We are now getting the first data points which will inform the increasing disconnect between a rebound in shares and the freefall in the real economy. And, after yesterday’s rally in share prices, we are seeing a risk-off tone to the market today, on the back of a freefall in WTI oil prices below $20 a barrel.
I want to get back to oil later. But, bank earnings reports are coming in and the numbers are relatively dismal. I think that’s where we can focus, since the financial sector is key in keeping real economy distress contagion in check. Some thoughts below
Bank vulnerabilities
I am looking to talk to Chris Whalen about all of this for Real Vision later this week or early next week because he is a banking analyst with deep knowledge. But, without getting his view, let me give you the list of issues I am looking at for banks:
- Percentage of revenue from international customers
- Percentage of revenue from consumer businesses like mortgages and credit cards vs trading and investment banking
- Leverage to specific corporate sectors like airlines, energy, retail, commercial real estate
Overall, let’s remember that these numbers from the banks only show the coronavirus impact from March plus loan loss provisioning for the future. The second quarter numbers are where we will see the coronavirus-related losses mount. And, I noted that neither JPMorgan Chase nor Wells Fargo gave earnings guidance yesterday. That tells you how uncertain these numbers are.
Also, banks tend to under-provision for loan losses during up-cycles. So I expect that we are going to see massive hits to capital going forward as this under-provisioning is made clear in a historic economic downturn.
The large banks and the legacy investment banks, Goldman Sachs and Morgan Stanley, are the most international. Wells Fargo is the least international, followed by Bank of America. I believe a lack of revenue diversity presents downside risk, first for the regional banks and then for the less international two large banks.
The concentration of revenue in consumer businesses may also be an Achilles heel for the regionals and BofA and Wells Fargo. Given the huge uptick in unemployment and consumer distress, this business will get hammered. When JPMorgan Chase reported yesterday, its results were helped by its capital markets revenue. And I expect that to remain the case going forward to the degree they are not negatively impacted by proprietary trading positions in this post-Dodd Frank world.
You should expect the legacy investment banks Goldman Sachs and Morgan Stanley followed then by the too big to fail banks — Citigroup, Bank of America, Wells Fargo and JPMorgan Chase — to be less sensitive to consumer businesses than regional banks.
Finally, I don’t know these banks well enough to know which ones are most leveraged to the industry sectors like energy and the airline sector that at most risk in this downturn. I saw overnight that JCPenney is going to file for bankruptcy. They were downgraded deeper into junk to Caa3 by Moody’s.
Expect other retailers to follow. And its not just the asset managers with these bonds in their portfolio who will lose here, banks with credit lines and loans to these companies will lose too. Also remember that, in the last downturn, seemingly healthy but over-leveraged retailers like Linens ‘n Things went into liquidation. That’s going to happen again, particularly for Private Equity-backed companies, which will hit banks via the leveraged loan market too.
Bank earnings
Here are a few tidbits from the earnings I have sen
- JPM had credit writedowns that mostly on the consumer side. Does that mean that this is where the vulnerabilities are?
- For me, the missing link here is commercial real estate. Big losses are coming there in addition to the consumer business
- Goldman came in at $3.11 per share just now and did really well on the capital markets side. It definitely highlights how these IBs and larger banks are more insulated from where the locus of weakness is right now
- Even Bank of America showed a big gain from capital markets, highlighting why regionals are more exposed. CNBC says “fixed income traders produced $2.7 billion in revenue, about $200 million more than expected and equities traders generated $1.7 billion in revenue, about $300 million more than expected. “
- Citigroup is the most leveraged to net interest income of the big banks. I expect this to be a weakness for them.
- On the consumer side, credit cards are going to see writedowns, yes. Bit margins there are high. I suspect this will be a win for big banks relative to regionals.
- Mortgage originations will be something to watch in the second quarter. We have sen a big uptick in mortgage delinquencies and people are in lockdown. How well can mortgage businesses do in that environment?
- Regionals more sensitive to consumer business, and they don’t have capital markets and credit cards to save them. Regionals are also going to be more leveraged to smaller businesses. I think seeing their earnings reports will be key to understanding how overly optimistic share prices are now relative to the real economy.
- In terms of earnings, here are some thoughts. Banks have suspended buybacks, with dividends a big question. Costs compliance issues at Wells Fargo will mean their cost basis remains higher because they have been a bad actor. The big banks in general were bad actors in the last crisis. That means they can’t layoff workers in my view. So costs will be a question for them.
Oil, the energy sector and risk-off
So, that’s my data dump on the banks. As I wrote this the IEA came out saying they expect a 9% decline in oil demand in 2020, meaning a demand drop of 9.3 million barrels in 2020.
Oil prices are getting crushed as a result. Even yesterday, we saw heavy selling pressure, with WTI trading at a massive discount to Brent because of the land-locked nature of delivery to Cushing, Oklahoma. WTI was trading under $20 a barrel the last I saw. It is even worse for Canadian crude, which I saw trading under $3 a barrel yesterday.
I mentioned yesterday that perhaps 39% of oil firms going bust in the next year according to a survey by the Kanas City Fed. But this was given a $30 a barrel level for oil. We are now at $20 a barrel. If this lasts for any length of time, we are going to see an absolute tidal wave of energy sector defaults, bankruptcies and liquidations. It will be dire. This will hurt the financial sector in a very big way, both via energy (high yield) bonds bank (leveraged) loans.
My view
In conjunction with the fall in Treasury yields, this is telling me the real economy is doing very poorly and that the momentum in share prices is purely a garden-variety bear market retracement. Yesterday, we got to a 50% retracement level, which is standard. Could we make it to the next stop 62%? Yes, but I think the earnings season is going to provide a negative headwind and move us from a market dominated by hope to one more subject to fear.
In terms of fixed income, rates are down to 0.68% on the 10-year Treasury. When we get a sustained risk-off move, expect those yields to fall further as the curve flattens and the convergence to zero reasserts itself. The bond bull market is not over.
Gold is rallying to well over $1700 on the back of a prospect for sustained negative real rates. But this assumes that inflation will not turn to deflation. I don;’t have a strong view here. But, if this downturn is a depression, we will get deflation, and likely before 2020 is over. The prices for oil and industrial commodities are canaries in the coal mine there.
Overall, I would say I still hold out some hope that this is just a deep recession and not a depression. If so, then we likely have to see more fiscal stimulus and soon. Here’s why.
I looked at my bank account this morning and saw that I got my stimulus check today. That feels good. But I am not going to spend the money. It will remain in my account until further notice. For those of us who still have jobs that’s mostly how it will be. And so, the ‘stimulus checks’ are not going to goose GDP growth. They will simply fill a demand gap from deprivation and forestall the economy from falling into a Depression.
What happens next is the key. Once lockdowns are over and life resumes some sense of normalcy (in the summer I suspect), we will have to see how much of that initial stimulus is available for spending and what consumer behavior is at that point. My fear is that consumer behavior has been altered for a long while. And so, tax cuts will have little stimulative impact. Government will need to spend. But to do so requires planning and there’s a lead time there. The interim before that occurs will be very dicey indeed.
I wish I could end on a more positive note. But, we really have huge problems ahead. Consumers are not spending now because we’re in lockdown. They won’t spend at prior levels for months to come in my view, even if we return to some sense of normalcy. And stimulus checks aka tax cuts won’t change that. Only a boost from government spending will fill that gap. And that’s not going to happen anytime soon.