Charles Schwab's (SCHW 0.13%) stock has been under pressure for over a year. Weighing on the business are interest rates that have reached their highest levels in decades, which had Schwab customers moving funds out of their accounts. Schwab's deposit trends have been at the forefront of investors' minds, and its recent earnings gave investors some reason for optimism. Here's why.
High interest rates had customers moving cash out of their Charles Schwab bank accounts
Charles Schwab has historically provided solid results for investors thanks to its limited credit exposure and cost efficiency, which drive stellar margins. However, the financial services company has faced significant headwinds over the last couple of years due to the rapid increase in interest rates.
In 2022, inflation (as measured in the year-over-year change in the Consumer Price Index) reached its highest level in four decades. The Federal Reserve's job is to ensure price stability, and it aims to keep the general level of inflation around 2%. To put a damper on rising costs, the Federal Reserve raised its benchmark interest rate from near zero in March 2022 to an upper limit of 5.5%.
Schwab has struggled with something management calls "client cash sorting," where customers move funds from their Schwab bank account into other assets, like high-yield savings accounts or certificates of deposits (CDs), to take advantage of higher interest rates. Last year, the company saw bank account deposit balances fall by 20%, resulting in total client assets declining by 13%. The company's client cash sorting headwinds are also why Bank of America double-downgraded the stock in January.
It continues to see deposit outflows but at a much slower rate
Charles Schwab's deposit trends have improved over the last couple of quarters. The company saw deposit outflows worsen in August of last year through April. During that time, the company saw its deposit base decline by nearly $50 billion.
Since then, Schwab's deposit trends have been much more encouraging for investors. In the third quarter, the company's deposits declined by $2.5 billion, and its average bank account deposit balances now sit at around $100 billion. While deposits continue to bleed out slowly, the worst of the outflows appear to be behind Schwab.
Data source: Charles Schwab. Chart by author.
While interest rates continue to increase, the rate of those increases has slowed down dramatically compared to last year. This slowing pace of rate increases has been a welcomed sight for the financial services company, which shouldn't face the same strong headwinds as when the Federal Reserve aggressively raised rates last year.
The company should continue to see deposit outflows subside if the Federal Reserve pauses its interest rate increases. According to CME Group's FedWatch Tool, the market expects the Fed to hold interest rates steady until mid-2024.
The company is paying down its FHLB loans from earlier this year
Earlier this year, Charles Schwab CEO Walt Bettinger told the Wall Street Journal that the company had "a sufficient amount of liquidity right there to cover if 100% of our bank's deposits ran off without having to sell a single security."
Bettinger was referring to Schwab's cash balances plus untapped borrowing capacity. The company currently has $33 billion in cash and cash equivalents and borrowings from the Federal Home Loan Bank (FHLB) of $32 billion. It previously tapped into FHLB borrowing to ensure it had liquidity in the event of further outflows and continues to pay down these loans after they peaked at $46 billion in the first quarter.
What's next for Charles Schwab?
It appears that Charles Schwab's declining deposit issues have diminished for now. The company saw outflows in the third quarter, but they were a fraction of the outflows it saw last year and early this year.
The company has managed to navigate this challenging environment where interest rates are much higher than market participants expected a year ago. It should benefit from the Federal Reserve pausing (or drastically slowing) its interest rate hikes as inflationary pressures show some signs of receding.
SCHW PE Ratio data by YCharts.
Value investors may find Charles Schwab stock to be quite appealing. Since the start of the year, the stock has fallen by 40%, and investors are pricing it at 14.6 times earnings and 4.5 times sales -- its cheapest valuation over the last decade.
