Earnings season is underway, and we heard from some of the largest U.S. banks this week. The reporting confirms what we already knew: There is no V-shaped recovery whatsoever, and the Federal Reserve is doing a lot for Wall Street (though not Main Street).
Among the four banks we heard from — Goldman Sachs, JPMorgan Chase, Citigroup, and Wells Fargo — performance ranged from excellent to terrible, and the deciding factor was trading-desk activity.
That is to say, if the bank had an active trading desk and a culture where bank trading plays a dominant role, the results were great. This describes Goldman Sachs.
At the other end of the spectrum, if the bank had no meaningful trading-desk activity, and mainly had to go by commercial banking results and the need to provision for loan losses, the results were terrible. This describes Wells Fargo.
The driving factor on the trading-desk side was liquidity and market support from the Federal Reserve. Goldman Sachs, J.P. Morgan, and Citigroup all saw large-scale revenue and profit gains from trading desk-activity because of Federal Reserve largesse.
The trading desk of a bank does not “trade” in the way most people assume the term is used. Instead, a bank trading desk primarily engages in market-making activity, facilitating transactions in stocks and bonds (and sometimes currencies and derivatives) for the bank’s client base.
In order to transact in stocks and bonds for clients, the bank will hold an inventory of stocks and bonds on its books, in order to have supply on hand as it fills customer orders. The bank will also take the “spread” — the difference between the quoted price and ask price — when selling stocks or bonds for one bank client and buying them for another.
This activity is a “middleman” type business that can range from modestly profitable to fantastically profitable, depending on what markets are doing. If stocks and bonds are rising sharply in value during the period, the profits of the trading desk go up, too, because the bank is seeing mark-to-market price appreciation gains on the inventory it is holding.
And if stock and bond prices are rising in a volatile manner, that is even better, because the trading desk can use volatility as justification for taking a wider spread in client transactions (which basically means a larger cut of profit per transaction).
Goldman Sachs, in particular, had its best trading quarter in years, earning $2.42 billion in profit on $3.5 billion in revenue. These numbers significantly beat analyst estimates, and they were due to a surge in trading-desk revenue. Goldman’s equity trading revenue for the quarter was up 46% year-on-year, and its bond trading revenue was up a whopping 150%.
JPMorgan Chase also managed to save the quarter with outsized trading-desk profits. JPMorgan’s bond trading revenue was up 100% year-on-year, while equity trading revenue rose 30%. In absolute dollar terms, JPMorgan’s trading-desk activity generated a whopping $9.7 billion.
Citigroup came in third place, behind Goldman and JPMorgan, but still managed to beat revenue and profit expectations solely because of trading activity.
Again, though, most of this trading-related windfall was due to Federal Reserve support of the credit markets — including direct support of the corporate bond market — and the fact that the U.S. stock market all but levitated straight up in the second quarter.
That rosy scenario is not likely to repeat in the coming quarter, which is why the share prices of the various banks didn’t see much of a pop. (Goldman’s share price gapped open higher on Wednesday, but gave back much of the gain.)
Then, too, when the discussion shifts from Fed-supported trading-desk activity to commercial lending activity, the picture starts to look grim.
If you take away trading-desk gains, the banks look awful, and that is because the U.S. economy looks awful. That explains why Wells Fargo was the ugly duckling of the group, posting its first quarterly loss since 2008.
Wells Fargo does not have a robust trading-desk business in the manner of Goldman, JPMorgan, or Citi. Due to that unfortunate lack, Wells Fargo had no place to hide from the terrible state of the U.S. economy.
Wells Fargo had to set aside $9.5 billion for loan loss provisions, an amount $4 billion larger than Wall Street analysts had expected. This loan loss set-aside contributed to a $2.4 billion loss for the quarter, and also led Wells Fargo to slash its dividend by more than 80%, from 51 cents a share down to 10 cents.
