While no sector is immune to the virus battering global economies, few arguably have as much exposure as Financials. This could be especially true for some of the biggest U.S. banks as they prepare to report Q1 earnings next week.
More than other sectors, big banks can’t retreat to individual silos during a crisis. Every other sector’s problems quickly become theirs as consumer lending, corporate borrowing, investment banking, and other financial activity all take a hit. For instance, any bank that has travel or department store companies among its big customers is probably suffering right along with those downtrodden sectors.
The Q1 results from JP Morgan Chase & Co. (NYSE: JPM), Wells Fargo & Co. (NYSE: WFC) and Citigroup, Inc. (NYSE: C) next Tuesday and Wednesday will probably only tell part of the story, since the virus shutdown didn’t really intensify until the third month of the old quarter. That’s why investors and analysts might need to focus even more than usual on what bank leaders say about the future. Unfortunately, that’s just where things get complicated.
Banking sector leaders don’t possess crystal balls. They don’t know how long the emergency might last or what its eventual impact might be on their industry or on the other sectors that their lending supports. Things are likely to get rough, but how rough is the question. While the confusion could be helping some banks’ bottom lines from a trading volume standpoint, it’s probably hurting them in many other ways—and share prices have responded (see chart below).
Because of the extremes we’ve seen across markets where things have been spiking or completely fallen off, that might magnify the differences in bank business models. Based on those differences, you may see some significant variations in the results and in banks’ forecasts.
FIGURE 1: AS GOES FINANCIALS… Q1 was a rough quarter for the S&P 500 Index (SPX—purple line) as well as the sectors that comprise the index, such as Financials (IXM—candlestick). Data source: S&P Dow Jones Indices. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
The banking stocks have really been thrashed over the last month before rebounding a bit in recent days, and many financial analysts are throwing up their hands saying they’ve never had a tougher time evaluating company valuations. Of the three banks mentioned above, Citigroup might have been hurt the most so far, partly because it has a massive credit card business. Conceivably, consumers pulled back on purchases as unemployment and job insecurity raced higher over the last month.
Citigroup also has been expanding its investment banking business, but investment banking last quarter and in the coming quarters probably faces huge challenges. Few companies necessarily want to risk an initial public offering at times like these.
Even before the current global emergency began, the big banks saw challenges to their business, spending much of 2019 battling a tough yield curve, weak business investment, and trade issues. At the same time, however, most of the banks did an amazing job keeping costs low. This, along with a strong U.S. consumer, helped keep those challenges from having too big of an impact.
Now everything has changed. The consumers who kept the economy going last year are stuck at home. If they’re shopping, it’s probably online. Starting last month, open houses got cancelled around the country and few car dealers were selling new vehicles. Initial public offerings and mergers and acquisitions vanished—poof!—taking away more of the banks’ traditional profit drivers. No one knows when any of this will come back.
How’s Your Credit Risk? Big Banks Might be Re-evaluating
The crisis also raises concerns about credit quality. Can the banks count on being repaid for past loans to businesses and individuals? Credit quality was very strong as recently as Q4, but that’s no longer something the banks (or their investors) can take for granted.
There’s a lot of concern building about credit quality and credit risk, market research firm Briefing.com said recently. The full extent of the credit situation probably won’t be clear in time for Q1 earnings season, but bank leaders could potentially provide a lot more visibility on that in their Q2 calls when they know more.
Also, big banks are under pressure from the government and from businesses to ease some of the pain from this economic crisis. Banks are responding. For instance, JPM is giving a 90-day grace period for mortgage and auto loan borrowers and waiving late fees on credit cards. While you can commend JPM and other banks for being good corporate citizens, no one is under any impression that this helps their bottom lines.
Last week, in the company’s annual report, JPM CEO Jamie Dimon offered a preview of what investors might be hearing from JPM and other industry executives when earnings season starts. He believes the economy faces a “bad recession,” but added that the company’s 2019 pre-tax earnings of $48 billion “enables us to absorb the loss of revenues and the higher credit costs that inevitably follow a crisis.”
Dimon added that JPM believes it can remain profitable all year in a scenario where U.S. unemployment peaks at 10% and the stock market falls 50%. In an “extremely adverse scenario,” he added, where the economy does far worse than that, the company would still end the year with “strong liquidity,” but might consider suspending its dividend. The bank has $500 billion in liquid assets and an additional $300 billion in borrowing capacity from the Federal Reserve that it can use to support loans, Dimon said.
“Liquidity risks may be less of a concern with the Federal Reserve Bank aggressively funding many of the capital markets,” research firm CFRA observed in a note to investors this week.
JPM sees its earnings falling “meaningfully” in 2020 due to coronavirus. Shares took a major dive when the crisis hit, recently trading at $89. That’s down from $141 at the start of the year. Generally, $90 a share has been a resistance point for JPM shares that they’ve had trouble staying above.
Swimming Against the Current as Rates Plunge
Speaking of trouble, the current microscopic interest rates look like they’ll be a challenge for the entire sector at least in the foreseeable future. Treasury yields fell to record lows in Q1 as the Fed took unprecedented measures to keep rates down so that businesses have access to cash. One measure was reducing the Fed funds rate back to zero for the first time since 2015.
