Bank earnings to spotlight rising interest rates — and costs

Interest rates are on the rise and expected to continue upward, bolstering banks’ lending profitability and providing timely support for earnings.

But the rate lift may not prove enough to offset cost pressures or decreased fee income — or the fading benefit of loan-loss reserve releases.

First-quarter earnings, which roll out in April, will provide the year’s first glimpse of banks’ ability to navigate a landscape that is rapidly evolving amid shifts in Federal Reserve policy and the Russian invasion of Ukraine that amplified already intense inflationary stresses.

Fed policymakers raised their benchmark rate in March and forecast several more hikes this year. They are boosting rates to curb spending and ease inflation, but with this change comes the risk of overreaching and driving the economy into recession. The war adds to this concern, given the risk of Russian aggression spilling beyond Ukraine’s borders and causing greater global economic tumult.

“There are suddenly uncertainties on top of uncertainties,” said Mike Matousek, head trader at U.S. Global Investors. “And we still have the pandemic with us, too.”

Indeed, after coronavirus cases went on the decline in 2021 and early into this year, cases are mounting anew in Western Europe and China, forcing new lockdown measures to slow the spread of the virus. These include strict new mobility rules in Shanghai, China’s largest city, with more than 25 million residents. The challenges abroad remind bankers in the U.S. of the potential for a new outbreak here.

Piper Sandler analysts projected that banks will collectively report 6% linked-quarter loan growth with their first quarter results, reflecting the strength of a growing U.S. economy and pent-up commercial demand for loans to finance expansion projects. With rates exceptionally low until the Fed’s action in mid-March, the analysts predict that banks will report net interest margins remained under pressure in the quarter — flat to down slightly — but they look for improvement as short-term rates rise through 2022 in tandem with Fed hikes.

However, with stock prices struggling in 2022, Piper Sandler predicts lower revenue from wealth management and capital markets. The analysts also expect declines in mortgage fees, given that limited housing supply and soaring prices curbed home-buying activity — while long-term rates, already rising early this year, diminished refinancing demand. In total, they expect fee income to fall 2% from the previous quarter.

What’s more, when making comparisons to prior periods, first-quarter results may suffer because of temporary gains last year. After beefing up reserves to cover potential loan losses in 2020 — fearing a prolonged recession amid the first wave of the pandemic — banks reversed course in 2021. The economy rebounded unexpectedly fast last year, and banks collectively released nearly $60 billion of reserves during the year, bolstering their bottom lines, according to S&P Global. There is little left to release this year, however.

At the same time, the Piper Sandler team notes, costs continue to rise along with inflation that hit a 40-year high in February. The analysts expect first-quarter expenses across the sector to rise 1.5% linked-quarter and 7% year over year.

Bottom line: The analysts project first-quarter earnings per share, across Piper Sandler’s coverage universe, will drop 13% from the prior quarter.

The rest of the year may fare no better.

“Going into 2022, we were thinking of a banner year for banks, given a solid economy and the prospect for measured rate increases,” said Brad Milsaps, a Piper Sandler analyst. “But as we sit here today, there’s the fear of something negative around every corner, and with inflation where it is, we may get a much faster pace of rate increases than we thought.”

Community banking

Rate hikes may not be enough to cure economy's ills, bankers say

Banking executives and analysts worry that the Federal Reserve's aggressive plan to raise interest rates will be insufficient to tame inflation and overcome economic fallout from the war in Ukraine.

Earlier this year, Milsaps and his colleagues anticipated three rate hikes in 2022 — they now expect seven, Milsaps said. While rapidly rising rates are likely to prove bullish for banks’ loan books, they may also present potential headwinds for credit quality, he said.

Wedbush analysts agreed. Over the last 35 years, the Fed engineered five rate-tightening cycles and the U.S. economy went into a recession four of those times, they said. Loan losses tend to pile up when the economy falters.

“Uncertainty has crept into the outlook from the fallout from the Russian invasion into Ukraine, leading to higher inflation pressures and a higher risk of a recession,” the Wedbush analysts said in a report.

Scott Brown, Raymond James’s chief economist, painted a similar picture.

“Of course, the Fed may end up tightening policy less aggressively,” he noted, but that would happen only because the economy is slowing for other reasons. Either way, he said, recession risk is rising.

Nearly across the board, bankers remain optimistic as they prepare to report earnings, according to Milsaps. But should the specter of recession intensify, concerns about threats to credit quality would inevitably mount.

An economic slump “would have knock-on effects everywhere,” Milsaps said.