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Margaret Moran
Margaret Moran
Articles (348) 

What's Next for Bank Stocks as Fed Aims for Increased Inflation?

A look at how major US banks are trying to find new income in a weak economy

On Sept. 16, the U.S. Federal Reserve released its latest monetary policy statements following September's Federal Open Market Committee meeting.

As investors and analysts alike expected, the Fed has decided to keep the base interest rate at 0% to 0.25% to stimulate the weak economy and make borrowing cheaper. Citing continued low economic activity and unemployment compared to recent years, the committee now aims for inflation that will result in a "longer run" average of 2%.

Inflation has often averaged below 2% in recent years. Specifically, since 2010, U.S. dollar inflation averaged below 2% in six years - 2010, 2013, 2014, 2015, 2016 and 2019. As a result, the FOMC is aiming for conditions in which inflation will "moderately exceed 2 percent for some time" before reassessing the policy, indicating that inflation will likely exceed 2% in at least six years over the next decade in the FOMC's ideal scenario.

So far, banks have (thankfully) avoided any major collapses during the Covid-19 economic crisis, though they are still feeling the pain from lower interest rates, as interest is the primary source of income for traditional banking activities. Presumably, the big banks learned their lesson during the 2008 financial crisis, though it is still far too early for the full effects of increased loan defaults, bankruptcies and long-term low yields to show up on their balance sheets.

The economy is far from being out of hot water, and with continued low interest rates and higher-than-typical inflation expected, banks will certainly feel the pain as their traditional revenue streams slow to a trickle (or, in the worst-case-scenario, dry up completely as more customers cannot repay their loans).

These headwinds are why bank stocks are still among the most undervalued on the market, despite the total market cap of U.S. publicly traded companies increasing as investors pour money into initial public offerings and tech stocks. The Shiller price-earnings ratio for the financial services sector stands at 17.8, making it the second-most undervalued sector after energy.

However, this does not mean that all banks are certain to see decreased earnings in the years ahead. Some big names in the sector, such as JPMorgan Chase & Co. (NYSE:JPM) and Goldman Sachs (NYSE:GS), are looking to new sources that could bring in cash flows. Let's take a look at some of them, and how likely they are to achieve revenue growth in the future.

Investment banking

Quite a few banks are seeking to grow their investment banking services, which typically bring in higher cash flows than traditional banking activities, especially in times of market turmoil when there is more transaction volume.

One driver for increased interest in investment banking is the economic downturn at the beginning of 2020 and the subsequent bull market. After the February and March selloffs, investors began falling in love with the idea of "pandemic stocks," i.e., the stocks of companies that have seen material benefits due to the pandemic and its effects on consumer habits.

As for companies that do not benefit from the pandemic, yield-starved investors who are no longer able to achieve meaningful returns outside of the stock market (and perhaps the high-yield corporate bond market) have been increasingly willing to price in future recovery now. In other words, the low federal funds rate can be directly linked to more investment dollars being shifted to the stock market via investment banking.

All of the "Big Six" U.S. bank majors have at least some investment banking activities, especially Goldman Sachs and Morgan Stanley (NYSE:MS), for which investment banking represented 20% and 16% of net revenues during the second quarter. JPMorgan is also aiming to grow its investment banking arm, as are Bank of America (NYSE:BAC), Citigroup (NYSE:C) and Wells Fargo (NYSE:WFC).

Trading stocks of private companies?

On top of investment banking in publicly traded securities, JPMorgan is planning to take it up a notch by offering customers the ability to trade shares of private companies.

Yes, you read that right. The bank major is putting together a team of experts to connect sellers and buyers as the demand for shares of private companies grows. Andrew Tuthill, a senior vice president from Forge Global, will head up the new team.

In the past, due to the difficulty of trading the shares of private companies as well as the lack of publicly available information on their financials and inner workings, investors – especially individual investors – were not really interested in this type of security.

