Potential recession doesn't shake our conviction in Morgan Stanley and Wells Fargo

Published Wed, Jan 11 20236:00 AM ESTUpdated Wed, Jan 11 20238:59 AM EST

Fears of an impending recession have been a drag on bank stocks for months. But we've stayed invested in our two financials — Wells Fargo (WFC) and Morgan Stanley (MS) — on the belief that an economic slowdown isn't enough to take the shine off their attractive qualities. Wells Fargo has benefited from the Federal Reserve's higher interest rates and a focus on actively reducing expenses to boost profitability. It also stands to gain from renewed investor- and customer confidence as it moves past a slew of costly scandals. Morgan Stanley, meanwhile, is on steady ground with CEO James Gorman, who's led a multiyear effort to turn the investment bank into an asset-and-wealth-management powerhouse with steadier earnings streams. Despite an uncertain economic outlook, we see the fundamentals of both banks intact as the sector approaches fourth-quarter earnings season. Wells Fargo is set to report Friday, while Morgan Stanley reports Jan. 17. Some on Wall Street think the banking sector has an especially favorable near-term setup, bolstering the Club's own outlook. In a research note to clients Monday, Bank of America identified financials as very well positioned in the short term and the most attractive sector based on valuation, price momentum and earnings trajectory. It's the first time in 18 months that energy did not hold the top spot in their survey. "We are overweight the sector and see it as a higher quality sector with better earnings stability than the S & P 500, cleaner balance sheets thanks to U.S. regulators, and less recession risk than other more crowded and expensive cyclical sectors like [information technology]," Bank of America analysts wrote in the note. When bank earnings get underway, analysts at Credit Suisse said they'll be looking for commentary from management on forward guidance and signs of "banks' fundamental resilience—sufficient earnings power and balance sheet strength to manage through macro deterioration with respectable results." Wells Fargo A key aspect of Wells Fargo's earnings story is higher interest rates from the Federal Reserve, which boost the company's net interest income, or NII. This is essentially the money Wells Fargo makes on the difference between what the bank charges on loans and what it pays customers for their deposits. Higher interest rates tend to expand that difference, translating into higher NII. Wells Fargo's large customer-deposit base makes it a major beneficiary of this dynamic. In the three months ended Sept. 30, Wells Fargo's NII rose 36%, compared with the same quarter in 2021, when the Fed was holding interest rates near zero. Analysts expect Wells Fargo to generate $12.9 billion in NII in the fourth quarter, according to FactSet, which would be a 39.5% year-over-year increase. It also would be a nearly 7% increase quarter-over-quarter. The banks Q4 results are expected to be dented by a $3.5 billion operating loss expense, stemming partially from a settlement with the Consumer Financial Protection Bureau announced in December. But the sizable penalty is a positive step toward moving past the bank's longstanding regulatory issues. Analysts at UBS agree. "In our view, WFC remains the most compelling turnaround story in large-cap financials, and we think the disappointing-on-the-surface late December announcement ... on regulatory matters actually sets the stage for further regulatory remediation medium-term and potential near-term relief in operating losses," the analysts, who have a buy rating on Wells Fargo shares, wrote in a note Tuesday. Investors also expect Wells Fargo to have set aside additional funds for credit losses in the fourth quarter, after provisioning $784 million in the third quarter. While we believe Wells Fargo maintains a high-quality loan book, banks should be proactive in building reserves in this economic environment. Strong NII, however, should help fund provisions for credit losses, "which will protect capital and also help maintain earnings levels as the cycle moves along," Jefferies analysts wrote in a note to clients Monday. The analysts rated Wells Fargo shares a buy, with a $49-per-share price target, and called the bank their top pick among its peer group. Meanwhile, Wells Fargo's decision to take a large step back from the U.S. housing market, as reported Tuesday by CNBC , aligns with CEO Charlie Scharf's vision to reshape the scandal-ridden bank. It's unlikely to significantly affect the bank's upcoming quarterly results, but management may offer insight into the future of the bank's mortgage business on Friday's earnings conference call. Overall, Wall Street expects Wells Fargo to earn 63 cents per share in the fourth quarter on $20.02 billion in revenue, according to estimates compiled by Refinitiv. Morgan Stanley Morgan Stanley has been hurt by a sharp slowdown in mergers and acquisitions (M & A) and initial public offerings (IPOs) over the past 3 quarters — and the fourth quarter of 2022 should be no different. Analysts are projecting $1.33 billion in investment banking revenue in the period, according to FactSet, which would be a roughly 48.5% decline from the same period last year. That won't come as a surprise to Wall Street. But going forward, it's hard to imagine Morgan Stanley's investment banking business having as bad of a year in 2023 as it did in 2022. We're not expecting a dramatic rebound back to the booming days of the Covid pandemic in 2021, when a flurry of mergers and IPOs pushed investment-banking revenues to record levels . But investment banking should become less of a drag on the rest of the enterprise. Morgan Stanley is in the midst of a business transformation, as it leans into asset and wealth management to develop more stable earnings streams, relative to that of trading and investment banking. This is a key part of the Club's thesis, and the progress has started to show up in the results following the acquisitions of brokerage E-Trade and investment management firm Eaton Vance . Those deals — valued at roughly $13 billion and $7 billion, respectively — pushed Morgan Stanley further into the money management world. In the third quarter of 2022, asset and wealth management accounted for 56% of Morgan Stanley's $12.99 billion in revenue. That's up from roughly 51% in the third quarter of 2019, prior to the Covid-19 pandemic, and analysts expect that figure could reach nearly nearly 60% of the firm's total revenue by the third quarter of 2023. Over time, we expect investors to reward Morgan Stanley's steadier earnings with a higher valuation. In the meantime, Morgan Stanley rewards investors for patience with a robust capital return plan. The stock's dividend yield of roughly 3.5% is above its 5-year average of 2.5%, according to FactSet. And in the 3 months ended Sept. 30, the firm repurchased $2.6 billion worth of stock. Still, Wall Street is generally less sanguine on Morgan Stanley compared with Wells Fargo. Only 55% of the 29 analysts who cover the company have a buy or overweight rating on its stock, with 10% recommending it be sold, according to FactSet. Nearly 80% of 29 Wells Fargo analysts rate its stock buy or overweight, and there are no sell ratings. Wolfe Research is one Wall Street outlet that recommends selling Morgan Stanley, citing concerns over valuation and pressure on operating margins if NII peaks. Analysts at Wolfe last week downgraded Morgan Stanley to underperform, or sell, from outperform, or buy. Heading into next week's earnings print, analysts expect Morgan Stanley to earn $1.25 per share on $12.64 billion in revenue for the fourth quarter, according to Refinitiv. Bottom line Opinions on bank stocks vary across Wall Street, thanks in large part to the uncertain economic outlook. We think being selective on the sector makes sense, which is why our positions are limited to only Wells Fargo and Morgan Stanley. These are investment opportunities with cause for optimism over a longer time horizon, not simply near-term trades that depend on macroeconomic clarity. (Jim Cramer's Charitable Trust is long WFC and MS. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

Pedestrians pass a Wells Fargo bank branch in lower Manhattan.

Spencer Platt | Getty Images