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US investment banks: Uncertainty around investment bank earnings

FICC and DCM earning boost might not last; JPMorgan report says ROE growth will not come from investment banking.

First-quarter US bank earnings brought little comfort. In spite of improvements in net incomes and capital markets revenues, there remains substantial doubt that financial institutions are on a growth trajectory. Fitch Ratings went so far as to say that the first-quarter earnings levels would be difficult to sustain over the year as a whole, adding: “The first quarter is generally the strongest period, and the industry still faces unpredictability on capital markets revenues and earnings.” Capital markets revenues were very strong at the five largest US universal banks. Although revenues were down 7% on the first quarter of 2012, they were up 36% on the fourth quarter.

Cheap money

In particular FICC and DCM was a booster. JPMorgan, Bank of America Merrill Lynch, Citigroup and Goldman Sachs all reported solid FICC results. As Rafferty Capital Markets analyst Dick Bove says: “There’s a lot of cheap money around, an increase in the money supply, so there is simply more trading.” FICC revenues were up at the largest five banks by 64% on the previous quarter, although they were down on the first quarter of 2012. At Citi, FICC was up 69% to $4.6 billion; at JPMorgan up 50% to $4.7 billion. Goldman Sachs FICC revenues were $3.2 billion, up 58%; Bank of America Merrill Lynch revenues were also $3.2 billion, up 48%.

An April analyst report from JPMorgan predicts that FICC will be the largest contributor to investment banking revenues out as far as 2015, but that the revenue will decline at an annual rate of 3%.

Vibrant debt markets also boosted debt underwriting revenues, which provided more than half of investment banking revenues at the largest five US banks. Goldman Sachs had record debt underwriting revenues of $694 million. The US investment banks look to be the big beneficiaries from the pull-back in corporate lending by European banks both abroad and at home. European corporate clients are instead turning to debt capital markets to raise money and giving the US investment banks a share of the pie.

Fitch Ratings, however, offers a reminder of profound macro concerns. “Global sentiment remains vulnerable in light of economic weakness in Europe; fiscal drag and deficit concerns in the US, and broader global growth worries,” it says. “Any change in the direction of US monetary policy potentially involving a scaling back of Fed bond purchases could have big implications for financial markets and revenue generation for the largest trading banks.”

Other policy moves carry a threat, notably Europe’s directive for a financial transactions taxof 0.1% on bond and equity trades and 0.01% on derivatives. Traders worry about the cascade effect of the tax applying to each underlying leg of a trade, across many participants – vendor, broker, clearing members, clearing system, funds – raising costs and reducing volumes in the process.

Investor doubts

Investors share the uncertainty, in some cases leading them to sell stock. BAML’s stock price fell after it announced higher-than-expected earnings, as did the stock prices of Goldman Sachs and Morgan Stanley.

Goldman Sachs made investors nervous in spite of its 7% increase in net income. Chief financial officer Harvey Schwartz gave little away on the earnings call, and couldn’t be pinned down on the bank’s return on equity targets. He said: “Macro uncertainty continues to be a meaningful consideration for the global marketplace; while the environments were improving, there will clearly be bumps along the way. So, despite an improvement in the outlook, some uncertainty remains. Another uncertainty that has occupied investors’ minds is the potential impact of regulatory reform on our industry.” Investors were also concerned that Goldman’s results might reflect an increase in the amount of risk the investment bank is taking on.

Morgan Stanley investors were nervous about low trading revenues. Morgan Stanley has been scaling back on FICC trading while building on the Smith Barney brokerage platform and fears are that revenues from the latter won’t be enough to compensate for the decrease in trading revenues. FICC revenues were just $1.2 billion – far lower than those of its peers – although that was an increase of 165% on the previous quarter and also an increase on the first quarter of 2012 – an achievement barely any other bank managed. Chief executive James Gorman, however, was more upbeat than most of his counterparts about the future, saying he expected the broader global economic outlook to be stronger over the next few years.

Analysts at JPMorgan are less optimistic about the revenue generation of investment banks. In their April report, analysts say they foresee investment banking revenues will run at levels of 2005 and 2006 and will not be the driver of higher returns on equity. “We estimate IB revenues in 2015E to be 31% below peak levels seen in 2009,” says Kian Abouhossein. The report says that very little has been done in the innovation of new products, and that emerging market investments will not translate into revenues for the next few years.