In our Insight “Five Reasons We Don’t Own C. JPM, BAC, GS, or MS” (June 14, 2016), we explained why – despite their low valuations – we held no positions in these widely owned banks/brokers. We outlined that we prefer mid-cap banks over the largest banks, for reasons including: (i) earnings headwinds for the larger banks, (ii) higher rate sensitivity for the mid-caps, combined with (iii) lower regulatory risk, and iv) the potential benefits from ongoing sector consolidation. Q2 reporting helped support this overall portfolio positioning.
Second quarter earnings season for U.S. banks has wrapped up, and the four largest banks in the country – i.e., BAC, C, JPM and WFC, often referred to as “universal” banks – continue to face intense earnings headwinds. In fact, operating earnings per share for these banks declined a very large 9% year-over-year (median). By contrast, the small/mid-cap banks increased EPS by 9% for over the same period.
Given the tough interest rate environment, banks are more reliant on fee income to make up the revenue shortfall, but unfortunately this was flat Y/Y for the universals (while up 6% for the small/mid-cap banks). Net interest income growth was also flat for the year, as the median loan growth of 6% was not enough to overcome the 3 bps of margin compression.
Credit quality remains relatively benign for the largest banks. Changes in net charge-offs were flat for the universals and remained at 50 bps, although this is a considerably higher level than for the banking sector as a whole (9 bps). The median ROE for the universals in Q2 was 8.2%, a Y/Y decline of 154 bps, although this was an increase from the very depressed first quarter of 2016.