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Caihua Insight|Is Wall Street Bank Stock “Booming” or “Salted Fish Reviving”?

Buffett likes financial stocks the most. Relying on the floating savings of insurance companies he holds, he has achieved the financial freedom of an “empty glove white wolf,” and has also continued to invest in financial stocks to achieve sustainable return growth.

In his US stock portfolio, except for the one with the highest share of shares$Apple (AAPL.US)$In addition, the second-largest holdings have just announced the results for the third quarter ended September 30, 2022$Bank of America (BAC.US)$。 As of June 30, 2022, out of 49 stocks held in his US stock portfolio, there were 16 financial stocks.

Even when the Federal Reserve changed its monetary policy, he did not change his investment portfolio. Is it because bank stocks have the appeal of crossing cycles, or is it because the valuation of these bank stocks has not reached a level suitable for sell-off?

How to evaluate the performance of the top five Wall Street banks?

After Wall Street plummeted in early 2020 and the Federal Reserve began to release water vigorously, US bank stocks experienced a massive rise in stock prices. Since this year, with the Federal Reserve's monetary policy shift, bank stocks have also followed the decline in the market.

However, since banks took the lead in starting the third quarter performance season, the unusual state of bank stocks has become a new force driving the market to rise. In fact, looking at the performance of many major banks in the third quarter, it is far from good. Presumably because expectations are too poor, performance that slightly exceeds expectations can easily cause a market with no good products to buy in a hurry to perform.

Below, let's take a look at the overall performance of the five major Wall Street banks in the third quarter of 2022, including Bank of America,$JPMorgan (JPM.US)$, Wells Fargo (WFC.US), Morgan Stanley (MS.US), and Citigroup (C.US).

In the third quarter of 2022, in terms of revenue alone, J.P. Morgan achieved a quarterly revenue growth of 10.35%, the best performance among the five major banks. Its net interest rate was 29.76%, which was also superior to that of its peers.

The worst performer was Morgan Stanley, which accounted for the majority of non-interest income. Quarterly revenue fell 11.98% year over year, which was inferior to the other four banks that achieved positive growth, as shown in the table below.

As can be seen from the table above, in the third quarter of 2022, the five major banks, whether in terms of return on equity or net profit attributable to shareholders, all declined year-on-year.According to Caihua News Agency, the high base created by the boom in the capital market in 2021 is the main reason, and this is mainly affected by the Fed's interest rate hike cycle.

How does the Fed's interest rate hike cycle affect the business performance of the five major banks?

Let's go back to March 2020.

Affected by the pandemic, US stocks have experienced an epic continuous meltdown. In order to revive market confidence, the Federal Reserve provides unlimited liquidity on the basis that market interest costs are already close to zero. In other words, you can obtain loans in US dollars at extremely low or even close to zero interest costs.

This laid the foundation for the next bull market in the US stock market. Capital flooded into the stock market, chasing high-risk returns.

For banks in the US, this has pros and cons.

The traditional banking business is mainly an interest business. What you earn is the difference between interest on lent capital and the cost of obtaining capital. Under an infinitely loose monetary policy, interest spreads in banks' traditional interest business are getting smaller and narrower, and profits are getting thinner and thinner.

However, most modern banks are not only engaged in interest business, but also many non-interest businesses, such as investment, financial management, asset management, investment banking, etc., and the income earned is mainly commission income, investment income, and transaction income.

These non-interest businesses generally do not require huge amounts of capital. They rely on services, expertise, and licenses. They are asset-light businesses, so the return on assets is also higher than traditional interest businesses, which require huge amounts of assets as collateral or reserves.

Therefore, in the “quantitative easing” cycle, banks' traditional interest business is being squeezed. However, on the other hand, due to the sharp increase in liquidity, the prosperity of the capital market has been promoted, customers have been greatly attracted to participation in wealth management and transactions, and the bull market has attracted financing activities, thus driving strong growth in investment banking business.

As shown in the chart below, the scale of IPO financing for NYSE and NASDAQ in 2020 and 2021 was far greater than in previous years.

Since March of this year, the Federal Reserve began a cycle of interest rate hikes, capital costs have increased, US stocks have also declined from high levels, and IPO activity has shrunk markedly. As can be seen from the chart above for the first nine months of 2022, this is significantly lower than the previous two years. As a result, the revenue growth rate of many non-interest services, such as investment banks and trading, hit the brakes.

But on the other hand, as interest spreads widened, banks' traditional interest services began to resume growth.

