Earnings season is underway, with Jefferies Financial Group (JEF 0.23%) as the first to provide insight into how other financial companies may report earnings this season. Jefferies specializes in investment banking, and its earnings can give us a clue about how capital markets are doing for major deals and issuances.
The bank's third-quarter earnings underwhelmed compared to what experts expected. However, the bank provided a glimmer of hope that the capital market recovery could be underway. Here's what investors learned from Jefferies' earnings and what it could mean for the stock moving forward.
The boom and bust business of investment banking
Investment banking boomed in 2021, and the industry celebrated record fees on a flurry of initial public offerings, debt issuances, and mergers and acquisitions. According to data from Refinitiv, investment bank fees of $160 billion were the highest on record going back two decades. That year, Jefferies earned $4.42 billion from investment banking, its best earnings ever.
Investors didn't expect a repeat of record investment banking performance from 2021 but also didn't expect such a drastic drop in activity. A couple of causes behind such a drastic drop were inflation and the Federal Reserve's response. Since early 2022, the Federal Reserve has been aggressively raising its benchmark interest rate to put a lid on inflation.
The record pace of interest rate increases made many market participants step back from deals, including mergers and acquisitions (M&A) and initial public offerings (IPOs). In the second half of last year, deals fell by 33%, one of the steepest declines on record going back to 1980. Meanwhile, Jefferies' annual revenue fell 25%, while net earnings plummeted 53%.
Dealmaking across the industry remained sluggish in the first half of this year, dropping 4% from last year, while Jefferies' investment banking revenue fell 36%. Despite the challenges, CEO Richard Handler and President Brian Friedman told investors they believed the second-quarter earnings "reflect a cyclically low period and a particularly challenging environment."
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Green shoots are emerging for investment banks
Jefferies' third-quarter earnings came short of analysts' expectations on both revenue and income. However, its investment banking revenue of $645 million grew from the second quarter by 28%, and management struck a positive tone, saying, "We are increasingly optimistic that we have come off the bottom of the cycle and that momentum in investment banking will continue."
One thing that has helped dealmaking is the stabilization of interest rates. Over the last year, we have seen declines in some key inflation gauges, including the Consumer Price Index and personal consumption expenditures. A slowing inflation rate has meant a slowing of interest rate increases by the Federal Reserve.
Market participants likely believe rates are stabilizing and are more willing to make deals. Jefferies' management noted a modest improvement in M&A activity and a market more willing to accept leverage finance and new issuances, saying, "The green shoots we mentioned last quarter have multiplied."
Investment banks are poised for a rebound
Interest rates are still near multidecade levels, which will continue to impact markets and the economy. Despite this, Jefferies has navigated the challenging backdrop over the last year and a half. Its strong capital position allowed it to grow its team of managing directors by 20% from last year, which should have it well positioned to deliver in a "more normal capital formation environment" in 2024.
Investment bankers previously noted plenty of pent-up demand for dealmaking when markets normalize, and Jefferies' recent earnings are a positive signal that the worst may be in the rearview mirror for the industry.
