A Recession Is Coming. Big Banks Can Handle It.
Bank earnings have been tough to digest. Nearly all of the big banks topped third-quarter forecasts, and their stocks popped a bit. Yet the sector hasn’t caught on, trailing the market since earnings season began.
The disconnect reflects the fact that investors are looking ahead to 2023—and don’t like what they see. The economy may be headed into a recession within nine months, predicts JPMorgan Chase (ticker: JPM) CEO Jamie Dimon. If a recession settles in, it would put banks back on their heels after a strong recovery in core banking and capital markets from the pandemic-era lows.
Among major banks, JPMorgan, Bank of America (BAC), and Wells Fargo (WFC) do look well equipped to navigate through the tough climate. But all will have to overcome skepticism that the sector can outperform in a difficult economic stretch ahead.
For now, profits at the big banks appear to hitting Wall Street’s targets. Results weren’t as strong at Morgan Stanley (MS) and Goldman Sachs Group (GS), due to their exposure to investment banking and other capital markets areas.
The next few months could be tougher for the sector. The housing market is ailing, depressing loan volumes. Interest income from lending activities isn’t likely to grow as much. Deal-making has slowed, pushing investment banking revenues to the lowest levels in a decade. Provisions for loan losses are rising.
Some analysts are souring on the banks. Wells Fargo’s head of equity strategy, Christopher Harvey, cut his rating on the sector to Neutral this past week, writing that he’s “no longer bullish.” While the fundamentals look fine, he said, “banks will struggle to outperform as economic growth slows, credit normalizes, inflation abates, and sentiment weakens.” Stresses in credit markets may pressure profit margins. And chances are dimming for the Federal Reserve to “pivot” toward a more accommodative stance on interest rates, at least until late in 2023, putting the economy in a slow-growth mode or recession.
Investors shouldn’t brush away these issues. Rising interest rates have increased banks’ net interest income, including the margins they make on loans. But that tailwind is likely to wind down, as the Fed is expected to ease off rate hikes in early 2023.
At the same time, banks face pressure to increase yields on deposits, potentially ramping up their costs and putting another squeeze on margins. Despite a big jump in rates this year, banks are still paying meager interest—averaging 1.09% on savings accounts. Rival money-market funds yield almost 3%. Bank deposits are considered to be “sticky,” since it’s such a hassle to switch banks, but deposits could come unglued if yields don’t rise.
“We haven’t gotten to the point where it has created a liquidity crunch,” says Chris McGratty, head of U.S. bank research at Keefe, Bruyette & Woods. “But certain banks are impacted by this dynamic more than others.”
Consumer lending could also weaken, particularly in housing. Far fewer homeowners and buyers are taking out loans or refinancing as 30-year mortgage rates rise to nearly 7%, more than double their 2021 average of 3%. Mortgage applications recently hit a 25-year low, and banks are seeing sharp drops in loan volume for purchases and refinancing.
If the economy enters a recession, these pressures will increase. That said, the big banks are heading into a downturn in far better shape than before the financial crisis; capital buffers are now robust, and lending standards have tightened.
JPMorgan, for one, epitomizes the strength. The bank raised its forecast for net income interest through year end and said it plans to resume stock buybacks in 2023. Despite Dimon’s recession warnings, JPMorgan said it’s on track to lift its capital ratio buffer to 13% in early 2023, up from 12.5% in the fourth quarter. The bank’s confidence in hitting that target “should reignite the market’s trust in their ability to manage their balance sheet while generating solid revenue growth,” wrote UBS analyst Erika Najarian in a note this past week.
Bank of America has been raking in deposits, including 418,000 new consumer checking accounts in the third quarter. Its Merrill Lynch wealth management business is adding assets, pushing total client inflows for the bank to a net gain of $100 billion this year.
Bank of America isn’t as exposed to volatile capital markets as rivals like Goldman Sachs. BofA’s lending standards are relatively conservative, reflected in its percentage of nonperforming loans at just 0.39%.
Wells Fargo analyst Mike Mayo reiterated an Overweight rating on the stock, seeing it hit $55, up from recent prices around $34. BofA is a “leader in tech among banks,” he wrote, which should help it reach a target of capturing a quarter of U.S. bank deposits. “Overall, BofA is a Goliath at a time when Goliath is winning,” he said.
Wells Fargo is a turnaround in the making, following a series of scandals and management shuffles. The bank reported a 36% rise in net interest income in the quarter, from a year ago, hitting $12.1 billion and topping Wall Street estimates for $11.6 billion.
Wells Fargo has scaled back on issuing mortgages, historically a large part of its business. The bank is improving its operations, according to Edward Jones analyst Kyle Sanders, who sees Wells Fargo becoming a “more productive and profitable firm,” according to a recent note.
Granted, if the economy cracks next year, bank stocks will suffer. Sticking with the giants might be the best way to handle the shakier ground.