Here’s what bank stock investors need to know ahead of fourth-quarter earnings

Published Thu, Jan 12 20239:55 AM EST

It's been a confusing time for investors in bank stocks. The industry got what it wanted last year — higher interest rates, courtesy of the Federal Reserve — but bank stocks still got hammered because of recession fears. This year, bank shares have climbed on hopes for an economic soft landing that would help them avoid a wave of profit-crushing loan defaults. The 24-company KBW Bank Index has climbed 5.3% so far, compared to a 24% decline in 2022. Analysts are expecting a mixed bag of conflicting trends when four of the largest U.S. banks report fourth-quarter results Friday. Higher rates will help companies earn more interest income, but some of that boost will be offset by larger provisions for expected loan losses as the economy slows. As a result, analysts are torn as to whether now is the time to invest in bank stocks, or whether it's better to wait until getting an all-clear signal on the industry. For clues on the sector's direction, here are four key metrics to watch: Net interest income Net interest income (NII), one of the main drivers of bank revenue, should continue to rise in the fourth quarter, JPMorgan analyst Vivek Juneja said in a Jan. 6 note. NII is expected to rise about 5% over the third quarter on average, thanks to higher rates and loan growth, according to the analyst. But the future path of this crucial yardstick is what most concerns investors. How much further the Fed raises rates and how long they are kept elevated, before a potential pivot, are all factors. Investors are concerned that NII growth will stall out later this year if loan growth subsides and funding costs rise thanks to competition for deposits. "Our continued cautious view ... reflects ongoing macro risks and likely weakening bank fundamentals —including peaking net interest margins," Deutsche Bank analyst Matt O'Connor said in Jan. 5 note. Reserves Thanks to recent changes in accounting rules, banks have to set aside reserves for loan losses when they anticipate a turn in the economy. The result is that even before borrowers default, banks begin to register the impact of an impending recession. Morgan Stanley analyst Betsy Graseck thinks that loan loss provisions will be higher than expected for every large bank she covers, according to a Jan. 6 note. That's in part informed by her tracking of filings from the credit card industry, which show that late payments are rising at the fastest pace since the 2008 financial crisis, she wrote. "With most U.S. economists forecasting either a recession or significant slowdown this year, banks will likely incorporate a more severe economic outlook" in their scenario planning, Graseck wrote. Wall Street Investment banking fees will end a tough year on a low note compared to a year ago, when the market was booming. Revenue is expected to plunge 50% in the wake of frozen IPO markets and subdued deals activity, Barclays analyst Jason Goldberg wrote in a Jan. 11 note. That will be partly offset by a 10% rise in trading revenue, thanks to a boost from fixed income operations, Goldberg wrote. Finally, lower average levels in the stock and bond markets will pressure asset management fees, he added. The outlook Investors tend to discount fourth-quarter results in favor of what managements say about their outlooks for the coming year. For that reason, conference calls with bank executives will be crucial for investors to discern changes in forward guidance on metrics including reserves, net interest income, share buybacks and expectations for investment banking, trading and lending in 2023. "While 4Q earnings should be fine, we remain cautious about commentary regarding the outlook and overall earnings trends," JPMorgan's Juneja wrote in his note. "Uncertainty about a recession and whether it is mild or harsh will likely pressure markets medium term." Of special interest is guidance on expenses, given concern that wage inflation will force banks to contend with rising costs at the same time that revenue could fall. "We expect above-consensus expense guides will likely weigh on bank stocks during 4Q22 earnings as managements communicate their 2023 budget plans," Graseck said. — CNBC's Michael Bloom contributed reporting