Weekly Review & Outlook: October 16, 2023

In an eventful week, the early reporting banks uniformly beat EPS consensus estimates for 3Q23. Inflation readings for September reinforced a higher for longer monetary policy path. Geopolitical risks rose as actions escalated in the Middle East.

First, September inflation data from BLS included a 3rd consecutive elevated monthly PPI reading and year over year consumer inflation holding near 4%. In terms of key readings influencing the monetary policy path, core CPI for September was in-line at 0.3%. In my opinion, we are now in a very granular response phase from the Fed. Core CPI and corresponding core PCE monthly changes of 0.2% or less for a prolonged period will allow for target rate easing. Prints averaging monthly increases of 0.3% fit the higher for longer framework. Should monthly prints begin to exceed 0.3%, the case for additional restriction through a higher target rate would become more likely. Current CME FedWatch probabilities show no additional target rate hikes and three ¼ point cuts in 2024.

As noted at the top, the 4 early reporters all beat EPS estimates. Key measures such as Net Interest Margin (NIM) and Net Interest Income (NII) were mixed but stable from the June quarter while higher by about 10% from a year ago. Non-performing assets crept higher while still demonstrating very high quality well below historical levels. Provision was lower from June as stress scenario probabilities lessened with the broader economic rebound and credit specific issues were mostly unchanged. While hand wringing over the long anticipated recession weighed on sentiment in the quarter, CET1 capital ratios improved more than 3%.

I have pulled some call Q&A quotes that I found interesting. At PNC where NIM and NII decrease -2.6% from June, CEO William Demchak answered as follows when asked about potential NIM/NII inflection at the bank (my emphasis).

“All of it ends up being dependent on what you think the Fed is going to do. Personally, I think the Fed is higher for longer, even higher for longer than the market expects on our official forecast. I guess we have 2 cuts towards the back half of next year. As short rates stay higher, you will continue to see betas creep up, both because we’re going to reprice the back book and secondly, because you’ll just not on betas, but just on the shift from noninterest bearing to interest-bearing.

So when that inflection point is — has in some ways to do the most with what’s going on with the yield curve and the Fed. As the curve continues to flatten by the long end selling off, all else equal, that helps not withstanding the marks on our existing bonds, it helps with the price we get on the roll down and reinvestment. So there’s too many variables in there. But the basic notion that were at the inflection point, I think, is entirely dependent on what happens with the Fed in the coming year.”

Bank stocks turned negative Friday after initially surging higher on the pre-market EPS beats. I think the concern about further deposit beta increases which did not materialize this quarter can be categorized as fighting the last war. JPM CFO Jeremy Barun commented in answering how Chase achieved 41% Return on Equity in the Consumer and Community Bank (my emphasis).

“It’s not just credit, it’s also deposit margin, right? So when we talk about overearning on NII, a disproportionate amount of that is coming out of the consumer franchise for all the reasons that we’ve talked about.

But I would also point out, sometimes, we don’t like the word over-earning because right now, customers are happy and they’re doing CDs. And the broader answer to your question about why we’re able to compete effectively really comes back to a decade, 2-decade long history of investing for the future and recognizing that there’s a holistic value proposition here that includes branches and the app and all the online services and the entire suite of products and services that is around this enterprise, which drives engagement and customer loyalty. And we’re seeing some of the benefits of that now, although we’re not complacent.

The competition is still there, the fintechs are still there, and we know we need to continue investing to preserve the value. And it’s also true that the particular circumstances of the current rate and credit environment means that the earnings are a little bit above normal, but that core franchise is extremely robust.”

Bank stocks continue to trade biased to very negative investor sentiment. The sector headwinds are real and plentiful. Recency of the liquidity stress earlier in the year along with continuing risk of fall out from duration mismatch. Broader economic risks as leading recession indicators remain elevated in probability of recession over the next twelve months. Further creep higher in funding costs as term funding rolls higher. The long awaited CRE office loan maturations. Credit risk from a consumer that has exhausted excess savings. And now, the greatest risks of all, that of kinetic war with a tragic human toll exceeding the still important economic impacts.

When discussing the outlook for banks, for me, the most often overlooked point is valuation. Multiples and earnings can both fall further but the negative revisions and 4 to 6 turn P/E discounts are already quite substantial. I will hold judgment on credit normalization as we see how the economic growth/contraction plays out in 2024. From the perspective of yield curve impact as earnings driver, we seem to be much closer to a better environment for spread lenders. I am actually sanguine about further NIM/NII revisions from today.

One last comment in a longer than usual note, the financial press continues to echo a negative sentiment on banks. I think it is instructive to search back 2-years ago to see what these same writers were publishing in October 2021. When I do I find very bullish sentiment on banks, consumer interest rates and even tech IPOs! This bullish sentiment right into the cycle peak could not have been more wrong. Maybe this time is different? I continue to believe there is a through cycle enduring value to most companies in the banking sector. Barnum’s quote outlines how Chase creates enduring and highly profitable customer value. Trees will never grow to the sky, but some time in the not so distant future, we may begin to see stories that once again suggest that is the case.