US bank profit warnings on lower interest rates

Thursday, 18th July 2019 10:30 - by Shant

And so the markets continue to twist and turn themselves into a corner!  After another set of healthy earnings results from US banks, key players have been quick to refer to the impact (on banking) of the impending rate cuts the Fed is set on delivering over coming months - 25 basis points fully priced in at the end of the month.  This has been a recurring theme for some time now, but more banks are becoming fearful that of a low interest rate environment will impinge on profitability going forward.  The mathematics of this dynamic is simple enough, but one which is set to plague stock and bond markets alike, as the dynamics between the asset classes continue to battle it out, not only for best reflection of the economy today, but also positioning into what could potentially be the top of the rate cycle in the US.  That we have seen US stocks outperform on the basis that the worlds leading economy is doing likewise compared to the rest of the pack is indisputable at this stage, but there are now headwinds on the horizon.  

This week, we heard Bank of America warning of a severe hit to net interest income if the Fed cuts rates by 50bps this year, while JPMorgan is looking at a total of 75bps for 2019 which will have an even deeper impact on earnings going forward.  So while the broader narrative that cheaper money is positive for stock markets in general, not all sectors will benefit from lower rates.  But this is perhaps the tip of the iceberg - the first derivative if you like.  

However, at this point, it is worth looking at things in perspective, and one only needs to look to Europe and Japan where rates are and have been negative for some time now.  Despite outside warnings that domestic banks will suffer accordingly, the respective central banks seem unconcerned over bank profitability, with the ECB president Mario Draghi consistently having to reassure markets that this remains the case.  With Italian banks still nursing toxic assets and the likes of Deutsche bank proceeding in ever-decreasing circles, such optimism is hard to share at present.  Even so, it deserves recognition in light of the fears rising in the US. 

So this brings us to the next point - lending.  Irrespective of tightening spreads, lending volumes will have to compensate for decreasing margins in the current environment and looking at Q1, US banks have reported strong demand for loans up until now.  However, when we look at some of the underlying concerns by the Fed - which have led then to pivot towards some near term easing, there are ominous signs.  Business investment has been sluggish and the Fed has cited this as one of the main reasons that they are considering an 'insurance' cut as a result.   

Over the near term, the US consumer looks to have maintained its resilience which should prop up Q2 GDP, though forecasts have been moderated inside the 1-2% range.   As we saw on Tuesday, retail sales grew a little more than expected in Jun to round off a healthy quarter, but the forward looking PMIs will continue to paint a picture which warrants a more cautious approach.  In the UK this morning, we also saw the consumer showing a strong front, but here also, business investment is at a near standsill - for obvious reasons.  So the point here is that while some of the headline economic data may show strength on the face of it, developments below the surface may warrant a little more attention.  It has certainly caught the attention of the Fed - despite the fact that mainstream pundits are calling the latest pivot yet another bow to pressure from the White House.  There may well be more to it than that, so for once, we may have to start looking past the obvious positives of lower rates, and what they actually mean - and practically do at this stage in the business cycle. 

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.