Repealing Dodd-Frank Won't Be Easy for Trump
As the markets process the aftermath of the US presidential election, financial stocks like Morgan Stanley (NYSE:MS) have rallied on the prospect of a friendlier regulatory environment that could provide a very significant boost to their revenues and profits.
Of course, the rally assumes that the Trump administration's stated goal of dismantling Dodd-Frank will be successful. Indeed, the market is in a weird middle place of excessive optimism regarding what the ultimate impact of the Financial Services Policy Implementation Team's ('FSPI') efforts will be since details are hazy and won't become clear until after President-Elect Trump takes office.
In any case, the early suggestions is that it faces an uphill battle. Prominent members of Congress have declared that they'll fight the Trump administration's efforts to 'gut' Dodd-Frank. Moreover, as this CNBC article points out, the optics of Donald Trump, who ran on a populist platform, making life easier for Wall Street would be highly negative and run counter to his core campaign message.
Dividend and Outlook
These concerns are well-known - Senator Elizabeth Warren came out against Trump's efforts to take apart the Dodd-Frank not long after the election results became clear. Despite these, financial stocks have held onto most of their gains, with the KBW Banking Index still up by 14.3% since Election Day. Morgan Stanley itself is up by 19.3%, suggesting that the markets anticipate that the Trump presidency will boost its prospects even further than the banking sector as a whole.
In the year to Election Day, investors in Morgan Stanley had to contend themselves with a relatively meager return of 6.9%, largely as a result of Morgan Stanley's four straight quarters of exceeding Wall Street earnings estimates. This return was supplemented by Morgan Stanley's fairly pedestrian pre-election dividend yield of 2.35%, which has since slipped to around 2%. Consequently, investors who buy $10,000 worth of Morgan Stanley's shares can expect around $200 in passive income - less than what they can receive from investing in the S&P500.
In short, prior to the election, Morgan Stanley was just a middling stock. Now, it's performing well above the market indices thanks to the notion that a looser regulatory environment will be salutary to profits. How does this work exactly?
Like Goldman Sachs (NYSE:GS) - and unlike more conventional banks such as Bank of America (NYSE:BAC) - Morgan Stanley derives a large portion of its revenues from its investment banking business. In this case, nearly 80% of Morgan Stanley's revenue come from what might be considered risk-taking or investment banking activities, unlike Goldman Sachs, which has been pursuing more traditional banking activities of late and which derives roughly half of its revenues from similar activities. Indeed, even if we strip out Morgan Stanley's Asset Management revenues from the equation, investment banking and trading account for roughly 50% of its revenues - making it similar to Goldman Sachs.
Morgan Stanley, like Goldman Sachs and other entities such as JP Morgan (NYSE:JPM) and Citigroup (NYSE:C) recently petitioned the Federal Reserve for a five-year deferment of the Volcker Rule, the sections of the Dodd-Frank Act that effectively prevents banks from engaging in proprietary trading. This action will be rendered superfluous if Trump's FSPI succeeds in its efforts. Success on this front would essentially preserve 50% of Morgan Stanley's revenue base that it would otherwise have had to wind down in favor of lesser 'market making' activities for its clients.
Moreover, Trump is known to favor a '21st Century' Glass-Steagall Act - a regulation introduced in the 1930's that separated Investment Banking and Commercial Banking. In its most radical form - forcing money center banks like JP Morgan and Bank of America to spin-off their investment banking units - a 21st Century Glass Steagall would benefit Morgan Stanley in two ways: eliminating competition and providing a way to grow through acquisition. To wit, the combined investment banking revenues of both Bank of America and JP Morgan would be about as large as Goldman Sachs and Morgan Stanley.
In short, if things break right for Morgan Stanley as far as the regulatory environment is concerned, it could see 10 to 15% annual revenue growth in the next 3 to 5 years - as opposed to the 3.4% revenue contraction it's witnessed in the last half-decade. In such a paradigm, Morgan Stanley's earnings could rise by 13.9% per annum - meaning that at the end of 5 years, its earnings would have doubled. This performance would also be several magnitudes larger than the 2.93% earnings growth it has registered in the last five years.
Of course, not all is rosy for Morgan Stanley in Trump Land. Trump has proposed a massive $1 trillion infrastructure spending plan that would put upward pressure on interest rates. While higher interest rates boost market volatility and could help Morgan Stanley's trading profits, it would also lead to a decline in its net interest income. As Morgan Stanley's latest 10-Q shows, every 1% rise in interest rates would cause its net interest income to fall by $87 million - while a 2% rise in rates would lead to a $171 million decline (for an earnings dip of about $0.09 per share).
In an ideal world, Morgan Stanley could probably wind down its traditional banking activities and focus on investment banking, thereby taking full advantage of friendlier regulations and higher interest rates - but this is probably not going to be an immediate development and investors should be aware that rising interest rates aren't necessarily the friend of investment banks.
The balance of risks considered, we see Morgan Stanley benefiting from what will likely be a more bank-friendly regulatory environment. That being said, the nearly 20% rally in its shares since the Trump victory does lead us to believe that the stock will pull back sometime soon and we would recommend that investors trim their positions for now - particularly as the backlash against a Dodd-Frank challenge gains steam and Trump's mooted policies gain more scrutiny.
In the next twelve to eighteen months, however, we see Morgan Stanley's shares trading at $50 per share on the back of higher risk-taking associated with a more bank-friendly White House. While this target is considerably higher than the consensus target of $34.50 per share, investors should note that analysts have been slow to revise their estimates and we believe that subsequent revisions will align the consensus closer to our price.
In any case, investors should hold off on buying Morgan Stanley's shares right now and instead use any major pullbacks as an opportunity to buy them with the potential for a big payoff down the road.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MS over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Company financial data is taken from the company’s latest SEC filings unless attributed elsewhere. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.