US earnings season: It’s doom and gloom for the banks

Analysts expect a 24% retreat in JPMorgan’s profit and a 14% reversal for Bank of America.

Starting on Friday, the global banking industry will feel the sharp edge of tightening financial conditions and a volatile geopolitical environment, as  four big US lenders kick off the third-quarter profit reporting season.

In the first half of the calendar year, the return on equity of large banks in advanced economies crept higher than pre-pandemic levels, with rising interest rates supporting profitability as growth in the price of loans skipped ahead of deposit rates.

But now the outlook has changed – central banks have sharply hiked policy rates to combat stubbornly high inflation, leading to significant downgrades in financial asset prices and deteriorating growth forecasts.

Corporate borrowing costs have spiralled and banks have modestly tightened the credit tap, introducing an extra layer of risk for debt-laden companies exposed to higher input costs.

If there’s a silver lining, UBS believes there is an opportunity for US banks to prove themselves as investments rather than trading opportunities in the unfolding downturn.

“Bank stocks have been portfolio headaches since the global financial crisis and, as such, have often been dismissed by the market as cyclical trades as opposed to investments,” the Swiss investment bank says in a note.

“That said, given the generational change in capital, liquidity and stress testing, especially on the latter for US banks, could a downturn actually change the perception of US banks to portfolio managers? We think the answer is yes.”

Four of the elephants of the US financial sector – JPMorgan Chase, Citigroup, Wells Fargo and Morgan Stanley – report on Friday, followed next week by Bank of America and Goldman Sachs.

The common themes are expected to be a slide in net income as fretful markets cast a shadow over investment banking activity and borrowers fall behind on loan repayments due to surging interest rates.

The US Federal Reserve has lifted the benchmark rate from close to zero in March to the current range of 3-3.25%, with more increases to come.

While higher rates should benefit JPMorgan and Bank of America – the two largest banks in the US – the rising cost of borrowing could also crimp mortgage and auto-lending growth.

Analysts expect a 24% retreat in JPMorgan’s profit and a 14% reversal for Bank of America, as robust growth in the latter’s consumer division partially offsets a decline in advisory fees, according to Refinitiv.

Net income for Citigroup and Wells Fargo is expected to dip by 32% and 17%, respectively.

The brunt of compressed deal-flow due to volatile markets and uncertainty is likely to be borne by investment banking behemoths Goldman Sachs and Morgan Stanley, with their quarterly profits forecast to slump by 46% and 28%, respectively.

“Bank stocks have been portfolio headaches since the global financial crisis and, as such, have often been dismissed by the market as cyclical trades as opposed to investments.”

– UBS

JPMorgan president Daniel Pinto told investors at a New York investor conference in September that he expected the bank’s investment banking fees to fall in a range of 45-50% in the third quarter.

This followed a 31% slump in global fees from advisory, underwriting and syndicated loans at the end of August compared to the record level in 2021, according to Refinitiv.

Equity capital market fees were down 68%, with reductions of 25% from debt underwriting and 15% from mergers and acquisitions.

Bank of America chief executive Brian Moynihan said the deal pipeline remained strong, and bankers were optimistic that activity would pick up when markets stabilised.

“It’s not theoretical deals that could happen, it’s stuff that’s ready to go but will require the markets to stabilise,” Moynihan said.

At JPMorgan, Pinto said the flipside was that markets revenue would increase by about 5% as companies sought protection from the deepening volatility.

What about the European banks?

Europe’s big lenders, which report their third-quarter earnings later in the month, are more vulnerable to current geopolitical factors because of their domestic economies’ exposure to surging Russian energy prices.

The European Systemic Risk Board, set up in 2010 in response to the global financial crisis, said in June that the worsening outlook would increase credit risks for some European banks and fan longstanding vulnerabilities, such as higher non-performing loans and weaker profitability from structural challenges and higher costs.

Bank equity prices have fallen by more in the euro area than in most other advanced economies in 2022.

Credit default swaps, or insurance for investors against debt default, have increased for most lenders, notably led by Credit Suisse due to persistent stability concerns.

The multiple layers of risk suggest that a continental recession is not just a possibility, but very likely.

UBS says that investors are positioning themselves to buy banks later when the sector’s visibility has improved.

“The established view – don’t own banks into a recession no matter what the balance-sheet strength or valuation – appears to predominate,” the note says.

While there was a glimmer of hope in some surprisingly buoyant second-quarter earnings, mainly driven by higher interest rates, senior executives cited a bleak 2022 outlook, blaming galloping inflation, the war in Ukraine and energy shortages.

Deutsche Bank, for example, beat consensus earnings estimates, but then backed away from its cost target, cast doubt on a profit forecast and said its investment banking division was plagued by the same global dynamics as its US peers.

UBS of Switzerland was part of the same trend – its profit growth was smaller than expected and chief executive Ralph Hamers backed it up with “buyer beware” commentary, warning about an “uncertain” remainder of the year and “subdued” sentiment. The bank’s stock tumbled 9%.

In Britain, Lloyds Banking Group, the country’s largest domestic lender, dared to be different, lifting its dividend and full-year profit forecast despite lower first-half earnings and a gloomy outlook.

While risk overwhelmingly favours the downside, the expected US downturn will “nowhere near resemble the global financial crisis (loose credit standards reined in by a generational shift in bank capital and liquidity standards) or the pandemic (a 15% peak in US unemployment)”, according to UBS.