Bank earnings preview: Analyst details ‘perfect storm’ for strong Q4 execution

CFRA Research Director Kenneth Leon joins Yahoo Finance Live to discuss upcoming bank earnings and the outlook for the U.S. economy.

Video Transcript

- Welcome back. Big banks kick off earnings season tomorrow-- JPMorgan, Chase, Citigroup, and Wells Fargo. Leading things off here with a preview of what we can expect is Ken Leon, research director at CFRA Research. Ken, thanks so much for being here. So what do we see tomorrow, another round of record profits helped along by IB, lower than expected loan losses? How long does that story continue?

KENNETH LEON: Well, this time might be different. So for investors first in the big picture, cyclical stocks might outperform growth. And banks certainly are cyclical. And they also have the added boost from a rising rate scenario expected from the Fed over the next two years.

We would call it a perfect storm for really strong execution and performance. The consumer is back. And also, when you look at the mechanics into what drives higher revenue, which is net interest income, it's about 55% to 65% of total revenue. Rising rates and increased loan volume gives them a great opportunity.

And if you get into the weeds as an analyst, we're at a 10-year low in terms of total loans to total deposit ratio. That means simply that banks have huge dry powder to unleash increased loans for consumer or for commercial and get wider spreads than they could have in the last few years.

- And Leon, I guess the question is, will the demand for those loans be there in an environment where we're pretty sure interest rates are going to be moving up? I mean, Goldman Sachs now saying that they expect four interest rate hikes this year alone from the Federal Reserve-- so if you're looking at it from that lens, which banks do you think stand to benefit the most in a higher interest rate environment?

KENNETH LEON: Well, let me first set the stage here-- is if you have rising rates in a strong or growing economy, that's a positive. It's not a negative. And for the largest banks that have a high ratio of net interest income and are definitely going to outrun some of the peers-- would most certainly be Bank of America and Wells Fargo.

- And, you know, I wonder-- we've seen a lot of volatility in markets since the beginning of the year. So a lot of the froth-- some of the liquidity has been taken out. How does that affect bank valuations, do you think?

KENNETH LEON: So banks are really total return vehicles. They're over-capitalized. We're going to see significant buyback and dividend increases.

You know, when you think about liquidity, it's more of what feeds into the economy and demand-- loan demand. So if you did see a worst-case scenario of the Fed trimming its $9 trillion balance sheet down below $4 trillion in one to two years, that means the economy will shrink. There will be greater risk to recession. We don't see that, absolutely not. I think the balance sheet of the Fed will decline. But the market is awash with liquidity.

- What do you think we're going to see in terms of that net interest income, which we know is an important number? It's the profit that the banks make on loans and securities after covering the cost of funding. So I know that there was just a marginal rise in net interest income, Q3 versus Q2. What are your expectations for Q4 and then going forward?

KENNETH LEON: So there's really two parts of it. A is the rate. B is the volume. On the right side, we're going to begin to see wider interest earning spreads, which means their yield on an asset versus the liability of what they borrow will be wider. But then what we haven't seen in most of 2021-- we'll get a glimpse of that in the fourth quarter-- is increased loan activity, particularly from the consumer because they have spent down their personal savings rate back to a normalized rate. So those consumer loan balances are going to be increasing for credit card and other-- and personal loans.

Look ahead to a growing economic recovery in 2022. Loan activity from small business or even corporates that still need funding for capital investment-- that will increase commercial loans.

- Now, Ken, what are the biggest risks to big banks' stock performance?

KENNETH LEON: I love the question because everything is going well. It, surprisingly, wouldn't be credit risk or where there's industries that could be a big negative. What we see is the risk is really federal policy and regulation.

The Biden administration and many of the staff of Senator Elizabeth Warren are really seated at the FDIC. We may also see Sarah Raskin nominated by President Biden to be the vise chair of regulation and supervision at the Fed.

So there's a little bit more tilt to a more progressive view, more, maybe, total pro-consumer, possibly the scenarios. You just don't see M&A of banks above $100 billion in assets, no. But that's the one to watch. And I think that's the risk.

- OK. Well, we will wait and see what happens tomorrow. Thank you so much, Ken Leon, research director at CFRA Research, for your time and for stopping in today.