As you can see in the chart below, out of the top five banks, with the exception of Morgan Stanley, which excels in investment banking business, the other four banks all account for more than half of interest income. Among them, Wells Fargo and Citigroup account for more than 60% of interest business.

Moreover, judging from the growth performance in the third quarter of 2022, non-interest income has declined, while net interest income has achieved a very ideal growth rate.

Since Morgan Stanley's non-interest business accounts for a relatively high share of the non-interest business, and the scale of the interest business is much smaller, the negative impact of the sharp decline in US stocks on it is even more serious, so overall revenue has declined.

Since March 17 this year, the Federal Reserve has successively raised interest rates by 3 percentage points. The federal funds rate increased from 0-0.25% at the beginning of the year to 3.00%-3.25% on September 22, 2022, as shown in the table below.

Let's also take a look at the interest yield situation of the four largest banks that account for more than half of the income from interest services. See the table below. Their net interest yield (NIM) has invariably increased significantly. This indicator reflects the ratio of net interest income after bank interest minus capital costs to average interest-bearing assets.

Among them, Wells Fargo's NIM expanded the most, so despite a decline in the size of its average interest-receiving assets, its interest income growth rate was still the highest among its peers, mainly due to the widening of interest spreads.

Taking Bank of America as an example, see the chart below. Starting from the second quarter of 2020, its net interest yield fell sharply by 46 basis points from 2.33% in the first quarter of 2020, then remained hovering below 1.7%. It was only after the interest rate hike in March 2022 that the net interest yield rose from 1.69% in the first quarter of 2022 to 1.86% in the second quarter of 2022, and further increased to 2.06% in the third quarter.

Over the next two months, against the backdrop of high inflation, the possibility that the Fed will maintain an interest rate hike of 75 basis points in November is rising, and it is also likely that it will maintain this rate hike in December, which means that capital costs will rise further.

Interest spreads in traditional interest business are expected to widen further, which should benefit banks which account for a relatively large share of interest business. However, on the other hand, the increase in interest costs has also reduced the attractiveness of venture capital, and the growth of bank non-interest services will continue to be pressured.

Although interest rate hikes may seem beneficial to banks' interest business, they are not necessarily beneficial to their profitability.

The relationship between the Fed's monetary policy cycle and banks' preparation for additional allocations and impairment

The Fed dares to aggressively raise interest rates and reduce its balance sheet because the US economic data is ideal, the unemployment rate is at an all-time low, and job vacancies are at an all-time high. Raising interest rates and reducing inflation is more conducive to the sustainable growth of consumption power.

However, after interest rate hikes increase the cost of social capital, they will gradually weaken consumers' spending power and companies' willingness to invest in expanding production capacity, which may lead to a decline in production.

When the impact of sharp interest rate hikes begins to be perceived by the market, the negative impact on capital costs, investment, and consumption will become apparent. Due to a decrease in available capital (the impact of reduced balance sheets) and rising capital costs, companies and individual consumers with less than ideal financial conditions are beginning to feel pressure. As the impact spreads, this risk has a domino effect. The impact on banks will be that consumers do not pay credit cards, enterprises do not take loans... Banks perceive credit risk, and bad debt losses increase.

The four major banks, which account for more than half of the interest business, are aware of these risks, so they have increased reserves for future loan default in the third quarter of 2022 results, as shown in the table below.

Due to the negative impact of the pandemic on the global economy, these banks all increased their level of provisions drastically in 2020, but since the capital market conditions in 2021 were too good to be true, the possibility of customers not fulfilling their contracts seemed to have decreased. In 2021, previous provisions were returned one after another. This is the reason why they achieved good results in 2021, and the basis used for comparison this year is high, as shown in the table above.

As the Fed's interest rate hike increased, banks began to increase provisions again. This is an important reason why the decline in their net profit was greater than the decline in revenue. Although interest spreads widen or are beneficial to their interest services, high interest rates also release risks, and the possibility of provision and credit impairment has greatly increased. Therefore, the interest rate hike cycle is a double blade for the interest business.

summed

In summary, the development of the European and American interest rate hike cycle has advantages and disadvantages for bank stocks. The advantage is that interest spreads widen to favor interest business, and the disadvantage is that banks will likely bear the consequences of unleashed use risks.

This is one of the basic reasons why the stock prices of the five major banks have been falling since this year.

Considering the above potential risks and the Fed's interest rate hike path, the current short-term stock price rebound of these five major banks may be difficult for a long time, and the increase in provisions may partially offset the increase in earnings brought about by the growth in their interest business.

Author: Mao Ting

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