What could be next for New York’s money centre banks?
Money centre bank shares were the classic beneficiaries of the Trump reflation trade in 2017. The prospect of faster economic growth, fiscal stimulus, a rollback of Dodd-Frank, a steeper yield curve and thus higher net interest rate margins and better loan growth were a steroid shot to the valuation of financial shares. However, as the 10-year US Treasury bond yield has risen to 2.95 per cent on fears of inflation risk and aggressive Fed tightening, money centre banks have failed to benefit. The S&P 500 Financial Index has actually fallen 8 per cent since January 2018.
This implies that Wall Street is now worried that the surge in short (the 2-year Treasury note is at 2.50 per cent, its highest level since 2008) and long-term Treasury bond yields will choke economic growth and thus raise future recession risk, a disaster scenario for bank earnings and asset quality. This is exactly what happened during the “taper tantrum” of 2013, when the Bernanke Fed suggested it would reduce the amount of bonds it was buying and reverse the almost fivefold expansion of its balance sheet, albeit at a glacial pace. Yet once the financial markets realized that the Federal Reserve had no intension to nudge the economy into the cliff edge of recession, bank shares stabilised and the Volatility Index resumed its longer term downtrend.
I believe a similar scenario will play out for money centre banks in 2008. Trump’s tax cuts and the rise in capital spending preclude imminent recession threat. There is no 2006-style excessive leverage or risk taking in the property market and strategic deals, not speculative leveraged buyouts, define merger mania. Despite the risk of a Democratic victory in the midterm Congressional elections, there is no real risk of another Obama-era regulatory squeeze. In fact, I believe that bank litigation costs, a legacy of the financial crisis, peaked in 2016 except for outliers like the $1 billion fine on Wells Fargo for product misselling in its wealth management division. History tells me that loan growth, interest rates and credit trends are the key drivers of a valuation rerating in bank shares — and valuations are not excessive, though the case for further rerating is now over. Stock selection, not a mere sector bet, will be the catalyst to make money in US money centre banks in this uncertain macro zeitgeist.
Ironically, the Big Six US money centre banks all beat Street consensus in their first-quarter results. Net interest income was a blowout, thanks to higher interest rates and firmer loan pricing. The tax cuts were a nirvana for the bottom line. The rise in volatility has benefited trading results in fixed income, foreign exchange and derivatives. Credit costs and loan growth trends point to a Goldilocks economic milieu. Yet apart from Morgan Stanley and Bank of America, bank shares actually fell after their earnings growth as the Street is uncertain whether this earnings growth can last since tax benefits are a one time boost. In any case, the 19 per cent rise in the S&P 500 financial index in 2017 front loaded the anticipated benefits from Trump’s promise to “do a number” on Dodd-Frank regulatory rollbacks. The real test of Big Bank operating performance will come if earnings growth continues amid a trade war with China or higher US wage inflation. Bank outperformance is not necessarily a given in a less “kinder, gentler” phase of the global economic cycle.
Citigroup has been my favourite US money centre bank since 2012, when Michael Corbat replaced Vikram Pandit in a boardroom palace coup. Citi shares, profiled at least a dozen times in this column, were 25 then and are 68 as I write. At 68, Citi trades at just below book value and a reasonable 12 times earnings at a time when it will return at least $20 billion in dividends and share buybacks in the next 2 years. I envisage Citi in a 65-80 trading range.
Morgan Stanley has been my favourite Wall Street investment bank since early 2016, when the shares bottomed at 24 after the Chinese yuan devaluation. Firstquarter profits rose 19 per cent to $2.58 billion. Morgan Stanley has built the world’s preeminent wealth management advisory business, with a margin of 26.5 per cent. Trading revenues were the highest since the financial crisis, thanks to the spike in firstquarter volatility. However, Morgan Stanley is highly-leveraged to the bull market and lending revenue growth is will slow in 2018. The ideal entry point for new money in Morgan Stanley is 45-46 for a 60 target.