J.P. Morgan's Record High Crowns Bank-Stock Rebound -- Third-Quarter Report

By Telis Demos and David ReillyFeaturesDow Jones Newswires

Interest rates whipsawed bank stocks in the third quarter and are likely to be the dominant force for shares through the end of the year, despite investor optimism around a tax-code overhaul.

The S&P financials closed the quarter at a post-financial-crisis high, bringing their year-to-date rise to about 11%. But that fell short of the S&P 500's gain of 12.5%.

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The performance reflected that banks stocks, after surging in the wake of last November's election, have struggled at times this year to maintain their momentum.

In late August and early September, for example, bank stocks tumbled. That mirrored a drop in the yield of the 10-year Treasury, which fell to 2.04% from 2.39% in July, amid mounting hurricane concerns and rising geopolitical tensions.

As hurricane damage proved to be less than the most-dire projections, the yield reversed course and climbed to 2.33% by the end of the month. Bank stocks rose along with it.

After dropping about 5% between early August and early September, J.P. Morgan Chase & Co. bounced back by nearly 8%. The bank, the biggest in the U.S. by assets and market value, ended the quarter at a record close of $95.51 a share.

The Trump administration's unveiling of a tax-overhaul plan near the end of September gave bank stocks an added fillip.

The tax "proposal is a tailwind for the sector," said Jason Benowitz, senior portfolio manager at Roosevelt Investment Group, a New York-based asset manager with $3 billion under advisement. "The banking sector depends on economic growth, and to the extent we get tax reform that flows through to better growth, that supports the stocks."

Clarity on tax policy could also spur merger activity. "So we could see a pickup in activity that would support the advisory business of the banks," Mr. Benowitz added.

Still, bank stocks remain tethered to interest rates; lending and trading conditions might also prove short-term drags on their performance.

Some analysts have ratcheted back their expectations for banks' growth over the rest of the year. Nomura Instinet said last week that it lowered its third-quarter forecasts for big banks.

Executives at the biggest firms have already signaled that trading revenues for the third quarter are likely to decline from 15% to 20% versus a year earlier.

And Federal Reserve loan data also points toward softening loan growth, particularly in U.S. banks' commercial and industrial lending, which was down 0.1% from the beginning of the quarter through Sept. 20, according to analysts at Jefferies. Several analysts also noted possible dips due to Hurricanes Harvey and Irma.

Analysts also aren't yet giving any credit for the tax proposal, even if it holds the promise of quickly boosting banks' bottom lines.

"Some difficult special interest battles are ahead, suggesting Congress's true timeline for passage is longer than their currently stated goal of passage by year-end," wrote analysts at Morgan Stanley in a note last week.

The result is that banks may be even more dependent on what is happening with interest rates. On that front, bankers expect further, gradual rises, rather than any abrupt upward lurch that could disrupt markets.

"Any sort of planning starts with the environment and...the key word is measured," said Citigroup Inc. Chief Financial Officer John Gerspach, speaking to analysts in September. "It's not that we're talking about crazy increases in interest rates."

Yet plans by the Federal Reserve to begin whittling down its balance sheet have cast uncertainty over how long-term yields will behave. More immediately, short-term yields have risen at a faster pace than long-term ones as the Fed has increased its benchmark rate.

That has led to a flattening of the yield curve, which can weigh on bank profits. Banks typically generate higher profits when there is a bigger difference between short-term rates, which more closely track how much it costs for banks to gather deposits, and long-term rates, which tracks how much banks earn when they lend out money to home buyers or corporations.

The difference, or spread, between yields on the two-year and 10-year Treasurys is one proxy for this. Wells Fargo & Co. Chief Executive Tim Sloan told analysts in September that the rate of the bank's growth in the second half of the year will depend in part on "the level and slope of the yield curve."

Unfortunately for banks, the spread remains low; it was under 1 percentage point throughout the third quarter, although it did tick up a bit toward the end of September. The spread has averaged around 1.5 percentage points over the past five years and last was above 1 percentage point in mid-May.

The upshot is that banks' net interest margins, a key measure of profit, are likely to remain under pressure, especially with banks' holdings of longer-dated debt on the rise. "We believe that exposure to long-dated loans will keep net-interest margin compressed until bond yields rise," analysts at Keefe, Bruyette & Woods wrote in a recent note.

Write to Telis Demos at telis.demos@wsj.com and David Reilly at david.reilly@wsj.com

(END) Dow Jones Newswires

October 01, 2017 07:14 ET (11:14 GMT)