As bank earnings come out, here are the red flags to watch out for this season

Published Fri, Apr 12 20248:48 AM EDT

Financials began reporting Friday, and the spread in the earnings trend is unusually stark. FactSet is reporting that the financials sector is expected to see a very modest increase in earnings of 0.7% for the first quarter year-over-year, but there is an unusually wide spread in earnings expectations among industries in the sector. Banks are expected to report notable declines (expected down 18%), while insurance companies are seen posting notable profits (expected up 37%), and credit card companies (spread out between financial services and consumer finance) are expected to report modest profits. A lot of negatives for banks It's easy to get lost in the minutiae of individual bank reporting. Try keeping your eye on the big picture: credit trends, commercial real estate, wealth management, and the impact of higher rates on profitability. For banks, there is some good news, but a lot of negatives as well. For companies with wealth and asset management divisions, a nearly 10% rise in the stock market is good news. More assets under management is always a good thing. For the major banks, wealth management is now an enormous industry (assets under management are now in the trillions for banks like UBS , Credit Suisse, Morgan Stanley , Bank of America and JPMorgan ). But the negatives outweigh the positives. For example, we now have a higher interest rate environment that will add more pressure on deposit costs. Both JPMorgan and Wells Fargo noted deposits were down as customers continue to look for higher yielding alternatives to traditional bank accounts. Fewer interest rate cuts by the Federal Reserve means the yields on loans typically decrease, which will lead to potentially lower net interest income (the difference between revenue generated from a bank's interest-bearing assets and what it costs to pay out interest on its deposits). JPMorgan said net interest income fell 5% quarter-over-quarter, excluding the impact of the First Republic deal. At Wells Fargo, the net interest income declined 8%, but the bank left its guidance for 2024 unchanged at a drop of 7% to 9%. Credit is another major issue. Zero interest rates during the Covid pandemic created a lot of borrowing, and it shouldn't be a surprise if credit losses pick up. There is anticipation of more builds for reserves, particularly for commercial real estate, but also possibly for credit cards. Still, JPMorgan noted lower provisions for losses than anticipated, despite an uptick in net charge-offs in consumer banking. Wells Fargo also reported a lower level of provisions. The commercial real estate problem is the main issue. Banks hold about half of the $5.7 trillion in commercial real estate debt outstanding. Many of the banks with the greatest exposure are small and medium sized. It's one of the main reasons the SPDR Regional Bank ETF (KRE) is down more than 10% this year. The fund is an equal-weight index of regional banks, and is notably underperforming the SPDR Bank ETF (KBE) , which is down nearly 4%. The KBE is an equal-weight index of U.S. banks that includes the largest banks. "Anything that's levered like commercial real estate, it's a different world," Tom Michaud, CEO of Keefe, Bruyette & Woods, said in a recent interview on FactSet. "Almost all the loans made in 2021 and 2020 should be re-examined," he said, noting that interest rates went from almost 0% to 5% in a very short period. "I expect more commercial real estate losses in every category, the question is whether it is going to be cataclysmic or is it going to be manageable." Insurers helped by higher premiums Insurance companies are benefiting from higher premiums and a modestly higher interest rate environment, which can be beneficial because they take premiums and invest them in Treasurys that are now providing higher yields and higher income. That's why many insurance companies are just off new highs. Progressive is up 27% this year, Hartford up 21%, Allstate up 18%, Travelers up 16%. Travelers will be the first large insurance company to report its results, next Wednesday.