In this first article of my 2018 outlook series, we'll look at the improving economic conditions and how banks are benefitting in the form of increased lending and profits. We'll also look at how financials are positioned going into 2018.
2017 Was A Great Year For Bank Stocks
JPMorgan Chase & Co. (JPM) put up a solid 24% gain this year while Wells Fargo & Co. (WFC) gained 10% which is impressive given the scandals the bank endured. The Financial Select Sector SPDR ETF (XLF) posted a 20% gain for the year, which is an incredible return for an ETF.
Whether you believe valuations are stretched or whether you believe banks have more room to run higher, 2018's economic fundamentals will play a key role in investors' decisions as to whether to add to positions or take their profits and run.
Reasons 2018 Should Be Great For Banks
The U.S. services sector recorded its highest optimism in 12 years. The ISM Non-Manufacturing Business Survey posted a 59.8% reading, its highest level since August 2005. Also, September marks the 93rd consecutive month of increased economic activity in the non-manufacturing sector.
- Since 70% of the U.S. economy is comprised of the service sector, the report is important since it gives us insight of how business owners view the economy. If CEOs are optimistic about the economic outlook, it should typically lead to increases in capital investment and business expansion. More expansion leads to increases in demand for loans and ultimately leads to rising economic growth. At the very least, the report should add to the solid economic growth story and provide a floor or bottom for bank stocks in the coming months.
Growth In The Economy:
U.S. economic growth was revised higher to 3.2% for Q3 while Q2 was also revised higher to 3.1% by the BEA. This year marks the first year where the U.S. put up two consecutive quarters of 3% GDP growth since 2014.
Q4 growth should come in at a solid 2.8% according to the Federal Reserve Bank of Atlanta's GDPNow model. The number was revised down from 3.3%. However, I believe any growth figure close to 3% is great and should support the view that the U.S. economy is consistently growing at a healthy clip. What the GDPNow forecast also tells me is that the Fed believes the economy will grow which should boost optimism in the economy.
How does GDP growth impact banks?
Below are graphs correlating GDP to loan growth (by quarter) for Bank of America Corporation and JPMorgan Chase.
We can see how loan growth started to decline as economic growth fell from the end of 2016 and into Q1 of this year.
Once economic growth started to pick up again in Q2 and Q3, net loans for both banks began to rise again and post a 1% growth rate for Q3.
The above graphs of JPM and BofA, along with the impressive quarterly growth numbers in the U.S. economy, lead me to believe that as the economy grows, consumers and businesses are likely to borrow more. The result should be an increase in bank lending, loan fees, and ultimately net interest income.
Capital and durable goods spending rose in November by $3B or 1.3% according to the census department's durable goods orders report. November marks three out of the last four months of growth in manufactured goods spending. The all-important shipments of manufactured goods are up in six out of the last seven months.
Durable Goods have grown every month in 2017 except for two as shown in the graph below. I excluded the June and July numbers since June was from a one-time large purchase in aircraft orders which subsequently skewed the July month-to-month growth number, since the aircraft orders were not repeated in July. In short, the June and July numbers net each other out.
CEO optimism is high. Capital spending is on the rise and these outlays for large durable goods are long term in nature. This investment behavior demonstrates that CEOs are bullish on the U.S. economy. For example, CEOs wouldn't commit tens of millions of dollars to plant and equipment purchases if they weren't confident that the economy will be growing over the next year or two.
Banks stand to benefit from the current economic conditions. Consumer banking divisions should get a boost in revenues from the booming economy in the form of credit cards, auto loans, and deposit growth. Commercial lending should also get a lift as businesses expand and require increases in working capital.
Bank profits have been steadily rising over the last few years.
In the table below, I calculated the 2017 profits at $468B by averaging the first three quarters so far. I realize that's not perfect since Q4 profits have yet to be released, but it gives us an idea of how 2017 (so far) stacks up against prior years.
Bank profits are 3% higher versus 2016 and 5% higher versus 2014.
The table above from the BEA. Percentages calculated by Chris B. Murphy.
Remember how the 3% GDP growth in Q3 and Q4 was the first time we had two consecutive quarters of 3% growth since 2014?
And yet, 2017 bank profits are 5% higher than 2014. To me, this shows that the current economic conditions are far more favorable to banks compared to 2014 despite having the same economic growth rate.
Of course, there are a myriad of factors that drive bank profits besides economic growth such as rising yields, the Fed's tighter monetary policy, the taper, business investment, optimism, and the quality of assets on bank balance sheets.
A word on yields:
As I stated at the onset, we didn't cover the rise in yields as a result of the Fed's tighter monetary conditions and how bank profits should benefit in 2018. I'll have more on this topic in my next article because I really want to delve into it. However, I believe it's safe to say that if the economy continues to grow more or less at the same rate, i.e., 2.6%-3.4% on a quarterly basis next year, inflation pressures should mount keeping the Fed on its path for hiking rates.
Whether we get two or three rate hikes, I believe is immaterial to the medium-to-long-term investor since it's the path of rates that drives the markets, yields and ultimately net interest margins for banks. In short, inflation and growth should keep the Fed on track for creating tighter monetary conditions in 2018 and that's great news for bank stocks. More on this topic in my next piece.
As long as bank profits in Q4 remain near the average of this year of $468B, 2017 profits should be the best performing year in four years.
With Q4 economic growth expected to be 2.8% according to the Fed Atlanta, and historic optimism by business CEOs, 2018 is likely to include increases in business investment, capital spending, and ultimately bank profits. Unless growth falls off a cliff, which I don't expect to occur.
Please be careful in Q1, since its notorious for lackluster growth, but that's due to half the country being in winter hibernation, little housing construction, and lower consumer spending typically.
2018 should be a stronger year than 2017. Why? Because we're entering 2018 with far more certainty than Q4 2016. Sure, there was euphoric optimism surrounding the Trump victory and Q4 2016 was a fantastic quarter for bank stocks, but the key word is optimism. This year, we have results. Tax reform has been passed, the capital plans were approved for the majority of banks. The Fed has begun tapering and the world didn't end, economic growth is the strongest in years, while business spending and optimism all favor increased business activity.
The result: Banks should lend more, receive more deposits, buy more outstanding shares, and increase dividends. Also, I believe asset quality of bank balance sheets should continue to be very attractive, allowing banks to grow and take advantage of merger opportunities.
Whether it's consumer banking products like credit cards, personal loans, home loans or business products like commercial loans, working capital lines, and derivatives, banks are in the best position they've been in years to take advantage of the favorable economic conditions. As a result, bank stocks should remain very attractive in 2018, in my opinion.
Obviously, I didn't get into the valuations of bank stocks in this article, but the overall economic conditions support a bump up in bank earnings in 2018.
In my subsequent articles, I'll analyze how the Fed, inflation, and Treasury yields are likely to boost bank profits in 2018 and whether current valuations will be justified. Please become an "email alert" follower (see below) to have the article emailed to you.
Good luck out there. And may 2018 be a prosperous one for you where your stop losses never get triggered and your trade entries always bear fruit.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.