Monday Musings: July 18, 2022

Jul 18, 2022

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Public Trust Credit Team

Corporate earnings season is right around the corner; here is what we are looking for.

It has been an eventful quarter, filled with ample global news and macro developments that have impacted essentially every company in the S&P 500 in one way or another. In Q1, we saw a mixed bag across the corporate sector, with oil & gas posting strong financials due to elevated oil prices and demand, while the retail sector was hit hard by increasing costs from supply chain disruptions. We saw a common theme in retailers as well, as many companies drastically built up their inventory to get ahead of the potential increasing demand and climbing prices for goods worldwide. A strong economic indicator we are looking for in the Q2 numbers are the overall inventory levels; has projected demand by companies come to fruition or is their inventory buildup a result of wishful thinking? Increasing costs have plagued many sectors, so it is important to see how corporate institutions have weathered this storm. Many companies begun implementing cost efficient operational changes, as they realized high costs are more long-term than originally projected. Inflation has been red-hot this quarter as well, so we are looking to see if companies were able to mitigate these risks and maintain healthy margins, a key indicative credit metric. During periods of high inflation, many corporates walk a thin-line in determining how much of the inflation they can pass down to the consumer without dampening their top-line and overall margins. Operating leverage is another major component that will provide much needed color into how well-prepared these companies are in dealing with multiple adverse macro situations. Another non-traditional metric when analyzing companies is total headcount. We have seen many large corporate names in the news forced to execute large layoffs as they continue to face supply constraints, inflation, and lingering high expenses. Declines in headcount across corporates would suggest that the labor market may not be as strong as most observers think it is and that companies have begun bracing for economic headwinds.

What to pay attention to during reporting of European banks’ earnings.

As earnings season begins for European banks, we will be analyzing the impact that the global macroeconomic environment and the banks’ operating decisions have had on the profitability and underlying credit profiles of European financial institutions. Consensus estimates indicate that European banks with a larger reliance on investment banking revenues could be pressured by the lower merger and acquisition deal flows in recent months, but that recent market volatility is likely to have a positive impact on those with a larger reliance on trading revenues. Considering global increases in interest rates to combat rising inflation, the banks’ net interest margins are expected to be better than in the same period in 2021. While banks should benefit from a higher rate environment during periods of economic expansion, concerns persist that higher interest rates and the increasing effects of inflation could result in a recessionary environment and higher credit losses from borrowers being unable to repay loans. The sizing of the banks’ loan loss reserves will be a strong indicator of their views of the global economy over the medium-term and their expectation of any deterioration expected in the credit quality of their borrowers. Finally, the banks’ level of capital will reflect both recent adjustments to offset rising operating and credit costs from the currently high inflationary environment as well as their ability to withstand any longer-term financial pressures.

U.S. Moneycenter bank earnings: asset quality is strong but recession risks are beginning to show.

The largest U.S. banks typically dubbed the “Moneycenters” reported earnings last week and this morning. Results were similar across the banks as the companies dealt with rate increases, market volatility, and stress tests. Profit was down across the group against small increases in total revenue at most banks. Investment banking revenues were down with market volatility leading to a drop in deal volumes and a material drop-off in debt and equity issuance, though the market volatility was positive for trading revenues which surged to help offset some of the declines. Net interest margins (the spread earned on lending versus deposits) increased due to rate increases, but those same increases led to a significant drop in mortgage underwriting over the quarter. Asset quality was flat to improving at most banks; however, this is interesting since every bank took charges related to increasing their buffers against loan losses. This signals that banks are expecting the economic situation to worsen and are preparing for eventual losses but at the moment have not seen those losses materialize.

Before earnings, the banks completed the Fed’s annual Comprehensive Capital Analysis and Review (CCAR) stress tests which showed that most of the banks will need to hold higher levels of capital moving forward. Citigroup and JP Morgan have both announced they will be suspending their buyback programs to raise some capital amid the CCAR results. Overall, the banks remain on solid footing and the largest U.S. banks are well capitalized against an economic downturn. Most executives noted that the outlook for the economy is “more uncertain than ever” but were broadly positive about the health of the consumer. Check back next week to see how our European banking peers fared.

All comments and discussion presented are purely based on opinion and assumptions, not fact. These assumptions may or may not be correct based on foreseen and unforeseen events. The information presented should not be used in making any investment decisions. This material is not a recommendation to buy, sell, implement, or change any securities or investment strategy, function, or process. Any financial and/or investment decision should be made only after considerable research, consideration, and involvement with an experienced professional engaged for the specific purpose. Past performance is not an indication of future performance. Any financial and/or investment decision may incur losses.

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