” Mulberry said.

A slower economy will force smaller players to the merger altar and provide a benefit for deal-making that cooled considerably in 2022, he said.

“As the economy continues to slow, we’ll see a merger and acquisition cycle that’s good for banks,” he said. The banks will likely outperform the broad sector once M&A activity picks up, he said.

Big banks are also much better prepared for a recession than they were in the Global Financial Crisis of 2008.

“The efficiency lies with the bigger players in these types of economic cycles,” Mulberry said.

Ahead of earnings reports next week, Wall Street analysts have been tweaking some of their ratings on the major banks.

Deutsche Bank analyst Matt O’Connor on Friday downgraded Bank of America Corp. and J.P.Morgan Chase to hold from buy.

Analysts at Deutsche Bank cut the price target on Bank of America to $36 a share from $45 a share and trimmed JPMorgan’s price target to $145 from $155.

Deutsche Bank also hiked its rating on PNC Financial Services Group
PNC,
+3.04%
 to buy from hold and cut its price target to $190 from $200 and downgraded Truist Financial Corp. 
TFC,
+3.20%
to hold from buy and reduced its price target to $48 from $61.

BofA analysts said Thursday that Goldman Sachs, Wells Fargo and Citigroup offer an attractive risk reward at current levels, but they’re reducing their overall earning expectations for the sector.

“Bank stocks [tend] to struggle heading into a recession, but [the] group has historically bottomed ahead of trough GDP/peak unemployment,” BofA said in a research note.

Overall, BofA reduced its 2023 earnings expectations for its bank universe by 13% to reflected an accelerated build in loan loss reserves, but with a collective 9.6 times price-to-earnings ratio, bank stocks are mostly pricing in a mild recession.

In the past 12 months, shares of Bank of America are down 28.4%, JPMorgan stock is lower by 16.6% and the S&P 500 is off by 16.9%. Wells Fargo has lost 20.2%, Citigroup is down by 26.9%, Goldman Sachs has dropped 12.5% and Morgan Stanley is off by 15.3%.

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