Bank earnings are upon us. Optimism on the economy is running high, and banks are supposed to be able to demonstrate that. More demand for loans! Steeper yield curve!
But there are concerns. Investors are trying to reconcile a more optimistic outlook on the economy with troubling trends in bond yields and loan growth.
Here's the problem: a lot is expected to go right with bank earnings. Financials are expected to see a 15 percent gain in earnings in the first quarter. That is a lot. The gain is based on expectations that interest rates would be moving up, loan growth would improve, and credit risks would remain low.
But it's not quite playing out that way. Here's what's happening.
- Interest rates are indeed up — the 10-year yield was at roughly 1.75 percent a year ago, it's at roughly 2.35 percent today. That's a big jump, 60 basis points, and it's happened because the Fed has been raising rates and inflation expectations are higher. But rates have been trending downward recently--we were at 2.6% a month ago. What's that all about? How can investors reconcile expected Fed rate hikes with rates trending lower? That's a problem.
- There has been some cracks in the credit market. For example, delinquencies have been rising on auto loans and non-prime card loans. It's small, but it has investors talking.
- Most importantly, loan growth has been anemic. How anemic? Total loan growth is up only 0.4% in Q1 compared to the same period last year, and has been particularly disappointing with Commercial & Industrial (C&I) loans, where there has been virtually no growth:
Total loan growth up 0.4%
Commercial/Industrial up 0.1%
Consumer up 0.5%
Commercial Real Estate up 2.0%
Mortgages down 0.1%
These are disappointing numbers, because loan growth trends were stronger last year. What happened? Susquehanna's bank analyst, Jack Micenko, believes part of the problem is that banks are simply changing the way they borrow money: many banks are paying off their bank loans and going to the bond market for money. He also believes there is continuing deleveraging in loans in the energy sector.
But Micenko admits these reasons can account for only part the disappointing numbers. Here's another alarming statistic: bank deposits are up 0.7% in the first quarter.
Deposits are up, but loan growth is flat. That is not a good sign, Micenko notes. "In an expansionary environment, you see deposits go down and loan growth going up. The opposite is happening."
Micenko's conclusion: "Corporate America is sitting on their hands, and we don't know why. The optimism has not found its way into corporate behavior."
So who's right, the bulls or the bears? We don't know yet, and that is why there is so much interest in bank earnings and particularly in the management outlook. They will avoid talking about Trump tax cuts but they can't avoid talking about loan growth and why bond yields are moving down and what the impact of a flatter yield curve will mean for them.
For the moment, the optimists are still in charge. Bank stocks (KBE) are 10% off their recent multiyear highs in early March but still nearly 20% above where they were on the eve of the election (the S&P 500 is up only 10%).
There's several reasons bulls still have the upper hand, for the moment:
- Bank stocks are still comparatively cheap on a forward earnings basis. Evercore ISI notes that banks are trading at 12.3 times 2018 EPS estimates, up from just 11.7 times earnings pre-election.
- None of the analysts have incorporated any benefits from the Trump Agenda (tax cuts, infrastructure, less regulations) in 2017 earnings.
- Bank CEOs have not yet signaled alarm at the lower loan growth trends. They have acknowledged weak loan trends, but most have reiterated full year growth expectations.
Bottom line: a lot is riding on the commentary of a couple dozen bank CEOs in the next few weeks.