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Banks: 'Main Street, not Wall Street' is under a lot of pressure, strategist says

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Kenneth Leon, CFRA Research, Director of Research, reviews what Big Bank earnings may hold for the economic outlook and the Fed's interest rate hikes.

Video Transcript

[THEME MUSIC]

- Citi posting an upside surprise for the quarter, sparking a rally today in the banking sector. This comes, though, as Wells Fargo fell short of expectations, missing what the Street was hoping to see amid a very tough economic backdrop. Now, for more on this, we want to bring in Ken Leon. He's a director of research at CFRA.

Ken, it's good to see you. Wells Fargo missing similar to what we saw yesterday from JPMorgan. And also, Morgan Stanley Citi seems to be the standout, at least so far of the big banks. Help us make sense of the results that we've seen in this sector so far.

KENNETH LEON: Oh great. Happy Friday to you. So none of these banks were firing on all cylinders. Perhaps the best one by far is Morgan Stanley, but that's a very different business than those that reported today.

I think with Citi, when investors are staring at 40% discount to book value, it's an incredibly undervalued stock one where we're at really record lows-- 52-week lows. And it was just-- any signs of stability or positive was going to move the needle. And that's really what happened today with Citi. It also helped push up the rest of the banks.

You're right about Wells Fargo in that the quality of the results were really not that good. We did see some slowness in the non-interest income. This is all the businesses except what generates net interest income.

So I think overall, if we're going to have a shallow recession, or perhaps a soft landing, banks are cyclical. They're trading at incredible discounts to the S&P 500. And things might be better than the worst case scenario. That's why they're up today.

- Well, regarding, just that, Jane Fraser, Citi chief executive, saying in a conference call, nothing in the data that I see signals that the US is on the cusp of a recession. Do you agree with that now that you've seen the results?

KENNETH LEON: No, I don't agree with that. And each of the banks really did not increase to their credit loan reserves. There are only-- the credit risk committees for these large banks can only book what they see in the period of April to June. If Jamie Dimon thinks there's a hurricane coming in the next 12 months, the credit risk committee can't load up with $5 billion more for potential loan loss reserves. It's just the way that banks work.

But the equity market is forward-looking. We expect total loans to be down in the second half versus the first half. That will be partly offset by higher net interest income. The capital markets, investment banking might bounce off a really terrible second quarter. But that's off of the sugar highs of three years of great investment banking fees.

So no, I disagree with Jane Fraser. And I think we will see the effects of a consumer who is under an enormous amount of pressure. And that will affect in 2023 credit loan losses.

- So then as we look at these earnings through the lens of, obviously, the high that they've been riding on for the last few years, was this just a natural adjustment do you think?

KENNETH LEON: I think it is. I think it is. You hear often, whether it's the equity market-- or sometimes it could be fundamentals, in this case bank fundamentals, you get reversion to the mean. You can't every six months grow 50%.

So we are seeing somewhat of a leveling off. But there are some real concerns because we're in an environment where we're going to be tested because of Main Street. Wall Street will probably bounce back a bit, but Main Street's under a lot of pressure.

For banks like Wells Fargo, which feed off of the consumer and small business, that might be a tough road. We've already seen this with big drops in mortgage and auto loans. And again, nobody is firing on all cylinders.

What we do like is the banks have strong balance sheets. Some of them might take a pause on share repurchases just to meet the Fed's regulated capital buffers. But overall, this is not a replay of 2008 or '09. Banks are in a much better position.

So if we do have a cyclical play here into next year, these bank stocks probably would do well. We have a buy in Citi, a buy in Morgan Stanley, a hold on Wells Fargo. I'm really looking forward to Monday, where we get even better quality companies, like Goldman Sachs and Bank of America, to share their results, and hopefully maybe look out to the second half of this year, because none of these banks really did that in a big way.

- Ken, what are you hoping to hear from-- let's start with Goldman Sachs, because we know that is such a bellwether. Obviously something that the Street is going to be closely watching next week. What are you expecting to see?

KENNETH LEON: Well, we already know that investment banking, equity debt underwriting, and M&A will be down significantly, partly offset by strength in fixed-income commodities and equity. Goldman always finds a way to make money. And sometimes, it could be one of those large one-time gains that kind of smooths out the print, just so the earnings per share look good.

But overall, they are building world-class asset management and consumer and wealth management businesses. They are just incredibly well-managed. And the one thing about Goldman-- and we heard a little bit of this from Morgan Stanley, is they're global banks. But 75% of their revenue is North America. Unfortunately, Europe is going to be a drag on future performance in the next 12 months or so, just because of the impact of the war of Russia into Ukraine.

- And much of this that we've discussed the last two days is backward-looking. But forward-thinking, when you look at the number from JP Morgan yesterday, $428 million write down in terms of future bad loans, and then today, we hear on Citi $1.3 billion for future bad loans. How significant are those numbers regarding what's coming next?

KENNETH LEON: Well, they have those. But you have to look at the mechanics of what they're charging, and then what are they adding to what's called reserve build. So you always want to end up looking at the book of total allowance for credit losses or reserves. And they really didn't move that much.

You know what was amazing? In 2020, with COVID, they went up huge-- several billion dollars. And then all of a sudden, we found, well, COVID wasn't bad when everyone was working from home.

So all of a sudden, you had this cushion. That was a reserve reversal that boosted earnings in '21. And that's why these large bank stocks were up over 30% last year. Will we have that movie again where we see some reserve built for recession, then next year maybe it's not so bad? If you're a CFO of these large banks, that's a pretty good optionality, because one, your reserved if there's recession, and two, if it doesn't happen, can bolster earnings, which helps your valuation.

- Indeed. Well, great getting your insights. Ken Leon, CFRA Research director of research. Thank you so much.