Nor was it just Wells Fargo who took a big loan loss provision. Wells Fargo, JPMorgan, and Citi collectively set aside a whopping $28 billion for anticipated loan losses in the upcoming quarter.
As a result of strict accounting rules, banks are obligated to set aside funds for a rainy day when the loan outlook is bad. If a bank expects a wave of customer loan defaults to hit in a coming quarter, the loan loss provision is like an advance cushion to cover it.
In terms of estimating what kind of loss hit could be coming, banks have deep visibility into the state of the U.S. economy. That is because banks make many types of loans — commercial loans, consumer credit cards, auto loans, student loans, mortgages, and so on — and maintain real-time data on the payment status of all the loan assets they have.
What the banks are telling us now, straight up and point blank, is that the U.S. economy is in absolutely terrible shape, and that the worst by far is still yet to come. They said it with the size of their coming quarter loan loss provisions — $28 billion is eye-bulging — and they also said it directly.
“I don’t think anybody should leave any bank earnings call this quarter simply feeling like the worst is absolutely behind us and it’s a rosy path ahead,” said Citigroup CEO Michal Corbat. “We don’t want people leaving the call simply thinking the world is a great place and it’s a V-shaped recovery.”
The pain of a broken and battered U.S. economy has not hit yet, in part, because of the major short-term impacts of monetary and fiscal stimulus.
As mentioned, the Federal Reserve provided heavy-duty credit market support, even as the U.S. government also sent out trillions’ worth of emergency loans, stimulus checks, and unemployment top-ups. These efforts are like morphine for a hospital patient: They numb the pain here and now, but the effect wears off at some point.
“This is not a normal recession. The recessionary part of this you’re going to see down the road,” said JPMorgan Chase CEO Jamie Dimon. “You will see the effect of this recession. You’re just not going to see it right away because of all the stimulus.”
On its earnings call, JPMorgan also said it expects the U.S. unemployment rate to stay in double digits (at 10% or above) for all of 2020, falling to 7.7% by the end of 2021. That is a very grim outlook.
Keep in mind that, during the 2008 financial crisis, 10% unemployment was the worst that it got, the high point of the unemployment rate.
Here and now, in 2020, JPMorgan thinks 10% will not be a ceiling, but a floor. And with that gloomy estimate, JPMorgan almost certainly did not calculate the impact of new COVID-related shutdowns in multiple states when putting together its unemployment forecast.
When the present reality of the virus is factored in — with California rolling back the reopening, Arizona, Texas, and Florida heading into a state of COVID-19 emergency, and other states on the brink — it is almost certain that 10% unemployment for the rest of 2020 is optimistic, not pessimistic.
Nor do we know what kind of “fiscal cliff” is coming as topped-up unemployment benefits run out at the end of July and rent forbearance grace periods expire. Washington seems amenable to another round of emergency stimulus, but not without bickering — which means we don’t know how much or when.
All told, the quarterly earnings results of Goldman, JPMorgan, Citigroup, and Wells Fargo confirm what we knew. The Federal Reserve is doing an incredible amount to help Wall Street — and succeeding in that area, insofar as their activity helped save the quarter for multiple banks.
But the Fed’s liquidity tsunami is not doing much at all for Main Street, and the road to a U.S. economic recovery looks grim and drawn out no matter what — even if new COVID-19 infections are kept under control, and right now that is a very big “if.”
As we have argued repeatedly in these pages, the V-shaped recovery outlook and the “back to normal” are pure wishful thinking, more rooted in fantasy than reality. This is not a bullish backdrop for markets overall, or the general corporate earnings outlook.
It is a very bullish state of affairs, however, for areas of the market that will benefit from the fiscal and monetary authorities doubling down frantically on their last-ditch efforts to keep the economy propped up, even as the U.S. economy goes into stall mode.
As such fiscal and monetary rescue activities contribute further to exploding deficits, an exploding Federal Reserve balance sheet, and a deteriorating U.S. dollar outlook, investors will be more and more drawn to places of shelter in the presence of ongoing fiat debasement.