Bonus time for Wall Street, but stagflation concerns remain
Stock markets were a sea of green on Thursday, as European and US stocks surged. The S&P 500 closed up 1.7%, which is the largest single day gain since March. Sentiment was boosted by some stellar bank earnings after Citi and Bank of America posted results that were better than expected. As I mentioned in my previous report on US Q3 bank earnings, deal-making bolstered revenues at Wall Street giants, with Morgan Stanley and JP Morgan posting investment bank revenues that were 67% and 52% higher than a year ago, while Bank of America saw investment banking fees jump 23% to over $2bn, which helped to fuel double digit earnings growth. This news bodes well for Goldman Sachs’ results that are due on Friday.
Digging into the detail
Overall, advisory revenues have helped to protect banks’ earnings from a dip in trading revenue, as markets have been less volatile than they were in 2020. As a whole, investment bank advisory fees have jumped 39%, which is helping to make up the shortfall from trading revenue, which has fallen 4% over the same time period. Ahead of earnings season, some analysts were concerned about fixed income trading, with some expecting FI revenues to fall 20% in Q3 compared with a year earlier. However, these estimates were some way off the mark, with Citi and Morgan Stanley reporting a 16% drop in FI trading fees, while BoA’s earnings had declined less than 1%. This helped to drive even more interest in banking shares on Thursday, with JP Morgan rising 1.5%, Morgan Stanley up nearly 2.5%, Citi up 0.7% and Bank of America making a big comeback, jumping more than 4% and rising to its highest level since 2007.
The good times could last for the banks
The good news for banking sector bulls is that gains in fee income are likely to continue in Q4, after a report from KPMG earlier this week said that deal-making could rise to $6 trillion this year, which would be a record, on the back of cheap financing and the ongoing post pandemic economic recovery. Added to that, volatility has picked up at the start of Q4, which could also boost other revenue streams for the banks. Thus, expect a flurry of earnings upgrades for the banks full-year results in the coming weeks, which may keep US banking stocks buoyant in the short to medium term.
Stagflation: what are the risks and how to trade it
A positive outlook on the banks fits into a major theme for financial markets right now: stagflation. Based on the 10.3mn results that come up on Google if you type in stagflation, there is a huge amount of concern about stagnant or slowing growth at the same time as inflation is rising across the globe. US data on Thursday has helped to ease some fears about stagflation. It is also worth being clear: we do not believe that we are in a stagflation environment – growth levels are rising in major markets – and inflation, although high relative to the recent past, is not running nearly as hot as it did in the 1970s, the last time there was a period of stagflation for the major economies. US data on Thursday eased inflation fears a touch, producer prices moderated slightly for September, with the annual headline figure moderating to 8.6% from 8.7%, while the core rate of producer prices fell to 6.8% from 7.1% in September. So, while there is undoubtedly inflation in the pipeline, at least it is not increasing. Added to this, initial jobless claims fell last week to 293k down from 319k the previous week, which suggests that job creation in tew US could bounce back for October. This data does not suggest that we are in a stagflation environment.
Today’s focus on stagflation is to help traders to prepare for a potential stagflation environment, even if we think that there is a low risk of that happening. In this environment, many asset classes do not perform well. For example:
Bonds: they tend to fall sharply as bond yields rise/ prices fall on the back of rising inflation and the prospect of higher interest rates. You tend to see a global synchronised rate hiking cycle when inflation is rising broadly, thus there are no places to hide for bond investors in an environment of stagflation.
Tech: growth companies without a track record of decent profit growth, who are generally untested in tricky economic environments, and that rely on current interest rates to discount future cash flows on which to base equity market valuations are also likely to perform badly in a stagflation environment. We think that some of the big tech names could continue to do well, for example Netflix and Apple, whose products have fairly sticky demand profiles. However, Amazon might be an outlier, as people could cut back their spending on needless items online.
Those sectors that could do well include:
1) Consumer staples: Anything with a sticky demand profile should be able to weather the stagflation storm better than their peers. Thus, supermarkets and healthcare companies are ones to watch.
2) Banks: rising interest rates are good news for banks as it means that they can generate higher loan income. We didn’t see significant loan growth from the larger US retail banks in their Q3 results, however, the strong housing market does bode well for interest income growth in the coming quarters for US banks. Added to this, the continued boom in global deal making should mean that investment bank fees continue to be an important stream of income for banks in the coming quarters.
3) Luxury goods: In the current environment, where inflation is rising but economic growth is strong, and the global savings rate has risen, then luxury goods can thrive. The fearmongering in the press is not putting people off treating themselves to designer goods. LVMH’s stock price jumped more than 2% on Thursday after posting 46% growth compared to 2020. After a weak performance in the summer due to the crackdown on conspicuous consumption in China, LVMH’s results suggest that this has not had an impact on its bottom line. We would expect it to do well in a stagflation environment, due to the sticky demand profile of luxury goods combined with a strong savings rate in western economies.
4) Energy: if commodity prices continue to rise then expect the energy and materials sectors to outperform.
As you can see, there are many risks when trading in a stagflation environment, however, there are some harbours from the storm. Good luck trading!