What Do Earnings From The Big Banks Tell Us?

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I have often looked at the sources of profits for the big four money center banks banks, Citi (C), JP Morgan Chase (JPM), Bank of America (BAC), and Wells Fargo (WFC), and used that information to assess market prospects for the few months that follow.

In this respect, banks are an exception. Most of the time, the performance of any one company tells us little about the underlying economy. The same goes for reasons and excuses for that performance offered by management. If there is a theme to bank earnings, however, it can be very informative. The problem this quarter is that no such theme exists.

Bank earnings are incredibly complex with so many moving parts that they are often bewildering to anyone other than the specialists who analyze them for Wall Street, but sometimes overall trends can be detected. From 2001 to 2007, for example, trading profits accounted for a large and growing percentage of revenue and profits at the banks. With hindsight, obviously, that was a problem, although at the time the focus was on profit, not the source.

After that house of cards collapsed in 2008, the extent to which the big, money-center banks have been able to wean themselves off the “easy money” from trading, and profit from more traditional sources has ebbed and flowed and has often been a good indicator of the pace of the recovery. That makes sense. The traditional bank business of lending to consumers and businesses fluctuates according to confidence, and that confidence in turn drives growth.

Early this week, on the surface at least, it looked as if there was going to be more good news on that front when both JP Morgan and Wells Fargo pointed to good results from their consumer divisions as they reported limited beats of expectations. Citi, on the other hand, talked mostly about profits from fixed income trading, and Bank of America highlighted cost-cutting in their comments. But those two also reported better than expected results in “interest income,” which is profit from lending.

So far so good. What's the problem?

The issue comes in the banks’ forecasts for the rest of this year. They were somewhat mixed, which wouldn’t be too much of a problem were it not for the almost unanimous expectation of an interest rate cut from the Fed this month. If rates are headed even lower, shouldn’t that stimulate, not suppress loan generation and therefore interest income?

The answer to that question is “not necessarily.” When the starting point for a rate cut is already low interest rates, the effects are muted, and a cut in short-term interest, which is what the Fed controls, only stimulates consumer and business loan activity when people want to borrow. A 25-basis point cut will have only a marginal effect on that desire, while the message it sends of potential problems ahead will have a much bigger one.

If the bond market saw a rate cut as addressing those potential issues and significantly reducing the risk of an economic slowdown, that inversion would disappear. Then banks, who typically borrow short-term money to lend long-term and profit from the spread between them, would be expecting to make more money from lending, not less.

I know this all sounds a bit confusing, but it's enough to know that the reason for the big banks’ lack of optimism is not really the concern. Just the fact that they can’t agree on whether a rate cut will help or hurt their lending business tells you all you need to know. Those most directly affected by the Fed’s decision are unsure whether it will prove to be good or bad for their business and in those circumstances, a complete and drastic policy reversal seems incredibly risky.

If the banks’ outlook for their lending business is correct, it suggests that a rate cut this month will have at best no effect on the real economy of borrowing and investing, but that there are real risks to that decision. At this point, as we flirt with record highs, those risks aren’t being priced into the stock market. It may not be a coincidence that as those bank earnings and outlooks have come in over the last few days, stock have started to pull back from those highs and if that is the case, more of the same can be expected.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Earnings , Economy , Stocks
Referenced Symbols: C , JPM , WFC , BAC

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