The chapter has been written. They've all gone to the tape. The large banks. For the most part, what I had told you earlier still rings true. The banks find ways to remain wildly profitable, but valuation remains overly dependent upon net interest margin. Hence, the ultimate value investment sector for now, as long as the Fed pins the short end of the curve in place... while maintaining liquidity in cash markets, and while allowing the long end of the curve to respond to potential growth, should this trade deal with China actually enhance prospects for U.S. commerce, should the consumer remain aggressive.
Morgan Stanley (MS) reported the firm's fourth quarter performance on Thursday morning. The firm posted adjusted EPS of $1.20, or $1.30 when GAAP principles are applied. Both numbers easily topped expectations. Revenue printed up 27% at $10.86, another handsome looking beat. Break these numbers down, and it quickly becomes apparent that across the board, this firm is executing at a high level. Think Wade Boggs in his prime. The guy led the league time after time in on-base percentage, batting average, hits, walks, doubles, while paying a Gold Glove caliber of defense at third base... he just plain found a way to beat you. Morgan Stanley has been that good.
Back In Time
Morgan Stanley CEO James Gorman has been at the helm for a decade. Over time, he has transformed the firm from a wildly volatile investment "boutique" to a well rounded operation focused more on wealth management than anything else. By no means, does that directional shift mean that Morgan Stanley somehow forgot how to trade. No, not at all.
Okay, let us not go quite that far back. September, the sudden appearance of, or really the sudden scarcity of necessary short-term liquidity in overnight markets makes headlines in the wake of the Fed's balance sheet having been drawn down to a rough $3.9 trillion though quantitative tightening, or in short... the methodical destruction of the monetary base that the Fed itself had built up over a number of years.
At the time, Morgan Stanley analyst Kelcie Gerson predicted that temporary repo operations would not be enough to settle these cash markets in the long-term, that the Fed would need to increase the size of its balance sheet by $315 billion. Other banks offered even higher estimates. The Fed will release the size of their balance sheet this evening as they do every week. Last week, the headline number stood at $4.15 trillion, as the Fed has purchased $60 billion worth of T-Bills monthly ever since while continuing with the already mentioned repo-operations when needed, which has been regularly.
Back to Morgan Stanley
Morgan crushed expectations across business lines as I have indicated above. For the quarter, net interest income increased 18%, Investment banking popped by 11%, as did Wealth Management. It all adds up to a record year for the firm in terms of net income as well as revenue. The crown jewel however, year over year, goes to Sales & Trading. The unit posted 29% growth. Within the unit, equity trading was flat, fixed income? Wait for it, wait... growth of 126%, even better than the 86% growth on the same line reported by JP Morgan (JPM) . The fact is that this item was simply strong across the industry.
Now take a look at the spread between the what the U.S. 3 month T-Bill and the U.S. 10 year note yielded in between October 1st and December 31st of 2019...
Starting the period inverted at -19 basis points, the spread un-inverted within days, and ran as high as +39 basis points within a month, a swing of 58 basis points, which by the way for those that maybe do not follow credit markets all that closely, is incredible. This spread remained rather volatile for the rest of the year, bottoming at +14bp in late November and closing the year at +37bp. I won't even go into corporate debt markets, but you know that these large banks did.
Threats to Sustainability
The fact that so many of Morgan Stanley's businesses did very well does matter, and will matter more so going forward, as there are obvious threats to the health of the yield curve going forward. The upside threat to these spreads will come in the form of consumer level inflation that will push out the long end, but that brings a double edged sword, as the Fed would then have to re-target the Fed Funds Rate at higher levels. Away from potential for economic growth and/or more inflation than the central bank would welcome, there comes a threat from the mere fact that the central bank will become uncomfortable with the programs currently underpinning these markets.
The balance sheet expansion program was originally meant to run through March, but will in my opinion run through tax season. Withdrawal, or even the mention of reducing the pace of these purchases will at that time probably produce something akin to a "taper tantrum" across financial markets. Don't moan, expect it. There has also been talk that at some point, the Fed would like to reduce its unwelcome role in short-term repurchase agreements. The media has bandied about the idea of the Fed possibly lending short-term cash directly to securities dealers and hedge funds through the FICC (Fixed Income Clearing Corp.). While this might be a politically dangerous move, it would if come to fruition remove the function of larger banks as middlemen in these markets. Just food for thought.
I do like having some exposure to the large banks, and Morgan Stanley is doing what looks to be an excellent job. At a tangible book value of $40.01 per share, Morgan is cheaper than "best in breed" JP Morgan, but still more expensive than... say Citigroup (C) . If I were to venture into this name, it would not be on a morning where the shares are up 8% in response to earnings, with the broader indices all up more than half of one percent.