Banks Fall As Investors Fear A Flattening Curve

Stocks Rally Modestly

The stock market rallied slightly on Friday as the S&P 500 was up 0.11% inching closer to the record high set in January. The Dow outperformed the Russell 2000 as the trade war fears faded. The Dow was up 0.38% and the Russell 2000 was down 0.19%. The Dow was helped by Walgreen’s which is its newest member; the stock was up 2%. I mentioned before the banks started reporting earnings that if they impressed investors, the market would reach a new record high.

The XLF was down 0.45% as the major banks all sold off after their reports. It’s a bad sign for the overall market that the financials are struggling mightily. They are like the 10 year yield because both likely peaked for the cycle. The 10 year yield peaking has flattened the curve which has spooked investors in financials. With an inversion coming in the next 6 months, investors are shirking these names.

JP Morgan Reports Great Results, But Falls

JP Morgan, Citigroup, and Wells Fargo all reported their earnings. This was a case of the good, the bad, and the ugly. Let’s start with JP Morgan which was the “good” part of that statement. JP Morgan’s profit increased 18% which beat estimates for a 9.4% increase. EPS was $2.29 which beat estimates by 7 cents. This marks the 14^th quarter in a row the bank beat estimates. Revenues were up 6% to $28.4 billion. Even though the company is doing well and taking share from laggards like Wells Fargo, the stock has been doing poorly. The stock was down 0.43% on Friday and is down 10.45% from its peak on February 26^th. The stock is down 0.54% year to date which is worse than the S&P 500 which is up 4.78%.

Economy Doing Well, But Will It Continue?

In talking about the economy, JP Morgan’s CEO Jamie Dimon stated, “If you’re looking for potholes, there are not a lot of things out there and growth is accelerating.” It’s interesting to note the sharp divergence in his optimism from his own stock’s weak performance. The ECRI leading index strongly disagrees with the notion that growth is accelerating. As you can see from the chart below, the leading index growth rate is at 1.5%. This doesn’t mean a recession is coming in the 2^nd half of 2018, but when you have weakness and nearly an inverted yield curve, the situation looks unnerving.

Yield Curve Is Near Flashing A Warning Sign

The 10 year yield fell 1.83 basis points to 2.8271%. I like to predict the 10 year yield, but I also use it as a signal. The fact that the 10 year yield is falling while the stock market is rising makes me cautious on equities because I trust the bond market to be less euphoric and more rational. The 10 year yield started increasing in July 2016 which signaled the economic weakness was over. The yield accelerated higher from September 2017 until May 2018. This reinforced my bullish expectations as Q2 GDP looks great. The 2 year yield was less than a half of one basis point below the cycle high in the morning, but it fell throughout the day, closing down 0.79 basis point. This means the curve flattened again to 25 basis points.

I’m discussing the yield curve because Janie Dimon was asked about it. He said, “There’s a lot of evidence that there’s slack in the system … Finally, people are going back to the workforce. The consumer balance sheet is in good shape. Capital expenditures are going up. Household formation is going up. Homebuilding is in short supply. It is the banking system that’s very, very healthy compared to the past. Consumer confidence and business confidence are very high, albeit off their highs probably because of something like trade.”

There is slack in the labor market which I think has the potential to exist for another 2-3 years. However, a recession doesn’t necessarily need to be catalyzed by the labor market running out of workers. The sharp 2015-2016 economic weakness occurred even though the labor market had even more slack than it has now. Capex and confidence are up, but that can turn after the curve inverts. The bearish case based on the yield curve implies a recession in 2020, so those factors which show the economy is doing well in 2018 are irrelevant.

When asked about the 10 year yield, Jamie Dimon stated, “In history, we’ve had rates going up where we’ve had a healthy environment. It’s not always true that the 10-year going up is bad. We try to manage those risks. We want more clients. In almost every business we’re in, we want to do a very good job for them in products and services.” It’s interesting to see him defending the 10 year yield going up. I agree that the 10 year yield increasing is good, which is why I’m worried about the 10 year yield falling 30 basis points since the high in May. Clearly, to Jamie the yield is still in an uptrend.

Finally, we have CFO Marianne Lake’s take on the flattening yield curve. She said, “As we look at economic data, not just here in the U.S., but also globally, there are no real signs of fragility. She said that the current curve flattening is “good … from a bank profitability perspective and not [because there is] some looming risk of a recession embedded in it.” All I can say here is that this statement is wrong. The flattening curve is bad for the banks which is why their stocks have suffered. Even as JP Morgan beats out the competition, it’s stock still underperformed the S&P 500 because the yield curve is near an inversion. There is no sign of an impeding global crisis, but that’s not what the yield curve is implying yet either. I will be discussing the “bad” Citigroup earnings and the “ugly” Wells Fargo earnings in my next article.