Why are financials selling off as earnings season starts next week? Large cap banks such as JPMorgan (NYSE:JPM) led the markets higher earlier in the year, but have since underperformed the markets. What gives?
First and foremost, when the markets are looking for a reason to sell, large cap financial names usually catch more that their share of attention. Remember that Wall Street only ever cares about the top 10-names in financials by market cap.
When the thundering herd sells, banks usually get a disproportionate share of the short volume. The sector accounts for about 15% of the S&P 500. When a broad selloff is underway, look for financials to participate and then some, both in terms of cash and the highly liquid derivatives.
Second, financials are overvalued – still. When JPM peaked at just shy of $120 per share on February 26th of this year, the market leader was trading just shy of 2x book value. The stock is still up 15% over the past six months vs single digits for the S&P 500. JPM has single digit equity returns and no real growth in terms of revenue. Hit the bid.
Third and most important is the question of net interest margins and financial repression. In the inaugural edition of The IRA Bank Book, we discuss why the banking industry is facing a squeeze on margins thanks to the Federal Open Market Committee. Few analysts on the Street know or care about this looming threat to bank profits.
At present, the US banking industry is earning about $130 billion per quarter in net interest income from loans and investments, but is paying depositors and bond holders a mere $20 billion per quarter for funding. This skew in favor of bank equity holders has been extreme since 2008, but the issue of financial repression goes back to the 1990s. Ponder the chart below.
In Q4 2007, when US banks grossed $180 billion from loans and other earning assets, they paid depositors and bond investors almost $100 billion. In 2015, the total cost of funds for the US banking industry was just $11 billion per quarter, but the industry booked $110 billion in net interest income. Get the joke?? Bank depositors and bond holders should be earning more like $40-50 billion per quarter.
Today yields on deposits and fixed income securities are rising faster than the yields on bank loans. Just as the FOMC suppressed the cost of credit for banks after 2008, now the financial engineering of former Fed Chair Janet Yellen has created an interest rate trap for banks a la the 1980s.
For those of you who missed that party, in the 1980s funding costs for S&Ls rose faster than asset earnings, gutting the capital of the entire housing finance sector. The unfortunate demise of the S&Ls also created the opportunity for banks to get into mortgage lending a decade later with similarly disastrous results.
We look for the cost of bank funding to rise faster than the yield on earning assets over the next two years, a situation that is likely to put an effective cap on bank earnings and public market valuations. The kicker in the analysis is that credit costs are also likely to rise faster than either revenue or pre-tax earnings, adding an additional headwind to financials as 2018 unfolds.
Whalen, Richard Christopher, The Financial Repression Index: U.S Banking System Since 1984 (April 3, 2018). Available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3155370
Christopher Whalen is Chairman of Whalen Global Advisors LLC, a Wall Street insider who understands the intersection of politics and finance, and says what he means. He has worked in politics, at the Federal Reserve Bank of New York and as an investment banker for more than 30 years. He is the author of three books Inflated (2010), Financial Stability (2014) and Ford Men (2017).
In 2017 he resumed publication of The Institutional Risk Analyst and contributes to many other publications and media outlets. He just launched the first volume of The IRA Bank Book, a review of the operating and credit performance of the US banking industry written for institutional investors.