As earnings season kicked off this week, the US banks were in the spotlight amid what is likely to be the worst quarter of economic activity in modern history. This week, however, they have largely showcased their resilience. Despite unemployment skyrocketing, businesses shutting up shop, sentiment all but vanishing, and a pandemic causing untold mayhem, the banks have largely managed to smash expectations and it’s all been thanks to their trading know-how.
Market volatility proves invaluable to the banks
While bank profits are (mostly) well down, that comes as no surprise given the extent of provisions that the banks have had to make with regards to potential, or dare we say, likely loan losses. In this latest round of reporting, the banks have increased their provisions by tens of billions of dollars, which suggests that they think the economic outlook remains challenging to say the least.
However, as we pointed out in our earnings preview earlier this week, banks have largely been shielded from the full extent of the economic crisis. In fact, not just through stimulus measures that have been deployed by the government, but the banks have been sheltered by the diversified nature of their very own operations.
Taking a brief look at the headline results:
- JP Morgan (JPM) managed to post record quarterly revenue, delivering US$33.8 billion
- Goldman Sachs (GS) not only managed to beat forecasts, but it actually delivered a higher profit than a year ago, coming in at US$6.26 per share versus US$5.81
- Bank of America (BAC) delivered net income of US$0.37 per share compared with consensus of US$0.28 per share
- Morgan Stanley (MS) reported net revenue and net income both higher than a year ago, up approximately 30% and 45% respectively
- Citi (C) also topped forecasts, with revenue increasing 5% year-on-year
- Wells Fargo (WFC) missed both top and bottom-line estimates, posted sizeable losses and has been forced to slash its dividend
Taking a look at the results, a clear trend is evident – and it is favouring the established investment trading banks. Wells Fargo doesn’t have the scale of trading operations as that of its peers. It is more oriented towards lending activity, which has taken a monumental hit despite possessing the smallest asset base among the bunch.
But in the case of the leading investment banks (JPM, GS, BAC, MS), which have sufficient scale in their trading activity, this has translated through to their results. Surging trading revenue has largely proven to be the catalyst to mitigate or even offset loan-loss provisions that would have otherwise had a significant impact.
Updating our position on financials
We have previously had a modest exposure to the financials sector, which reflected concerns around their ability to grow earnings, particularly with interest rates going nowhere in any hurry. Our ‘underweight’ exposure to this sector and our bias towards tech was one of the key driving forces in our FY20 performance, where our flagship Global Growth Portfolio delivered returns of 27%.
However, in light of this week’s earnings, we are looking to take positions in Goldman Sachs and JP Morgan. While we share the banks’ concerns around the path of the US economic recovery, their results reinforce our contention that they are significantly capitalised and well-positioned to ride out the ‘shock’ when loan defaults start to increase.
What’s more, the US government has indicated that they will be eyeing another round of stimulus to help with this transition, which we believe will help avoid the prospect of a ‘fiscal cliff’. Further provisions are not unlikely, however despite rising COVID cases in numerous states, the scale of such provisions may be capped by what appears to be largely improving economic data.
But the biggest tailwind supporting the banks at this time is their diversified operations. Lending activity is a clear issue. However, trading activity and corporate activity, which we expect to persist these coming months as market volatility continues, are helping drive the sort of growth in these divisions that isn’t synonymous with the banks.
Backing the banks from here is a mid-term proposition as the economic recovery plays out. It isn’t risk-free, but there are some mitigating factors we’ve mentioned that make it clear a thesis to support the banks isn’t just tied to their lending activity and exposure, it’s also tied to their diversity as investment banks. With earnings far better-than-expected across the segment, some clarity around dividends, and the relative underperformance of financials year-to-date, we believe it is likely that funds may shift from growth shares to value stocks such as the banks.
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