Banks Are Pointing To An Economic Slowdown

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“It all comes down to interest rates. As an investor, all you're doing is putting up a lump-sum payment for a future cash flow.” - Ray Dalio

This week we’re having a look at Big Banks Earnings and Recent IPOs.

Now that interest rates are back at 2008 levels, we wanted to share what their earnings reports tell us about the economy. And given the recent examples of IPOs slumping in this market, we have some suggestions for what to look out for before investing in an IPO.

🎧 Would you prefer to listen to these insights? You can find the audio version on our  Spotify or Apple podcasts !

5 Takeaways From Bank Earnings

10 year U.S. Banking Industry Valuation and Performance Analysis - Simply Wall St

The largest US banks have now reported third quarter earnings. This round of earnings was of particular interest because:

  1. Bond yields have risen to 16 year highs.
  2. Banks quarterly reports can share insights about the strength of consumers and the economy - which investors want to know due to how it impacts inflation and therefore rates.

Here’s what we’ve found so far:

  1. Most banks reported higher net interest income.
    • This isn’t surprising as higher rates allow banks to charge higher interest on loans. However, net income margins are expected to fall now as lending slows, while the rates paid on deposits rise.
  2. Consumer lenders did better than investment banks.
    • Morgan Stanley reported a decline in profits due to a slowdown in M&A activity, while Goldman Sachs took a hit on the sale of three business units. In general, fee income at most banks has grown very slowly over the last few quarters.
  3. Consumers are still in reasonably good shape, but spending is slowing:
    • Consumer lenders noted that most consumers are in good shape but borrowing and spending are slowing. Most banks expect a significant slowdown in consumer spending in the next quarter.
  4. Bad loans are rising:
  5. Mortgage lending was down a lot:
    • JP Morgan, Citigroup and Wells Fargo reported mortgage origination down 9%, 17% and 70% respectively. The variance here is a reflection of the different customer bases, but isn’t surprising given sky high mortgage rates.

And About Those Unrealized Losses….

Another topic that came up was the unrealised losses on ‘held to maturity” (HTM) securities.

US banks are believed to have unrealized losses on their balance sheets of $650 billion . The largest of these is held by Bank of America at $131 billion, but even JP Morgan has an unrealized loss of $40 billion.

Losses on HTM securities are pretty much what sunk Silicon Valley Bank earlier in the year.

The bank held long dated bonds which it had to sell at a loss when yields rose and depositors wanted their money back. Many of those depositors actually moved their accounts to BofA which increased the size of its deposit base.

The difference in this case is that depositors have nowhere else to go, and the large banks are far better capitalized than smaller regional banks, which should ease some concerns of a bank run occurring (to some extent).

So while some analysts say banks like BofA are insolvent, the odds of those losses being realized are probably very low given the reputation of the bank and its current  financial health . The odds of that occurring depend on how likely you think virtually every BofA depositor would want their money back right now.

The Wall Street Journal also noted that as those bonds mature, banks can reinvest the proceeds at higher yields - which add to their profitability. So it’s a somewhat short-medium term issue thanks to the quick rise in treasury yields.

💡 The Insight: Banks Love And Hate Higher Rates

There’s a rule of thumb that says banks benefit from rising and high interest rates.

The idea is that with higher rates banks are able to earn a wider margin between the rates charged to borrowers and the rates paid to depositors. Indeed this has occurred over the last few quarters with the larger banks reporting higher net interest income, but these benefits tend to diminish over time as competition incentivises banks to raise savings rates and lower borrowing rates to drive customer acquisition.

Higher rates can also be a double edged sword, and the type of business a bank conducts determines if and when higher rates are beneficial to the bottom line. Some of the downsides of higher rates include:

  • Slower loan growth as borrowing becomes unaffordable.
  • Higher default rates when borrowers can’t keep up with repayments
  • Higher balance sheet risk for smaller banks if depositors draw down on savings accounts.
  • Lower fee income from investment banking if corporate activity slows.

Many of these factors came up in this round of earnings, but the profile of each bank determined the extent to which the benefits offset the downside.

This is why it's important to understand what types of businesses each bank is exposed to when analyzing them as investments (i.e. consumer, investment banking, etc).

You can then build a narrative for each bank by identifying the catalysts that will affect the revenue streams and margins for the major parts of the business.

Then based on your assumptions, come up with a valuation, and monitor each catalyst over time. Check out this narrative for Bank of America below:

Bank of America Narrative and Catalysts - Simply Wall St

Now let's talk about these recent IPOs.

Another IPO Sinks

Birkenstock is the latest new listing to disappoint investors, following on heels of Arm Holdings and Instacart .

However unlike the earlier IPOs, Birkenstock traded below its offer price of $46 from the get go, and was 20% lower within three days.

IPO Returns vs Market Indexes 2010 to 2020 -

IPOs, or initial public offerings, have had a terrible track record over the long run, though some start out with an initial rally (depending investor appetite driven by market conditions).

That doesn’t mean ALL IPOs must be avoided - after all, every great stock once had to have its own IPO. BUT it is important to understand the process and the motivation behind the listing.

