The banking sector got off to a strong start in 2021, with the SPDR S&P Bank ETF (KBE 0.66%) rising roughly 24% through the first three months of the year, compared to just a 6% gain for the S&P 500. And the rally likely still has a ways to go as the sector appears to have emerged stronger after a brutal 2020 due to the coronavirus pandemic.
Next week, several big banks will kick off earnings season by releasing reports and they should give investors a first peek under the hood of 2021, which could be a very interesting year for the sector given all of the different factors at play.
Here are five things to expect from first-quarter bank earnings reports.
1. Improved earnings
Many banks will perform similarly or top their earnings from the fourth quarter of 2020. The fourth quarter of 2020 was the strongest quarter for banks during that difficult year. Analysts, on average, expect Bank of America (BAC -0.65%) and Wells Fargo (WFC -0.12%) to just slightly beat out their fourth-quarter earnings, while Citigroup (C -0.17%) is expected to beat its fourth-quarter earnings handily.
Analysts expect JPMorgan Chase (JPM -1.74%) to come up well short of its monster fourth-quarter earnings performance, but the bank released nearly $3 billion in reserves last quarter and had another banner quarter in its corporate and investment banking division. JPMorgan's earnings are still expected to easily beat its 2019 fourth-quarter earnings. Overall, I expect to see most of the banks in the sector beat or perform similarly to results from the fourth quarter of 2020.
2. Releasing reserves
More banks should begin to release reserves this quarter as the credit outlook continues to brighten. Nearly all banks last year reserved significantly in order to brace for heavy loan losses brought on by the pandemic. But intervention from the federal government in the form of stimulus staved off those losses and now there is a good chance that many of the losses banks were expecting to see won't materialize at all.
Since late December, Congress has injected roughly $2.8 trillion into the economy through two different stimulus bills, which has greatly assisted borrowers that might have been in trouble. Banks were not previously factoring these bills into their models. Additionally, many banks have also been modeling using gross domestic product (GDP) estimates below the 6.5% the Federal Reserve now projects for the year. With the credit picture much clearer and most economists projecting higher GDP, I expect a number of banks to release reserves back onto the income statement, which will juice earnings.
3. Disappointing commercial loan activity
When the pandemic abruptly sent the economy into a recession last year, both consumer spending -- and some consumer loan segments -- and commercial loan activity suffered. People were at times forced to shelter in place and generally stayed home more to avoid the virus. Businesses did not invest in their operations or expand given the economic uncertainty.
At a financial services conference earlier this year, Bank of America CFO Paul Donofrio said consumer spending through mid-February had ticked up 5% from last year. This is likely due to parts of the economy reopening. But in terms of commercial loan activity, Donofrio said volume declined in the start of 2021. Large corporations resorted to the capital markets, while loan revolver utilization among middle-market businesses dropped as well. Donofrio also said commercial loan spreads flattened to begin the year. While the news may be disappointing, banks should still make more net interest income on many of their loans and securities as a result of longer-term rates increasing significantly in 2021. And if the economy is going to grow 6.5% or 7% this year, business lending activity will be part of the equation, but this shows that most of this activity is expected in the back half of 2021.
4. Strong mortgage and capital markets
As it did through all of 2020, mortgage and capital markets activity should have continued to perform well in the first quarter. When the Federal Reserve abruptly dropped its federal funds rate to practically zero at the beginning of the pandemic, it triggered a wave of refinancing activity that continued to hold up through 2020. The yield on the 10-year Treasury note, which mortgage rates move in line with, has risen sharply in 2021 on inflation fears and the potential of future rate hikes.
That should begin to slow refinancing and purchase mortgage activity as mortgage interest payments get more expensive, but it doesn't seem to have impacted the first quarter. The real estate data firm Black Knight in March said data through mid-February showed refinancing activity in the first quarter could remain near record levels. That data is a little old now, so mortgage activity may have dipped as the 10-year yield has kept rising, but should still come in strong for the quarter.
Investment banking and capital markets should continue to be strong as well even if they will likely not be at some of the record levels we saw last year. As noted above, commercial borrowers continue to tap the capital markets. Additionally, Citigroup's CFO Mark Mason at a conference in February said he expects fixed income and equities trading activity to only increase in the mid- to single-digit percentage range from the first quarter of 2020, which was a particularly strong quarter. Mason also said he expects investment banking revenue to jump in the high teens to low 20s percentage range year over year.
5. A more confident tone
In 2020, bank CEOs were careful to model conservatively and, for the most part, express caution when it came to the economic outlook. With the credit picture clearer and analysts and investors much more bullish on the sector, I expect to see more optimism from bank CEOs on earnings calls. They now know that restrictions on capital distributions will end after the second quarter as long as banks can pass this year's stress testing, which will give them more clarity around their share repurchase and dividend plans. And if bank CEOs can report any optimism around a pick up in commercial loan activity or signs that it's starting to pick up, that should get investors excited about the rest of the year.