27 March 2023 Equities | US

Earnings Outlook: Bank Tensions Set to Persist

Summary

It was another rough week for banks, but the broader equity markets managed to rally on rate cut hopes and mostly solid earnings.
Banks remain under pressure because markets believe there are other problem banks. Meanwhile regulators offer assurances that the broader financial system is ‘sound’; while issuing conflicting guidance on the status of deposit insurance.
Tensions may persist into next week, but they will be resolved eventually. We suggest adding to positions in major banks, such as JP Morgan Chase (JPM) and Citigroup (C).
Only 14 companies report this week. One of them is Micron Technologies, which first sounded the alarm about rising chip inventories and collapsing demand for consumer electronics. Does it see that trend reversing?

What We Learned Last Week

The broader equity markets rallied last week on hopes that the Federal Reserve (Fed) will soon implement rate cuts to offset possible economic impact from a further tightening of bank credit. It was an up and down week, but the S&P 500 (SPX) was up 1.4% and pushing 4000, while the NASDAQ 100 (NDX) gained 2%. The small-stock Russell 2000 (RTY), which would be harder hit by tighter bank credit, was little changed.

Meanwhile, banks did not participate in the rally, with S&P banks falling 1.1% (Chart 1), and down 28% since 6 March. We might have thought the worst is over for banks after the Silicon Valley Bank failure, but no such luck. Even with a substantial $30 billion inflow of deposits from 11 major banks, First Republic Bank (FRC) stock fell by half to $12.36 as investors posted a vote of no confidence and await further action by regulators. Other major banks continue to trade near March lows.

Banking Crisis Is Still Live

In short, this banking crisis is not over. There remains a perception (as highlighted by FRC) that there are other problematic banks that must be addressed, as well as potential problems with commercial mortgages. Regulators to date seem to be trying to whitewash these problems, with broad statements about how the financial system is sound. And there is the ongoing imbroglio over the status of deposit insurance, with regulators seeming to both say the insurance ceiling will not be raised while offering assurances that deposits are safe. There are also continued tensions in Europe, with Deutsche Bank coming under investor scrutiny.

Buy Major Banks

We believe the selloff in the broad bank sector is overdone. We understand that tighter regulation may be coming, and tighter credit standards will hurt bank earnings. But it seems unlikely that earnings will be hit to the extent bank equities have been. Or, if banks do sustain that kind of hit, there will be plenty of collateral damage in the broader equity sector.

As problems are addressed and tensions ease, we expect banks – especially major banks – will outperform the SPX. We recommend adding to positions in JP Morgan Chase (JPM) and Citigroup (C).

Broader Equities Are Optimistic

The banking sector has had little discernible impact on the broader market, partly because it is small, amounting to less than 4% of the S&P 500 by market capitalisation.

A second reason is that equity markets are becoming increasingly confident about a soft landing scenario. They increasingly assume rate cuts are a given, to offset the banking crisis. And earnings remain mostly solid, and many companies are affirming or lifting previous outlooks. We think they are responding to the easing of supply chain problems and overstocked inventories, that were a drag on earnings in 2H 2022.

We suspect companies are overoptimistic on both counts – we think the Fed is unlikely to cut rates unless inflation drops significantly; and that they are focused on the easing of last year’s problems rather than focusing on emerging challenges.

But that is a topic for another week.

The Week Ahead

It is another light week for earnings, with only 14 companies in our Russell 1000 universe reporting. But there are several notable reports in the pipeline.

Monday

Carnival Corporation (CCL) will tell us how demand is shaping up for cruise vacations.

Tuesday

Micron Technology (MU) was the first tech company to sound the alarm about a collapsing demand for consumer electronics last summer. It has since struggled to get memory chip inventories under control. Even if they finally are, the big question will be whether it is because they simply stopped making them or because consumer demand is finally picking up.
Will Lululemon Athletica (LULU) follow Nike by reporting improving inventories and solid demand for sporty wear?
With employment high, Walgreen Boots (WBA) will likely report solid front store sales.

Wednesday

Are small and medium sized companies that rely on Paychex Inc (PAYX) for human resources and accounting software solutions in a investing or retrenching mood as Q2 2023 begins?