When long-term yields decline, that can weigh on mortgage rates, among other bank offerings. Sure enough, 30-year mortgage rates recently averaged 3.33%, according to the weekly survey from mortgage company Freddie Mac. That’s down from 4.08% a year ago.
This is especially tough for Wells Fargo (WFC), which has the biggest mortgage origination business of any of the three banks we’re talking about here. Last year, WFC’s CFO called mortgage lending the “core” of the company’s business. It’s tough for any company in the mortgage business at a time like this when people can’t even hold an open house.
You might think refinancing at low rates might help the big banks, but even that could be hard to do when people are stuck at home.
Rates are coming down for some borrowers, but spreads of investment grade or corporate bond yields didn’t come down as much. The typical spread for a typical corporate bond over a 10-year Treasury has almost doubled since mid-February. It shows the banks aren’t necessarily going to immediately pass lower rates straight through to borrowers. They’re becoming much more stringent about lending and it will be interesting to see how that affects demand.
The average rate on mortgages across the board have begun ticking up. Even though the 30-year rate is down significantly, some banks have reported a slight uptick. Things fell quite a bit over the past couple of months, but it hasn’t come down much when you compare it to how far the Fed has cut interest rates. Banks are requiring more compensation to lend right now, so we’ll see how that affects demand, as well. For banks, that can be a good thing. Their borrowing costs are low, but they can charge some of these companies 4% or more.
Then it becomes a play between that and volume, because if demand falls, that could mean less volume for banks.
One business that did appear to thrive for the big banks in Q1 was trading. Volatility in the stock and fixed income markets reflected heavy trading volume as the markets got whipsawed around, and that heavy volume probably translated into some quick cash for JPM and C, which have some of the largest trading businesses in the world.
Furthermore, the Fed stepping in could possibly make the outlooks more clouded because they’re being a player in actual corporate bond markets.
Setting the Tone for Earnings to Come
Typically, bank earnings coming early in the season help set the tone for the rest of the reporting period. This is definitely the case more than ever this time as investors want to hear straight from JPM’s Dimon and others where they see the economy going in this time of global emergency measures.
Dimon’s letter last week already gave some clues. In general, however, don’t expect the executives to offer much of anything definitive. They’re right up close to the crisis, but it’s a fast-moving situation that they’ll have a lot more insight into by next quarter. That means Q2 earnings might be the best time to get their more educated thoughts.
“We think the tone of the upcoming large banks’ earnings calls (is) likely to be very cautious to the 2020 outlook, as the demand side of the business driven by business and consumers remains uncertain,” CFRA wrote.
Unlike the 2008-09 crisis, diversified banks came into this situation “from a position of strength” in terms of capital, CFRA wrote. They’ve been preparing for a day like today as they’ve gone through all the government-required stress tests, for instance.
Going into earnings, there’s also quite a bit of concern about banks’ ability to return capital. They’re known to do that two ways: Through share buybacks and dividend payments. It’s looking like buybacks are less and less likely, analysts say, but no major bank has reduced or eliminated dividends yet.
JPMorgan Chase Earnings and Options Activity
When JPMorgan Chase releases results, it is expected to report adjusted EPS of $2.18, vs. $2.65 in the prior-year quarter, on revenue of $29.6 billion, according to third-party consensus analyst estimates. Revenue is expected to rise 4.2% year-over-year.
Options traders have priced in about a 6.6% stock move in either direction around the upcoming earnings release, according to the Market Maker Move indicator on the thinkorswim® platform from TD Ameritrade. Implied volatility was at the 42nd percentile as of Monday morning. Looking at the April 17 options expiration, puts have seen some activity at the 90 and 95 strikes, but much of the volume has been to the upside, with concentrations at the 120 and 130 strikes.
Note: Call options represent the right, but not the obligation, to buy the underlying security at a predetermined price over a set period of time. Put options represent the right, but not the obligation to sell the underlying security at a predetermined price over a set period of time.
Wells Fargo Earnings and Options Activity
Wells Fargo is expected to report adjusted EPS of $0.33, vs. $1.20 in the prior-year quarter, on revenue of $19.35 billion, according to third-party consensus analyst estimates. Revenue is expected to be down 10.5% year-over-year.
Options traders have priced in a 7.9% stock move in either direction around the coming earnings release, according to the Market Maker Move indicator on the thinkorswim platform. Implied volatility was at the 49th percentile as of Monday morning.
For the April 17 expiration, put activity has been concentrated at the 25 strike, while call activity has been highest at the 35 and 40 strikes.
Citigroup Earnings and Options Activity
Citigroup is expected to report adjusted EPS of $1.47 vs. $1.87 in the prior-year quarter, on revenue of $19.05 billion, according to third-party consensus analyst estimates. Revenue is expected to be up 2.5% year-over-year.
Options traders have priced in an 8.6% stock move in either direction around the coming earnings release, according to the Market Maker Move indicator. Implied volatility was at the 52nd percentile as of this morning.
Call activity for C has been highest at the 50 strike, while puts have seen activity at the 40 and 45 strikes.
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