Last year brought amazing results for the U.S. banking industry. Throughout the sector, shares rallied as strongly as they had since the financial crisis. From Trump's victory night on, large banks surged 20% to 30% across the board. And since January 1st, 2016, the Financial Select Sector SPDR Fund (XLF) has returned a laudable 27%, including dividends. However, one big U.S. bank missed the party. Shares of Wells Fargo & Co. (WFC) have hardly rallied at all. While the financial sector posted a 27% gain, WFC stock advanced a much more paltry 9%.
What went wrong? Scandal hit. Wells Fargo stock, previously known for its conservative approach and good reputation, got caught up in a major misdoing.
Former CEO John Stumpf left the bank. And Wells Fargo faced a major fine and hit to its reputation. Is it time to forgive the firm and buy into WFC stock? We stack up the pros and cons
Prices and data are from the original InvestorPlace story published on April 4, 2017. Click on ticker-symbol links in each slide for current prices and more.
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Con: Interest Rate Rally Has Paused
Over the past few months, the yield on the benchmark 10-year Treasury bond has soared. After bottoming out below 1.4% last July, the 10-year yield shot up to 2% immediately after the presidential election in November. Since Donald Trump's victory, the yield accelerated to the upside, topping 2.6%, as stocks became increasingly more attractive than bonds and the Federal Reserve raised short-term interest rates twice in three months.
That's a clean double.
Rising interest rates strongly correlate to rising bank stock prices. Normally, when rates rise, banks are able to jack up rates they charge on new mortgages, commercial loans and other such products. However, the rate paid to depositors normally lags the rate received on borrowers. This leads to a fatter profit margin for the bank.
But since the last Fed rate hike in March, 10-year bonds have started going in the wrong direction for banks. The 10-year Treasury yield has fallen from 2.62% in mid-March to just 2.35% today. (Bond prices and bond yields move in opposite directions.) Bank stocks slumped as yields pulled back. And WFC stock fell in sympathy, shedding 8% of its value since the Fed's last rate move.
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Con: Narrowing Spreads
The reversal in interest rates has kicked off another problem. The all-important 2-10 year spread has narrowed 25 basis points in recent weeks. This spread is the bread and butter of banking profits. As the saying goes, banks borrow short and lend long. Much of a bank's deposits are either demand deposits (checking or savings accounts) or short-dated time deposits. These time deposits include instruments such as certificates of deposit that generally pay low interest rates and are redeemable after a short period of time, such as one or two years.
Banks then take these cheap short-term deposits, and turn them into mortgages and other long-term loans. Generally, banks borrow at something close to the 2-year rate and lend at something, in aggregate, close to the 10-year rate. Over the last month, the 10-year rate (what banks earn) has fallen 25 basis points, but the 2-year basically hasn't changed. That directly strips a quarter of a percent off Wells Fargo's net interest margin. Since Fed rate hikes influences short-term rates the most, any further Fed hikes will drive up the 2-year yield, but may not trigger the same move in the 10-year, further narrowing this key spread.
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Con: Reputational Damage
Wells Fargo has attempted to create a new image. Its old top executive is gone. The board slashed bonuses for the bank's executives. Wells Fargo is gamely talking up a new culture.
But it may take awhile to win back customers' trust. And even if they do, it's worth remembering Wells Fargo was pushing the ethical envelope to earn more money per customer. Now that Wells Fargo is trying to win back its reputation and falls under closer regulatory scrutiny, you can be sure the bank will be less aggressive. This will hurt WFC's ability to get new customers and monetize them as heavily as before. Given big banking's cutthroat culture, there is a good chance some other national banks will benefit from Wells Fargo's impaired position and take a chunk of their consumer banking profits.
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Pro: A Stalwart Performer
Last year's regrettable scandal aside, Wells Fargo stock is one of America's soundest bank stocks. It and U.S. Bancorp (USB) were virtually the only large U.S. banks that didn't face an existential threat during the 2008 financial crisis. And those two are among the small handful whose stocks trade meaningfully higher today than they did in 2007.
While Wells Fargo did cut its dividend during the financial crisis, management quickly restored it. By 2014, WFC stock paid out a higher annual dividend than it had prior to the financial crisis. And though the company's reputation took a hit last year, there is little sign that the company's conservative loan book has lost much ground.
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Pro: Reflation Trade
The last two weeks have dealt President Trump a real setback to his economic agenda. Despite controlling Congress, the Republicans weren't able to push through their health care bill. The market has viewed this as a sign that the Trump stimulus trade is ending. That may be the case, but it's awfully early to conclude that.
WFC stock has sold off 8%, but could quickly head back to the highs. All it would take is for Trump to pick up momentum on some other investor-friendly topic, such as tax cuts. The fact is that the U.S. economy has gained strength in recent quarters. The Federal Reserve will hike rates more later this year. If Trump can deliver on any sort of stimulus, inflation should continue to rise, generating a rise in both interest rates and the all-important 2-10 year spread. If the Trump trade is merely taking a breather, this dip could be a bankable opportunity in WFC stock.
Pro: ATM Innovation
Wells Fargo has pulled ahead of competitors in one interesting way. By the end of this month, all 13,000 Wells Fargo ATMs will be modernized. The updated ATMs will be able to operate simply with a cell phone.
Users can download the Wells Fargo app and have an 8-digit code sent to their phone. Enter that into the ATM, and the customer can access their account. Later this year, Wells Fargo will take it a step further, allowing fund withdrawals simply by waving a phone in front of the machine.
Rivals JPMorgan Chase & Co. (JPM) and Bank of America Corp (BAC) have announced similar rollouts. However, Wells Fargo is first to the finish implementation. There is much more to do in order to win back disaffected customers, but this sort of measure helps.
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And the Verdict
For WFC stock, everything hangs on interest rates. If you believe the Trump trade is merely slumbering, it's a good bet to think Wells Fargo stock will soar past $60 in the coming months (from around $55 today). If interest rates stall out here, however, WFC stock will face choppy conditions for the remainder of the year.
Despite its scandal, Wells Fargo is still one of the stronger too-big-too-fail U.S. banks. And you can hardly go wrong owning it at a discount to other less scandal-tainted big banks. But I'd consider some smaller regional banks before buying any of the mega-cap U.S. money-center players.
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