For years, interest rates and the Federal Reserve’s actions were a major focus in the financial sector. After the Fed’s March hike, its third one since the financial crisis, and recent comments from Fed governors hinting at two to three more increases this year, investors might have gained a little more clarity regarding the future of interest rates. With some of the uncertainty around interest rates out of the way, investors seemed to have shifted focus to potential policy changes like economic growth, bank deregulation, and tax reform.
Q1 earnings expectations for the financial sector are high. According to FactSet Research, earnings are expected to grow at 14.8% year-over-year in the first quarter, the highest earnings growth projection across all eleven sectors. At the industry level, diversified financial services, capital markets, insurance, and banks are expected to report the highest earnings growth.
In the next two weeks, several major financial institutions report earnings. Wells Fargo (WFC), JP Morgan (JPM), and Citigroup (C) report before market open on April 13. According to consensus third-party analyst estimates, WFC is expected to report $0.96 earnings per share, or EPS, on revenue of $22.16 billion, JPM is expected to report $1.51 EPS on revenue of $24.57 billion, and C is expected to report $1.27 EPS on revenue of $17.97 billion. One area of focus when banks report is the impact of rising interest rates on these company’s net interest income—the difference between revenues generated by a bank’s assets and the expenses associated with paying its liabilities.
Later in the month Morgan Stanley (MS) is expected to report after market close on April 17 while Bank of America (BAC), and Goldman Sachs (GS) will report before market open on April 18. According to consensus analyst estimates, MS is expected to report $0.90 EPS on revenue of $9.10 billion, BAC is expected to report $0.35 EPS on revenue of $21.58 billion, and GS is expected to report $5.13 EPS on revenue of $8.37 billion. Many of these financial companies surged after the November elections, but they’ve started 2017 on a softer note (figure 1).
Expected Rise in Interest Income
After the Great Recession, the Federal Reserve and other central banks kept interest rates close to, and sometimes below, zero to help spur economic growth. Banks tend to benefit from a steeper yield curve since they generally borrow in the short-term at lower interest rates, and lend for the long-term at higher interest rates. Low interest rates have pressured profit margins at banks for many years, but interest rates have been slowly rising. Q1 financial sector earnings might show a better picture of how rising rates are hitting the bottom-line since the Fed’s last rate hike was at the end of Q4 2016.
M&A, Investment Banking and Economic Growth
The US economy has been growing faster than expected based on recent Commerce Department revisions to gross domestic product, a measure of the goods and services produced in an economy. Economic growth is generally considered a positive for financial companies since they provide services companies use like raising capital through debt and equity offerings, advisory services, and mergers and acquisitions. These activities tend to pick up when the economy is growing at a faster pace. The IPO market has slowed over the past several years, but underwriters could earn big fees if activity picks up.
Potential Impacts of Bank Deregulation
President Trump has made several comments that he intends to lighten the regulatory burden on financial companies. Many analysts see the repeal of Dodd-Frank, the financial reform legislation passed in 2010 in response to the financial crisis of 2008, as an unlikely event—especially after efforts to repeal the Affordable Care Act fell short. While an outright repeal might not be possible, there are still some areas analysts think could be tweaked: lowering capital requirements for banks, adjusting the way banks’ total leverage is calculated, or adjusting rules that limit proprietary trading at depository institutions. Analysts at Keefe, Bruyette, and Woods and Goldman Sachs analyzed some of these scenarios and estimated they could boost 2018 EPS estimates by an average of 1.8% to as high as 13.5% at some of the largest banks. Keep in mind these are hypothetical situations and there’s no way of knowing how regulations could change.
With financials close to recent highs, it might be a good idea to tread cautiously. If you’re bullish on financials, you can always wait for earnings to play out before looking for companies to invest in. Remember, you don’t have to be all in and you don’t have to be all out. Stick with a level of risk you’re comfortable with.