Banking Results Triggering Ahead of Fed Meeting Tomorrow

Analysts have discovered a way to profit even from underwhelming quarterly reports. The strategy is simple: provide the most pessimistic forecast, and sell the stocks when the company performs better than expected. This approach aligns with the saying, "Prepare for the worst, hope for the best."

Quarter after quarter, articles warning of an impending doomsday scenario are consistent. This earnings season, it’s estimated companies in the S&P 500 will report a 9% decline in profits for the second quarter of 2023, making this earnings season the worst since the pandemic.

Europe may face an even bleaker situation, with a projected 12% profit decline. However, despite these projections, the markets are not falling. Despite “potential” headwinds, investors recognize the questionable accuracy of this pessimism, or perhaps they have faith in the power trends and momentum.

Meanwhile, the actual results are better than anticipated. “Surprisingly,” the reports from JPMorgan and Wells Fargo exceeded analysts' expectations. Citigroup, too, performed well, despite announcing a significant profit decline due to challenges in the investment banking and trading sectors. 

Unfortunately, according to the stock screener, Goldman Sachs has been a disappointment. The bank, under David Solomon, reported its worst quarterly results in years, with a low single-digit return on equity, a crucial measure of profitability. Equity trading has been the only bright spot, but Goldman knows they need to get into more asset management, similar to Morgan Stanley’s efforts.

How is the sector faring overall?

It appears that the Federal Reserve’s credit lines and repos have calmed the banking sector. Following the collapse of First Republic Bank, there have been no indications of further runs on banks or potential restructurings. The central bank’s recent stress test uncovered no alarming irregularities among the financial giants.

According to the Fed, the capital levels of all 23 banks participating in the stress test exceeded the minimum requirements "despite the projected losses amounting to $541 billion." These numbers seem large, but versus a multi-trillion dollar system, the event could be distressing but not catastrophic.

So why are the forecasts not favoring profit growth in the sector but instead predicting a decline? After all, with interest rates on the rise, both commission and interest income should be increasing. Does this mean we are being deceived once again?

Not necessarily.

First, interest expense on deposits is increasing faster than overall loan profitability. While this is not a problem for large banks, the situation may be more difficult for smaller organizations to maintain profitability.

The same holds for deposits. It's worth recalling that this issue became the focal point of the crisis earlier this year when depositors rushed to withdraw their funds from some financially strained creditors. Have regional financial institutions managed to find a solution to this predicament?

As for the high-interest rates, there is also a significant drawback for banks to consider. These rates are placing increasing pressure on borrowers. Consequently, reserves to cover potential problem loans will likely need to be augmented.

For instance, the six largest banks - JPMorgan Chase (JPM), Bank of America (BAC), Citigroup (C), Wells Fargo (WFC), Goldman Sachs (GS), and Morgan Stanley (MS) - will collectively write off $5 billion tied to defaulted loans in the second quarter of this year. Still a small fraction of loans, but an uptick.

What else is there to consider?

According to the Federal Deposit Insurance Corporation, banks had accumulated over $500 billion in unrealized losses on their securities by the end of March. While the recent surge in U.S. government bond prices may have somewhat improved the situation, the extent of this improvement remains uncertain.

In addition, what if the Federal Reserve continues to pursue its hawkish stance and raises interest rates?

Another concerning factor is the sudden increase in potential losses on commercial real estate portfolios, including loans for office building construction. Although this topic may have lost some prominence in recent discussions, always essential to monitor the situation here.

Lastly, the banks have likely been impacted by the overall calmness in the market, resulting in a decline in trading revenues. We see this with quarterly reports in fact. Trading is not a bright spot for anyone right now. Despite an uptick in mergers and acquisitions activity in recent months, the number of completed deals remains relatively low, same goes for public offerings.

So, "puts" or "calls"? 

Even though things have improved in the industry, a few factors still hold back a full recovery. It's not an appealing sector at the moment. The big question now is what's in store for the U.S. economy in the latter half of the year and when the Federal Reserve will move to reassess its monetary policy, and of course, the big meeting this today.