Shares of Bank of America (NYSE:BAC) are down more than 13% since Brexit. The stock now trades at a forward P/E of 7.6 and just 60% of book value. The uncertainty caused by Brexit will undoubtedly weigh on BAC's businesses but many investors have considered buying at these depressed levels, anticipating a gradual return to higher profits as the Fed normalizes rates. The problem is that the US economy is weaker than many people realize, and after Brexit, BAC will increasingly rely on its Consumer Banking segment to offset weakness in other businesses. Economic weakness at home, not abroad, is the real why reason the Fed won't raise rates. Interest rates will therefore remain low even after fears of Brexit have subsided, and prevent BAC from earning its cost of capital. The low valuation is justified, and the stock could fall farther.
While the EMEA region accounted for just 8% of revenues in 2015, Brexit will have a significant impact on Bank of America. Increased volatility and investor uncertainty will lower trade volumes and the fees BAC generates as a market maker in its Global Markets segment (18% of revenues). In Global Banking (20% of revenues), clients will put off issuing debt and equity or pursuing M&A until some calmness returns to the markets. As businesses delay capital spending, commercial loan demand will take a hit. The fallout from Brexit will also give the Fed the excuse it needed to refrain from hiking interest rates for the remainder of the year, suppressing net interest margin and profitability. The fundamental problem is that rates would have stayed at current levels for the rest of the year even if Brexit did not happen.
The US economy is fundamentally weak, and after Brexit BAC will be forced to lean on its retail-based Consumer Banking segment for growth. But income in this segment has declined over the past three years (Figure 1). In its first quarter Economic and Business Environment review, BAC noted that US consumer spending increased at a slower pace for the second consecutive quarter, but executives were nevertheless optimistic about its consumer-facing operations due to steady job gains. It seems that management and many analysts do not understand that the US economy is in the midst of a real slowdown, if not outright contraction. The low unemployment rate is not a sign of tightness in the labor market but rather low labor force participation. The jobs gains we continue to see do not reflect strong hiring trends because businesses are replacing full-time workers with more part-time workers (which is what employers tend to do on the brink of a recession). Nor do the job gains spell promise for income growth, as most of the payroll additions are occurring in minimum wage service sector jobs. The Fed talked for years about how the economy has recovered, and more recently, how a case could be made for higher rates based on the employment data. But the economy is surviving on credit and low rates, and Yellen knows that if she raises rates the bubble will prick.
Figure 1: Consumer Banking Segment 2013 - 2015:
Brexit gives Janet Yellen the perfect excuse to push back rate hikes. The market has been growing more skeptical in recent months as she talked about a strong recovery but failed to hike rates. Now she can blame international volatility. BAC's management is just as misguided as everyone else, stating in the latest quarterly report that "international concerns remain a key factor in the Fed's resistance to raising rates". The implicit assumption is that once fears about Brexit subside, the Fed will normalize interest rates and BAC's net interest margins will expand. But we expect rates to remain low long after Brexit, suppressing profitability for the foreseeable future. BAC's large discount to book value is therefore justified. A P/B ratio below one implies that a firm does not even generate a normal profit, and is therefore destroying shareholder value by reinvesting earnings.
We do not see a path to higher returns anytime soon. Most people are aware of the impact Brexit will have on BAC's capital markets, commercial banking, and investment banking businesses, but not many seem to realize that US economic weakness will continue to weigh on the Consumer Banking business, and keep net interest margins low for a prolonged period of time.
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