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Possible Margin Compression Turns Wells Fargo Stock Watchers Bearish

Faisal Humayun

With Wells Fargo (NYSE:WFC) scheduled to announced second-quarter results on Tuesday, it’s worth remembering that when the bank surprised investors a stronger-than-expected first-quarter profit, WFC stock trended lower on a reduced profit outlook.

Possible Margin Compression Turns Wells Fargo Stock Watchers Bearish

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It is also worth noting that Wells Fargo stock is at the same level as it was at the beginning of 2019. That compares with a 14% gain in the 25-bank-stock Invesco KBW Bank ETF (NASDAQ:KBWB), which shows WFC stock as its fourth-biggest holding at 7.88% weight. This is indicative of the point that market participants remain uncertain on the company’s outlook.

I believe that even if second-quarter results are largely in line with estimates, the stock can turn bearish on potentially weak outlook for 2019 and 2020.

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Rate Cut Impact on Wells Fargo

Consider the following:

  • The GDPNow indicator forecasts Q2 GDP growth at 1.4%.
  • The probability of recession as predicted by Treasury spreads is at 32.9%. This is at the highest level since the recession of 2008-2009.
  • The Conference Board’s consumer confidence index declined to 121.5 in June, the lowest level since September 2017.

Clearly, there is a meaningful slowdown and it is not surprising that the Federal Reserve has indicated that it might cut rates sooner.

This is the first reason to be bearish on Wells Fargo.

When 1Q19 results were announced, the company indicated that it expects net interest income to decline in 2019. According to the company:

“Several factors have driven shifts in our view, including a lower absolute rate outlook, a flatter curve, tightening loan spreads resulting from a competitive market with ample liquidity and continued upward pressure on deposit pricing. We now expect NII will decline 2% to 5% this year compared with 2018.”

With a possible 50- to 75-basis-point interest rate cut likely within the next six-12 months, Wells Fargo is likely to endure further margin compression. Decline in NII will translate into WFC stock trending lower as EPS declines.

Expansionary monetary policies will imply ample liquidity for consumers and businesses. A competitive landscape would mean that banks have to keep rates attractive for core business growth.

Therefore, a clear downturn in the economy is negative for Wells Fargo stock and I believe that the stock can move lower after being sideways for so far in 2019.

Over-leveraged Consumers

An interesting point to note is that household debt balance peaked at $12.68 trillion in the third quarter of 2008. The subsequent financial crisis translated into deleveraging by consumers.

For the first quarter of 2019, household debt balance was at $13.67 trillion, a full trillion dollars higher than the 2008 peak. Clearly, consumers are over leveraged.

With gradual economic slowdown and decline in consumer confidence, another wave of deleveraging can’t be ruled out.

I am not suggesting a potential crisis for the banking sector, but interest income can decline in the coming quarters. What holds true for consumers also holds true for businesses. If leveraged spending declines, so will leveraged investments.

While these are macroeconomic factors rather than characteristics specific to Wells Fargo, they will still dominate headlines and stock trend in the coming quarters.

Importantly, these macroeconomic factors will result in net interest income margin compression for Wells Fargo. Additionally, credit growth will decelerate and the core business growth will be impacted.

Bottom Line on Wells Fargo Stock

I certainly don’t intend to paint a very bearish scenario that draws comparison with the 2008-2009 crisis. Even in a deleveraging scenario, Wells Fargo stock could benefit from a healthy balance sheet.

The company has created sustained shareholder value through dividends and robust share repurchase. While current dividend payout can sustain, the company’s earnings growth is likely to be under stress and that is likely to take WFC stock lower.

Therefore, more than 2Q19 earnings numbers, I would look for guidance on net interest income margin for the coming quarters. That will dictate stock direction along with prospects of consumer deleveraging.

As of this writing, Faisal Humayun did not hold a position in any of the aforementioned securities.

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