Big Banks – Rising Rates And Earnings Synergy

Stellar Earnings

The big bank cohort reported stellar earnings across the board and set the stage for earnings season while sparking a broad rally across the indices. The big banks have benefited from a confluence of impending rising rates, post-pandemic economic rebound, financially strong balance sheets, a robust housing market, and the easy passage of annual stress tests. The most recent earnings reports confirm this secular thesis as Bank of America (BAC), JPMorgan Chase (JPM), and Goldman Sachs (GS) all reported very strong quarters, with stock prices nearing all-time highs. The big bank cohort is in a sweet spot of a post-pandemic consumer, rising rates and balance sheets to support expanded share buybacks and dividend increases. These stocks are inexpensive and stand to capitalize on all these tailwinds over the long term.

A Healthy Consumer

The big banks are already transitioning beyond the pandemic based on the results and commentary from the collective companies’ top executives during their respective Q3 earnings. The six biggest banks by assets posted profit and revenue that beat expectations. These results came on the heels of booming Wall Street deals and the release of funds previously earmarked for pandemic-related defaults.

Bank of America CEO Brian Moynihan stated that whether it was a return to loan growth, credit-card signups, or economic indicators like unemployment levels, the company was back in expansion mode. “The pre-pandemic, organic growth machine has kicked back in,” “You see that this quarter, and it’s evident across all our lines of business.” The company said that loan balances at BAC increased 9% on an annualized basis from the second quarter, driven by strength in commercial loans.

Per JP Morgan, spending levels that are roughly 20% higher than before the pandemic will eventually result in more credit-card balances, and loan growth should accelerate into next year. That means that banks’ loan books are set to expand at the same time the industry is still benefiting from reserve releases and historically low default rates. Add in rising rates as the Federal Reserve eases off the accommodative measures taken to stave off an economic collapse, and bank profitability is set to jump. JP Morgan CEO Jamie Dimon stated, “Two years ago, we were facing Covid, virtually a Great Depression with the global pandemic, and that’s all in the back mirror.”

2021 Financial Stress Tests Easily Pass

The recent stress tests were easily passed and indicated that the biggest U.S. banks could easily withstand a severe recession. In addition, all 23 institutions in the 2021 exam remained “well above” minimum required capital levels during a hypothetical economic downturn.

The central bank said that the scenario included a “severe global recession” that hits commercial real estate and corporate debt holders and peaks at 10.8% unemployment and a 55% drop in the stock market. While the industry would post $474 billion in losses, the Fed said that loss-cushioning capital would still be more than double the minimum required levels.

Pandemic-related restrictions hindered the banks’ ability to return capital to shareholders via dividends and buybacks. Those restrictions will now be removed based on the recent stress test results. So now, the banking industry can hike buybacks and dividends by billions of dollars starting in July 2021. Nearly all banks have since increased their payouts to shareholders.

Impending Rates Hikes

Federal Reserve indicated that the central bank is likely to begin withdrawing some of its stimulatory monetary policies before the end of 2021. Although interest rate hikes are likely off in the distance, the economy has reached a point where it no longer needs as much monetary policy support. This pivot in monetary policy by the Federal Reserve sets the stage for the initial reduction in asset purchases and downstream interest rate hikes. As this pivot unfolds, risk appetite towards equities hangs in the balance. The speed at which rate increases hit the markets will be in part contingent upon inflation, employment, and of course, the pandemic backdrop. Inevitably, rates will rise and likely have a negative impact on equities. A string of robust Consumer Price Index (CPI) readings spooked the markets as a harbinger for the inevitable rise in interest rates. Although rising rates may introduce some systemic risk, the financial cohort is poised to go higher.

Jerome Powell stated, “The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test,” He added that while inflation is solidly around the Fed’s 2% target rate, “we have much ground to cover to reach maximum employment,” which is the second prong of the central bank’s dual mandate and necessary before rate hikes happen.

The Fed looks at employment and inflation as benchmarks for when it will start tightening. Powell said that the “test has been met” for inflation while there “has also been clear progress toward maximum employment.” He said he and his fellow officials agreed at the July Federal Open Market Committee meeting that “it could be appropriate to start reducing the pace of asset purchases this year.”

The Fed committed to full and inclusive employment even if it meant allowing inflation to run hot for a while. “Today, with substantial slack remaining in the labor market and the pandemic continuing, such a mistake could be particularly harmful.” “We know that extended periods of unemployment can mean lasting harm to workers and to the productive capacity of the economy.”

Powell noted that the delta variant of Covid “presents a near-term risk” to getting back to full employment. Still, he insisted that “the prospects are good for continued progress toward maximum employment.” “Inflation at these levels is, of course, a cause for concern. But that concern is tempered by a number of factors that suggest that these elevated readings are likely to prove temporary,” he said.

Conclusion

The big banks have benefited from a confluence of impending rising rates, post-pandemic economic rebound, financially strong balance sheets, a robust housing market, and the easy passage of annual stress tests. The most recent earnings reports confirm this secular thesis as the six biggest banks by assets posted profit and revenue that beat expectations. These results came in part due to the release of funds previously earmarked for pandemic-related defaults, which failed to materialize.

The banks are much more resilient and capitalized and have demonstrated their ability to evolve in the face of COVID-19. The recent stress tests were easily passed and indicated that the biggest U.S. banks could easily withstand a severe recession. Moreover, all 23 institutions in the 2021 exam remained “well above” minimum required capital levels during a hypothetical economic downturn. Inevitably, low-interest rates will not be here indefinitely, and bond purchases will need to subside, thus pivoting to a scenario of higher rates in the intermediate term. Thus, the big banks present compelling value, especially with the prospect of rising rates, which may serve as a long-term tailwind for banks to appreciate higher.

Noah Kiedrowski
INO.com Contributor

Disclosure: The author does not hold shares in any of the mentioned stocks or ETFs. However, he may engage in options trading in any of the underlying securities. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of www.stockoptionsdad.com where options are a bet on where stocks won’t go, not where they will. Where high probability options trading for consistent income and risk mitigation thrives in both bull and bear markets. For more engaging, short duration options based content, visit stockoptionsdad’s YouTube channel.

Source: https://www.ino.com/blog/2021/10/big-banks-rising-rates-and-earnings-synergy/