The guest commentary below was written by Christopher Whalen.
Once again it is time for earnings in the world of financials. Go back and compare the Sell Side view of financials at the end of Q2 ’18 with the narrative today. What you see is that the group basically has gone sideways for the past year. Peak gains for sector leaders like JPMorgan Chase (JPM) and U.S. Bancorp (USB) were about 5%, but both are down more than that amount since the great slide began in earnest in December.
We can blame the sudden downdraft on various externalities and global trade yada yada, but the simple fact is that financials were very fully valued at the end of June. They are less so today. Is this the signal to run back into the water with the Meg? Yes and no, depending on whether you are buying quality exposures for the medium term or merely seeking a quick flip.
As the recently released 2013 FOMC minutes confirm, unwinding the great Bernanke/Yellen asset bubble means above-normal market volatility going forward. Thoughts:
* There are some relative values in the financials compared with 6 months ago, but we would be cautious as the "great unwind" of the Fed balance sheet is going to continue to put pressure on valuations generally and also spreads, regardless of whether the FOMC raises interest rate targets for Fed funds. The easy days of up, up and away c/o quantitative easing are over for stocks.
* To us, the sensible risk position is to stay away from complexity and "high beta" plays, but look for bargains among the low beta exemplars. The upside optionality we all thought was free a year ago now has a cost as does short-term funding. Spreads were widening as the year closed, killing HY issuance in December, but now spreads are going the other way. We believe that the real storm in terms of credit is still 12-18 months away, but equity markets are already discounting that reality.
* We were a seller of PMT and NRZ going into year-end. Mortgage exposures are going to become more influenced in '19 and '20 by credit concerns. We've been a buyer of USB common and preferred because 1.7x book seems relatively cheap for the best performer of the top five banks. The USB common yields 3.25% and preferred is over 5%. LOW BETA. We like other boring, consistent names like BBT, STI and KEY for same reasons.
* We are not impressed by JPM at 1.4x book or BAC at 1x. Same with Citi and Capital One (COF) at a 25% discount to par value. These last two are subprime shops and thus trade at a discount to book, period. Different business model than JPM or USB. Likewise don't like Deutsche Bank (DB) or Goldman Sachs (GS) because of the multiplicity of "known unknowns," namely continuing fears of further operational risk surprises from these investment banks.
Sad to say, we still believe GS CEO David Solomon may need to fall on his sword in order to settle the 1MDB mess. Goldman Sachs is accused of facilitating fraudulent securities offerings that were ostensibly for Malaysia, but the proceeds were then stolen by various parties -- people that GS thought were clients.
The Malaysians are seeking the return of the full amount of the bogus offerings plus fees, some $7 billion or thereabouts. As we noted last month, the big issue facing GS may be with US regulators and the bank's internal systems and controls. Saying that the firm was deceived by its investment bankers is not the right answer, for example, if you are speaking to the Federal Reserve Board.
"I don't want to touch Goldman Sachs," analyst Dick Bove said on CNBC's "Trading Nation" last Wednesday. "People really don't understand what the issue is concerning Goldman Sachs. It's that they were involved in this huge scandal related to Malaysia. It's the fact that their compliance operations internally seem to have broken down." Ditto.
The market volatility in December was good for volumes at many dealers, but not so much for clients. We could see an upside surprise from GS, Morgan Stanley (MS) and Citi as a result of the December tumult. That said, Citigroup is showing 2% sales growth for the full year 2018 and 2019 as well, but 21% plus earnings growth in Q4 ’18 and the full year. The C common is down 21% for the year vs just -11% for JPM, but if you consider the greater enterprise risk that comes with Citi that valuation differential seems about right. Consider that C has a market beta of 1.6 vs 1.1 for JPM.
As we noted in the latest issue of The IRA Bank Book, the key issue facing banks in 2019 will be whether the rate of increase in funding costs – roughly 60% year-over-year – continues even as the FOMC shows signs of pulling up in terms of further increases in the target rate for Fed funds. The runoff of the Fed’s system open market account or SOMA is going to continue to tighten the US domestic deposit base regardless of whether the FOMC takes any further action in 2019. A pickup in capital markets volume, regardless of the reason, would be a nice surprise.
More important, the debt issuance by the US Treasury will be an even greater weight on short-term funding costs – this as the 10 and 30- year Treasury bonds rally while high yield spreads are falling. Thus funding costs for banks and non-banks are rising, but the investor exodus from the equity markets is driving long-term bond yields and credit spreads lower.
In normal times, such bullish bond market indicators like falling yields and credit spreads might suggest a substantial leg up awaits in the equity markets. Today, however, the market indicators are muddied by the side effects of QE, making traditional indicators less useful than ever. Then-Fed governor Jerome Powell said in the FOMC deliberations in January 2013:
“Although it doesn’t show up yet in the dealer survey, some investors are saying that they sense the end of quantitative easing over the horizon, and as a result, there’s a sense of a rotation into equities and away from the safety of Treasuries, which accounts for some of the very large increase in the yield on the 10-year. And we should welcome all of that and consider whether our statements and actions reinforce or restrain the positive feelings that are out there.”
As Powell predicted, the US equity markets delivered a stunning performance since 2014, with stock market valuations increasing by several orders of magnitude above the rate of US economic growth – what we lovingly refer to as the Bernanke/Yellen inflation. Now, however, with the Fed’s balance sheet shrinking and the fiscal deficits soaring, investors are seeing a sharp and somewhat contradictory pattern in the markets that was predicted by Chairman Powell in 2013. He said:
“While financial conditions are a net positive, there’s also reason to be concerned about the growing market distortions created by our continuing asset purchases… Many fixed-income securities are now trading well above fundamental value, and the eventual correction could be large and dynamic. You hear that all the time now in the fixed income markets—and in the media, for that matter, which actually may suggest that it won’t happen, of course. But you hear it all the time; we all do. The leveraged finance markets are a particular concern. Rates are low; spreads are not that low yet, but they’re definitely tightening; and terms are deteriorating rapidly. There are many examples of bubble-like terms, which we can talk about at the next meeting. The Dell leveraged buyout, if it does happen, may be very prolific in that theater. I don’t think there’s an imminent crash coming. I do think that the incentives will rule in the end, and the incentive structure that we put in place with the asset purchases, is driving securities above fundamental values. So there is every reason to expect a sharp and painful correction.”
Although the 2013 FOMC transcripts make clear that Chairman Powell was leading the charge against the Bernanke/Yellen tendency when it came to the scale and duration of SOMA asset purchases under QE, the markets still don’t seem to get the joke. Unwinding the Fed's asset price bubble is going to be a long and painful process. For financials in Q4 2018 and beyond into 2019, look for rising funding costs and still tough pricing for assets on the one hand, and lots of volatility on the trading book – good and bad.
EDITOR'S NOTE
Christopher Whalen is Chairman of Whalen Global Advisors LLC. 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 recently 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.