The first thing to know is that the timing and price of a new listing is decided by a few people: the company, early investors and the investment banks conducting the listing. The objective is usually to raise as much money as possible - not to ensure that new investors can earn a return.

The listing also comes at the end of a long road show and marketing campaign designed to drum up demand. The IPO is then “priced” (the offer price) and shares are offered to investors at that price by one or more brokers.

In many cases shares of IPOs aren’t available to retail investors - unless there isn’t enough demand from institutional investors. This is often red flag number 1 🚩.

When the stock actually begins to trade on an exchange the price is determined by supply and demand. The investment bank that underwrites the listing usually aims to have enough demand so that the first trade is above the offer price.

When there’s a lot of hype around an IPO it's not uncommon for the stock price to rally 10% or 20% on the first day. What happens next depends on the investment time horizon of pre-IPO investors and those who bought on day one.

💡The Insight: Know Why A Business Is Going Public

In many ways assessing a company that’s about to become publicly listed should be the same as any other company. Make sure you understand:

  1. The company’s business model,
  2. Its products and markets,
  3. Its future prospects
  4. And work out the price you are prepared to pay that will give you a return that justifies the risk.

However, in the case of IPOs there are few other questions you may want to ask yourself. You should be able to find all the information you need in the offering document or prospectus (and if you can’t, that’s red flag number two 🚩).

  1. Why is the company becoming publicly listed?

    • Sometimes companies become publicly listed to give them access to large investors, and capital to expand the business. Other times a listing is simply an exit strategy for current owners.
    • To justify a listing, a company would usually need to raise a substantial amount of capital and have a productive way to use that capital. Companies that only need to raise $10 to $20 million can usually do that via private equity funds. If they can’t, there’s usually a good reason - private equity investors don’t think it’s worth it.
    • Case in point, of the last 50 US IPOs listed on IPOScoop , 27 raised $10 million or less, and amongst those, only two are above their offer price. The rest are down an average of 61%! On the other hand, those that raised $200 million or more, are on average flat compared to their offer price.
  2. Who are the current owners?

  3. Is the IPO price reasonable?

You can approach the valuation from two angles:

  • The relative perspective: what price multiple do similar companies trade on?
  • The business owner’s perspective: what is the business worth?
  • Both of these metrics can be found within the Simply Wall St Valuation section.

The financial data for a company that’s about to hold an IPO is sometimes only available to market data platforms (including Simply Wall St) a day or two before the listing.

But you can still find a peer group by looking at the company reports for one or two similar companies. In fact you only need one competitor or peer to get started. Just follow these steps.

  • Step 1: Under the Company Overview , you will find a list of competitors.
    • You can then open the company reports for those companies to find other peer group companies.
  • Step 2: Section 1.2 (Price to Earnings Ratio vs Peers) will reflect the range of PE ratios (or price to sales ratios for unprofitable companies) for similar companies.
  • Step 3: Section 1.4 (Price to Earnings Ratio vs Industry) will reflect an even broader range of price ratios for the entire industry.
    • The image below shows how Birkenstock’s PE ratio measures up against the luxury goods industry. Prior to the IPO this would have shown you that the offer price of $46 implied a PE ratio of 50x which was right at the top of the industry range.
Birkenstock Price Earnings Ratio vs Industry - Simply Wall St

Once you’ve been through this process, you can compare the margins and growth rates for the company with its peers and industry to get a rough idea of a comparable valuation. You can then do a more in depth qualitative analysis to work out what you think the business is worth.

What Else Is Happening?

First a recap of the key data releases we mentioned last week…

And then, a few news items that we thought were worth noting…

  • 🚢 The US announced further restrictions on exports of high performance semiconductors to China. Nvidia is most affected though other semiconductor companies could also be affected.
    • The restrictions appear to affect the Nvidia chips that the company designed to comply with the previous restrictions.
    • While this may eventually have a financial impact, these chips were already a low priority for Nvidia. Keeping up with demand for its flagship A100 and H100 chips is probably more a pressing concern for the company.
  • 💻 Big tech (and media) quarterly earnings reports got off to a strong start with Netflix reporting its strongest subscriber growth in years.
    • In addition the company announced more price increases and a 70% quarter on quarter increase in subs to its ad-supported tier.
    • Checkout some investors' narratives on Simply Wall St, some bullish , and some neutral.

Key Events During The Next Week

This week’s economic data releases kick off with the UK’s unemployment rate on Tuesday.

Interest rate decisions will be announced in Canada on Wednesday and the Eurozone on Thursday.

US GDP data and durable goods order are due on Thursday, followed by the Core PCE price index, and personal income and spending data on Friday.

This is one of the biggest weeks of earnings season with three ‘big tech’ and lots of other large cap companies reporting. The most prominent names include:

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Simply Wall St analyst Richard Bowman and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

Richard Bowman

Richard Bowman

Richard is an analyst, writer and investor based in Cape Town, South Africa. He has written for several online investment publications and continues to do so. Richard is fascinated by economics, financial markets and behavioral finance. He is also passionate about tools and content that make investing accessible to everyone.