As earnings season kicks off, we generally agree with most consensus analyst estimates that expect the majority of Super Regional, Regional, and Super Community banks to report strong 4th Quarter results that, in most cases, beat analyst estimates. That’s the good news. Now the bad news: Look to these same banks to deliver dire warnings about 2023 performance and earnings growth.
Source: S&P
While normally these types of earnings increases would create optimism, we expect that the tone of most earning announcements and discussions will focus more on emerging headwinds than historical results. It is likely that most banks will use their earnings calls to set market expectations around lower earnings and identify key challenges related primarily to the overall economic environment.
Pressure on Net Interest Margins
Most banks have benefited from higher interest rates as loan yields have increased and business activity and consumer spending remained strong. Additionally, many banks maintained strong liquidity positions over the last couple of years and did not have to significantly increase funding costs to support robust loan demand. As a result, we expect the banks we cover to report strong 4th Quarter revenue and Net Interest Margins (NIM). It is likely that most banks will expect this to change in 2023 as rate increases slow and recessionary pressures increase. Additionally, we expect both consumers and businesses to continue to draw down deposit balances, requiring banks to, for the first time in a long time, compete more aggressively for stable core deposits.
Source: S&P
Pressure on Credit Quality
Let’s face it, the banking industry has been living off of historically strong credit quality for the last couple of years. When the pandemic hit and the economy went into the toilet for a couple of months, most banks immediately added significant amounts to their loan provisions to guard against widespread loan defaults in both the commercial and consumer markets. Well, as a result of the unprecedented stimulus and recovery programs put in place, those defaults never happened, leaving banks with huge amounts of reserves which weren’t needed. Over the last couple of years banks have been releasing these reserves thereby juicing earnings and, in some cases, masking mediocre performance in core operating areas. This started to change in the latter part of 2022 with a number of banks increasing provisions as a result of higher net charge offs and in anticipation of recessionary pressures over the next few months.
Source: S&P
Pressure on Expenses
As net interest margins increased, loan demand remained strong, and credit quality continued to be pristine, many banks ignored the expense side of the income statement – developing new capabilities, adding to staff, and expanding distribution and market presence. The question outstanding is whether this spending spree will have positive impact on revenue generation and/or productivity and efficiency going forward, or just create more bloated expense structures. This expense growth has also been fueled by inflation and a tight labor market. We expect most banks to identify expense management and reduction as a major focal point going into 2023. Since they can’t control what they see as economic headwinds – rising interest rates, recessionary pressures, business activity, etc. – they will announce expense reduction programs to offset any potential drop in earnings. We would take these pronouncements with a grain of salt. Very few banks have shown a proven ability to actually execute rational and sustainable expense reduction initiatives and would stay away from those banks that are betting 2023 performance in managing expenses more rigorously.
Market Impact
The question is “Will these earnings announcements and warnings have a significant impact on stock prices and performance?” Our answer is “Who Knows”, certainly not us. Conventional wisdom would suggest that reducing earnings expectations and outlook would create significant pressure on equity prices, valuations, and market multiples. Maybe, and that certainly is strongly possible in the short run. However, bank performance is strongly correlated with economic conditions and overall stock market performance. Most of the warnings and negative earnings revisions are based on the possibility of a recession, signaling a slow down in overall economic activity and acceleration of risk associated with a slowing economy. This is based on historical performance during recessions in which banks tend to lead the market down and lag going up. However, it is likely that if a recession does technically occur that it will not be your father’s recession. Let’s face it, we have never experienced a recession where businesses continue to expand, employment remains robust, consumers spend freely, and companies and consumers keep paying their bills. If warnings about a recession are correct, it is possible that it will be a recession in name only, and not create the kind of environment that will have the magnitude of negative impact on bank earnings that are driving management estimates and analyst warnings. If the recession is extremely mild or does not impact business growth, spending and employment, look to banks to exceed their negative EPS guidance.
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