In an interview with CNBC, Chris Berthe, the global co-head of JPMorgan's cash equities trading, attributed the newfound interest in private company stocks to the low-yield environment:

"Many of our clients are looking at this as the next frontier. What do you do when markets get so high? You're going to keep looking at value down the chain, and maybe that means getting involved in companies at earlier stages of their lifecycle."

Trading shares of private companies is still mostly done through old-school voice trading, and once the trade is negotiated, JPMorgan's team will then have to transfer the legal ownership of the contracts and get clearance from the company, which can take weeks. However, many investors may think the difficulty (and likely the high fees from JPMorgan's pioneer team) are worth it to invest in pre-IPO giants like SpaceX, Airbnb and Robinhood.

Consumer banking boost

The big banks that already have sizeable consumer banking arms continue to cut the interest rates that their standard checking and savings accounts offer, as low interest rates mean that the money they lend using these accounts is not as profitable as it used to be. This is especially true for accounts with deposits below the $10,000 range.

According to GOBankingRates' annual banking survey, approximately 69% of Americans had less than $1,000 in savings at the end of 2019, meaning that the majority of people in the country will need to look outside of consumer banking giants like Bank of America and Citigroup if they want any sort of interest income.

Enter Goldman Sachs, which has historically derived nearly all of its income from large corporations, financial institutions, governments and high-net-worth individuals. Unlike the other U.S. bank majors, Goldman Sachs does not have much history with things like retail checking and savings accounts and small personal loans. This changed with its launch of Marcus app in 2016, which started off by providing no-fee, high-interest savings accounts and personal loans. Next up, the bank plans to add checking and investment account capabilities to Marcus. Goldman also recently released the first version of a personal finance management tool for the app, which will allow users to view things like a monthly snapshot of their budget.

This move came as part of an effort to diversify Goldman's revenue streams. By offering retail customers high-interest savings accounts (0.60% APY versus the less than 0.05% offered by other major banks), the bank seems to be angling to snatch as much of this market as it can right out from under competitors' noses. Deposits made to Marcus increased more than 27% year over year to reach $92 billion in the second quarter, a much higher growth rate than other bank majors are seeing in similar deposits, so the plan seems to be working.

Conclusion

Low interest rates are likely here to stay, not just because of the current economic crisis but also because the U.S. federal funds rate has been on a general downtrend since the 1980s – that's four decades of capital structures slowly changing to allow increasingly higher leverage, which necessitates lower interest rates to avoid economic collapse.

Setting aside for now the issue of whether or not this combination is sustainable, it is a fact that banks are looking at a long road of low interest rates ahead. The ones that cannot find alternative sources of profitability are not likely to be seeing growth in their revenue or earnings any time soon.

Thus, investors who are interested in the banking sector's low valuations should first take a look at what banks are doing to prepare for the future.

Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research and/or consult registered investment advisors before taking action in the stock market.

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Comments

rubenc1989
Rubenc1989 - 2 months ago    Report SPAM

So why did Buffet increase in BAC?

Margaret Moran
Margaret Moran premium member - 2 months ago

Hello, thank you for your question!

There is a lot to like about BAC as well. We have no way of knowing why Buffett increased his position in BAC until he makes public statements on the matter - perhaps he will answer this question in his next annual letter to shareholders, or at Berskhire's next annual shareholder meeting. However, Bank of America has been maintaining stronger capital ratios and taking fewer loan losses than most of its peers during the current economic situation, which can be clearly seen from its latest SEC filings. In the Fed's annual stress tests earlier this year, BAC did better than many peers while GS floundered, showing the strength of BAC as a more predictable company. In fact, lowering the risk of significant losses is likely one of the main reasons why GS is seeking to rapidly expand its consumer banking segment.

In short, it seems likely that Buffett prefers BAC because it could suffer fewer loan losses and hold up better in a recession in terms of protecting its downside, perhaps even without cutting its dividend.

Praveen Chawla
Praveen Chawla premium member - 2 months ago

Excellent article. I think the low rates will also make leveraged buy-outs (LBO's) easier. Banks will want to fund LBO's to increase returns.

rubenc1989
Rubenc1989 - 2 months ago    Report SPAM

Thank for your reply. Regards

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