As Q2 2020 earnings season kicks off this week, led by the big banks, it's likely rising loan losses and strong revenues from their trading and capital markets units will be the highlights of these financial institutions' reports.
Investors shunned bank stocks this year, on concerns that one of the worst recessions in US history will crush profitability and result in rising loan losses. The first three months of 2020 presented a similar picture as near-zero interest rates and a free-falling US economy hit their revenues.
With many states enforcing lockdowns during the period, these trends further intensified in the second-quarter, eroding yet more significantly banks’ ability to make money on their routine operations, such as credit card transactions and working capital loans.
"We expect 2Q20 earnings to fall 69% year-over-year, as continued strength in capital markets and the benefit of larger balance sheets is more than offset by larger reserve builds and rates near 0%,” wrote Goldman Sachs analyst Richard Ramsden in a note.
This dismal situation along with the recession hitting consumer demand, means the largest US banking stocks have underperformed the broader market.
The KBW NASDAQ Bank Index is down 35% this year, compared with a drop of just 2.4% for the broader S&P 500. Wells Fargo (NYSE:WFC) is the year’s biggest loser among major banks, tumbling 55%.
The lender is scheduled to report on Tuesday, July 14, before the market opens. The consensus forecast calls for it to show a $0.1 a share loss on sales of $18.37 billion.
Swelling Loan Provisions; Suspended Dividend Hikes
One important number that investors will be monitoring carefully is the extent of provisions these lenders will be obligated to set aside in order to cover their bad loans.
For the industry as a whole, loan-loss provisions are poised to reach their highest levels since the 2008 financial crisis, according to analysts at Barclays. But any sign that provisions against the bad loans are bottoming out will be net positive for bank stocks.
Wells Fargo Chief Financial Officer John Shrewsberry said last month he expected the bank to set aside more for bad loans in the second quarter. JPMorgan Chase (NYSE:JPM) saw its first-quarter profit tumble 69% as the company set aside $8.29 billion for bad loans, the biggest provision in at least a decade.
The lender is also expected to release 2Q earnings on Tuesday, before the market open. Analysts are expecting $1.19 a share profit on sales of $30.4 billion.
Along with swelling loan provisions, investors are also grappling with the uncertainty of future dividend payments by these lenders.
The Federal Reserve told 33 of the largest US and global financial institutions last month that they’re not allowed to hike their dividends or resume buybacks through at least September, amid the global coronavirus pandemic which has pushed the US economy into a deep recession and increased risks for lenders.
The decision came after the US central bank’s annual stress test which examines a bank's ability to survive in a downturn. Through these tests, the Fed can force a change in an institution's capital-return plans, such as dividends and share buybacks, to avoid a situation like the one these lenders found themselves in after the 2008 Financial Crisis.
Wells Fargo would need to cut its 2Q dividend to $0.36 from $0.51, and Capital One (NYSE:COF) would have to slash its payout to zero, from its current $0.40, according to a research note by Morgan Stanely.
Despite the pressure on overall earnings, trading and underwriting are two areas of the banking business which are still thriving, helping some big lenders to weather the storm.
Combined stock- and bond-trading revenue at the five biggest banks probably jumped 31% from the second quarter of 2019, according to an estimate provided by Bloomberg. JPMorgan expects trading revenue to climb about 50% from a year ago, while Citigroup (NYSE:C) sees record trading volume for the period as markets staged a sharp recovery from the March slump.
Bottom Line
Given the depth of the current economic crisis and still raging pandemic, it’s unlikely that bank earnings will recover from their slump quickly. That being said, banks are much better capitalized this time than they were during the 2008 Financial Crisis.
That strength is encouraging some investors to look favorably at some beaten-down bank stocks. For them, this weakness will be a buying opportunity.