US Q3 bank earnings outlook

While bank stocks have underperformed the broader S&P 500, there are still reasons to expect strong earnings growth.

US flags
Source: Bloomberg

After solid earnings reports over the past few quarters, a note of caution about the outlook for the coming three months does seem justified. Some slowdown in loan growth and a quieter quarter for the trading divisions has been factored in, while higher interest rates and a still-healthy US economy continue to provide a firm foundation for performance.

Earnings season comes as US financial stocks, continue to lag behind the broader market. This does look odd; surely in a growing economy and rising rate environment financial stocks, and banks especially, should be leading the charge higher? The answer can be found in the monthly fund manager survey from Bank of America Merrill Lynch. Here we see that banks remain popular trades relative to the past 17 years of data; it is often the case that ‘popular’ trades underperform the broader market, as the ‘crowd’ is already long and there is little in the way of fresh funds to push prices higher.

Also playing a part are fears of ‘peak profitability’, as investors worry that banks have seen the top of the cycle and that a weaker economy is on its way, hitting earnings. Third quarter (Q3) earnings season could well see banks and other financial institutions seek to downplay this element, or even refute it entirely.

Loan growth continues to lag behind, with estimates of 2.4% growth for the quarter indicating that this weakness is set to continue. Rising rates do help net interest margins, boosting profitability, but they also sap demand for new loans such as mortgages. In addition, US corporate lending has not taken off in the way that had been expected in the wake of the Republican tax cuts of earlier in the year.

Summer is usually a tough quarter for the banks’ trading desks, and this was still the case in 2018. While the first six months of the year were volatile, the usual summer lull set in once more, so investors should expect the contribution to earnings from the trading division to be weaker.

Finally, profitability metrics continue to recover, as return on equity rises to the highest levels since the financial crisis, with return on tangible equity for the biggest banks rising to 14%. Bank stocks have yet to wake up to this fact, as their underperformance in stock price terms testifies, but this long-term fundamental support reinforces the idea that the sector will rise over time, even if its current underperformance does not immediately disappear.

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