If cracks are forming in the US economy, banks didn’t get the memo

If a recession is brewing in the United States economy, it will come as a surprise to the nation’s largest banks.

Big banks are hauling in fat profits, driven not by the ebbs and flows of fickle financial markets, but by strength in the real economy. Specifically, they’re cashing in on steady growth in spending and borrowing from American households — the main driver of the US economy.

During the second quarter, Bank of America (BAC) and JPMorgan Chase (JPM), the two leaders of the US banking industry, each made more money than ever before. Even scandal-ridden Wells Fargo was able to grow its customer deposits.

Banks, which are at the front line of the economy and talk to business clients every day, struck an optimistic tone about the health of the US economy — even as they warned of negative repercussions from looming rate cuts by the Federal Reserve that are aimed at speeding growth.

“I wouldn’t get too pessimistic yet,” JPMorgan CEO Jamie Dimon told analysts on Tuesday during a conference call.

Bank of America boss Brian Moynihan saidon an earnings call that his bank, which serves one in two US households, experienced “solid consumer activity, pointing to a continued growing economy in the United States this year, albeit at a slower pace.”

Bank of America’s consumer deposits grew by a steady 3%, while loans climbed by 6%.

Of course, the outlook could change rapidly should the trade war and economic slowdown in Europe and Asia infect US businesses.

CHICAGO, ILLINOIS - APRIL 09: A sign hangs above an ATM machine outside of a Bank of America branch in the Loop on April 09, 2019 in Chicago, Illinois. The banking giant has announced that it will be raising the minimum wage for for its employees to $20-per-hour in increments over the next two years, beginning with a jump to $17-per-hour on May 1. (Photo by Scott Olson/Getty Images)

Related article Bank of America rakes in record profit driven by strength from US households

So far that does not appear to be happening, at least based on the bank earnings reports. Bank of America’s global banking division grew loans and leases by 5%. Deposits jumped by 12%.

Importantly, major banks did not report significant credit issues such as a surge in bad loans caused by business or household trouble. Loan losses remained at muted levels.

“What the banks are telling us is positive. They aren’t signaling a decline,” said Christopher Marinac, director of research at Janney Montgomery Scott. “The industry is on very solid footing with credit issues low and capital high.”

Vanishing volatility

For the biggest US banks, sturdy consumer spending and borrowing helped offset trouble in trading.

The Fed’s shift from hawkish to dovish has caused already-muted volatility to vanish even further. Correlations — how closely asset classes are linked together — rose. Those are never good signs for the trading divisions that flourish on high-volume turbulence.

“The markets business has been tough — really tough,” said Nicholas Colas, co-founder of DataTrek Research. “It thrives on volatility, on people needing to make trades.”

Most major US banks reported declines in stock trading volume. Citigroup reported a 4% dip in fixed income markets revenue and called it a “challenging trading environment.” And Bank of America’s stock trading revenue dropped 13% due to weaker overseas derivatives trading.

Related article Goldman Sachs' sales slump, but it remains the king of Wall Street

The big exception was Goldman Sachs (GS), which managed to grow its stock trading revenue as it grabbed market share from rivals and benefited from investments in trading execution.

But trading turmoil is nothing new for the big banks. This part of the business has been in decline for years, if not decades, and will continued to be pressured by the rise of ETFs and passive investing broadly.

“Equities peaked in 1999. There are long-term trends at play here,” said Colas.

Rate troubles

The more serious threat to banks is the swings in borrowing costs driven by volatility at the Federal Reserve and the inverted yield curve — the gap between short and long-term rates.

Banks take in deposits at short rates and lend out at long rates. They make money off the spread between the two.

The Fed’s string of rate hikes enabled banks to almost immediately charge more for loans, while deposit costs rose more gradually and with a lag. Now, the opposite is happening as the Fed is expected to lower rates.

Bank of America, JPMorgan and Wells Fargo (WFC) all warned that Fed rate cuts will hurt lending profits. But the degree of that pain depends on how many times the Fed lowers rates.

“If the Fed cuts three or four times, it becomes far more than a nuisance,” said Janney’s Marinac. The CME’s FedWatch tool suggests roughly a 62% probability that there could be three or more rate cuts by the end of the year.

The banks are hoping that the Fed will cause a gradual steepening of the yield curve. That would help bank profitability.

But here’s the catch: A rapid steepening could confirm that the Fed was in fact too tight and a recession is coming. That would, of course, be bad for banks — and for everyone.

Buyback binge

For now, big banks continue to return vast amounts of cash to shareholders in the form of generous dividends and buybacks.

Aggressive share repurchases have sharply reduced share counts and inflated per-share profits. Bank of America repurchased $6.5 billion of its stock last quarter alone. Citigroup’s (C) share count dropped by 10%.

Analysts at Keefe, Bruyette and Woods argued in a recent report that earnings per share growth at banks would disappear if buybacks are excluded.

Perhaps investors are catching on to this. Banks trade at the lowest multiple to next year’s earnings of any sector in the S&P 500, according to Colas.

“They are the cheapest group by a country mile,” said Colas.

It’s hard to imagine what those low valuations would look like without buybacks.

Still, Colas urged investors to wait before scooping up bank stocks. He said real evidence of a recession, whenever it strikes, will cause bank stocks to get even cheaper and present a buying opportunity.

“We’re telling clients don’t touch financial stocks,” said Colas. “You make money in this group when things are bad. Things are obviously not bad right now.”