US Banks Kick Off Earnings

3Q earnings season begins this week, with the big US banks kicking off the show. Citigroup and JPMorgan Chase are first up on Tuesday, followed by Bank of America, Goldman Sachs Group, and Wells Fargo on Wednesday. Morgan Stanley reports on Thursday.

More broadly this earnings season will provide investors with an update on company fundamentals which is likely to cement the picture of the “K-shaped recovery” that we see represented in the stark divides between COVID winners and losers. The divergence visible not only at an index level when we look at the divergent recovery trajectories for technology stocks vs. for example, energy or travel and leisure stocks, but also throughout the economy as a whole. Large vs. small companies, white collar worker vs. frontline, automation vs. human contact, asset rich vs. otherwise. Although with financial markets settled into the present liquidity driven paradigm, these dynamics matter more for the real economy and its social fabric.

However, as earnings kick off risky assets are more focused on the ongoing fiscal stalemate, paused vaccine trials and the upcoming election, where increased odds of a “blue wave” and substantial stimulus spend in the new year is supporting sentiment. We are just 3 weeks out from the election and although investors seem comfortable with the prospect that another round of fiscal spending may not eventuate prior to the election, remaining focused on the prospect stimulus is coming at some point, whoever wins, there remains a lot of noise with respect to news flow. This supports the notion of choppy, rangebound markets until the election is out of the way. It is true that the trajectory of both fiscal and monetary policy, alongside the economic recovery path and the prospects of a vaccine will outweigh the election result, but there remains some ground to cover until we get there with a potentially noisy period for news flow to traverse in between.

What to watch as banks kick of 3Q earnings this week:

• The economic backdrop, although troubled, has improved. The sector remains under pressure, but the outlook is improving and a lowered bar makes it easier for financial to meet expectations.
• Loan loss provisions have been front loaded with significant 1H expenses and should decline on the quarter, reserve set-asides will be less than they were during in 1H 2020.
• Declining provisions will help the sector reports in 3Q. Although, depending on the trajectory of the virus and treatment programmes/vaccine rollout we may not be out of the woods with respect to future loan loss provisions.
• If loan loss provisions do decline, this may help keep intact recent price action across the sector as investors contemplate the prospects of the eventual economic recovery and eventual reserve releases.
• Investment banking activity and IPO flow remains supportive of revenues.
• Low rates dent profitability. Lower Treasury yields constrain profit margins, monetary policy is a key driver here. 10yr Treasury yields remain near record lows collapsing net interest incomes. Declining credit card activity has also been a factor negatively impacting net interest incomes. These factors will weigh on 3Q results and beyond.
• FICC revenues are expected to remain strong with volatility continuing into 3Q but are unlikely to repeat the blowout 2Q performance.
• Loose monetary policy remains supportive of capital markets and trading activity. In many ways performance of this revenue line highlights the “K-shaped” recovery. Large banks with diversified business lines will outperform smaller banks more reliant upon lending.
• Cost cutting and lay offs remain a focal point, outside of stimulus fueled financial markets in the real economy, the K shaped world that is being entrenched by the COVID-19 recession continues. The latest jobs data revealing the share of permanent unemployed is picking up, highlighting the requirement for ongoing fiscal support targeted within parts of the economy that continue to lag.

In recent weeks US banks have outperformed the broader index in tandem with the reflation narrative that has driven risky assets. 3Q earnings should confirm this momentum given the lowered bar to meet and beat expectations.

However the earnings themselves are less important in the current environment. What matters more for the share prices is:

• The prospects of a large reflationary fiscal stimulus package, alongside a steeper yield curve supporting pro-cyclical allocations
• These prospects go hand in hand with the election outcome
• The COVID recovery trajectory and timing on a vaccine promoting the return to normal
• Central bank policy, monetary policy remains extremely loose with unprecedented measures abound

The reflationary narrative that has gripped market sentiment, bolstered by the increased probability of a democratic sweep, supports a steeper yield curve and could be positive for the US banks into 2021/2022. A steepening yield curve means widening profit margins for banks, who borrow short and lend long, although more broadly lower yields relative to cycle highs will still constrain interest margins.

The US desperately needs the next round of fiscal stimulus – stimulus gap may emerge in Q4 economic data with no deal on Capitol Hill prior to the election. US 3Q financial sector reports are likely to highlight the fact that unprecedented government and central bank stimulus has been critical.

Better 3Q results for the big US banks aside, it is stimulus that has driven the economy in recent months, and has been critical in averting the worst case scenario for the economy. In many ways bridging the gap between crisis and the post pandemic return to normalcy. The present gridlock in Washington increases the risk of economic scarring with unnecessary layoffs and business closures that may occur with the stimulus gap in play. A concerning dynamic which will be negative for consumption down the track, the recovery momentum is too fragile to go without and monetary policy is pushing on a string.