What’s next for the Fed and US money centre bank shares?
Us money centre bank shares soared after the election of President Trump last November on the prospect of a rollback in Dodd Frank, less stringent regulatory/litigation fines, a steeper US Treasury yield curve, corporate tax cuts and higher US economic growth rates. Seven months later, US money centre banks still retain their rerated valuations, even though the politics and economics of Trumpian America is not entirely hunky-dory for the sector. The president is ensnared in a Watergate-style obstruction of justice scandal whose endgame could well be Trump’s disgrace and impeachment. US GDP growth could not even manage two per cent in the first quarter. The odds of tax reform or a major fiscal stimulus as the embattled Trump White House fights for its political survival seems remote. The US Treasury bond yield curve has flattened, not steepened, despite the Yellen Fed’s hawkish take on monetary policy.
I can easily envisage a 10-12 per cent correction in bank shares if second-quarter earnings disappoint, given the macro big chill that makes additional rerating impossible. For now, US money centre banks have benefited from the rotation out of Fang/Nasdaq growth shares. The Federal Reserve’s balance sheet “normalisation” could lead to a steeper US Treasury yield curve, as the yield on the 10-year note rises to 2.40-2.50 per cent range. The second stage of the Fed’s CCAR stress tests will authorise higher dividend payouts and share buy backs for Bank of America and Citigroup. Loan growth has begun to accelerate and positive operating leverage could well mean rising momentum in bank EPS growth. The rollback of Dodd Frank and the Volcker Rule in Congress has already begun. All this explains why big bank shares have not been gutted by the end of the Trump “reflation” trade.
Apart from second quarter economic disappointment, US money centre bank shares will fall if US economic data (payrolls, ISM, retail sales, inflation metrics) continue to weaken in July and August. This will make a September FOMC interest rate hike politically impossible for Dr Yellen. The dramatic fall in US Treasury yields and yield curve flattening mocks Janet Yellen’s hawkish take on inflation and growth. While the Yellen Fed has cried wolf on inflation since 2015, core CPI has now fallen to 1.7 per cent and May retail sales actually fell 0.3 per cent, showing that the US consumer (68 per cent of GDP) is not spending at the robust levels implicit in Fed models. The fall in oil prices to $45 and global terrorism/wars is also a deflation indicator, as are the lower food prices that will result from Amazon’s takeover deal for Whole Foods. This means lower, not higher, bond yields in 2018, a scenario that will unquestionably hammer US big bank shares at current levels.
Goldman Sachs, arguably Wall Street’s preeminent global investment bank and the alma mater of Trump’s (and Bush 43’s and Clinton’s) treasury secretary, has not been a profitable investment in 2017, down eight per cent even as its peer banking shares soared in value. Goldman Sachs is at 220, down from its 255 peak. Goldman no longer remotely earns the 25 per cent returns on equity as it did at the peak of the credit bubbles but I believe it is now undervalued at 10 times forward earnings and 1.3 times book value. Goldman Sachs is the most leveraged to a rollback in Dodd Frank and the Volcker Rule given its world class proprietary trading, derivatives and principal investing franchises. The Financial Choice Act is only the first step to financial regulation reform. I am a buyer of Goldman Sachs on any big bank hit, ideally near 210.
Goldman Sachs was the poster boy for the post-Trump bank rally, up 40 per cent from October 2016 to February 2017. The euphoria is gone and value metrics are once again manifest in Wall Street’s vampire squid of humanity!
Citigroup finally met my $64 target and traded at tangible book value, a scenario I had outlined ad infinitum since 2014, most recently at 45 last year. Citigroup derives 60 per cent of its earnings outside the US and 45 per cent from emerging markets, thus benefiting from the first synchronised global economic recovery since 2010. Citigroup can well get the green light from the Fed to hike its dividend payout and share buybacks given its excess Basel Tier One capital ratios. Citi now trades at 12.4 times current and 11 times forward earnings. Analyst expect weaker trading revenues in 2Q and mediocre results in the Global Consumer Bank. If Citi trades at 58, it becomes a compelling buy once again.