2023-12-04 07:58:23 ET
Summary
- Wells Fargo's net interest income is set to come under pressure next year due to a changing inflation/rate trajectory.
- Slowing inflation indicates that the Fed will change its tightening policy in 2024.
- While Wells Fargo remains profitable, its net interest income likely already topped out.
- The odds appear in favor of WFC trading at a discount to book value next year.
Wells Fargo ( WFC ) benefited from a strong U.S. economy in the third-quarter which translated to impressive profitability and high returns on equity. However, Wells Fargo is seeing growing pressure on its net interest income… which is a function of benchmark interest rates set by the Federal Reserve. Since I now firmly expect the Fed to cut interest rates next year in a lower-inflation world, I believe Wells Fargo, and the entire banking industry, are going to see weaker earnings prospects going forward than in the past. For this reason, I lower my rating on shares of Wells Fargo to sell!
Previous rating
I rated Wells Fargo as a strong buy after the bank submitted its second-quarter earnings sheet due to a combination of three factors: 1) The bank’s shares were cheap on a forward earnings basis, 2) WFC raised its dividend by 17%, and 3) The bank bought back a ton of its shares, resulting in Wells Fargo being a capital return play for dividend investors. And interest rates were still rising at the time.
I changed my rating to hold in October due to Wells Fargo facing commercial real estate risks and seeing a rise in credit provisions. I am lowering my rating to sell now due to WFC facing a changing NII and risk landscape.
The core reason for my downgrade is that the Federal Reserve is set to move away from its tightening policies in a lower-rate world next year which will translate to weaker earnings and NII prospects, and pressure on the bank's book value. Since Wells Fargo’s net interest income is already on the decline, I expect steeper drop-offs in net interest income next year.
A new risk factor for Wells Fargo: the Fed is done
Wells Fargo continued to be a very profitable Wall Street bank in the third-quarter: Wells Fargo earned $5.8B in net income, 61% more than it did in the year-earlier period. Wells Fargo’s growth in earnings was at least partially attributable to higher net interest income (+$1B Y/Y) in Q3'23, but also due to strong results from the consumer business. Wells Fargo reported a return on equity of 13.3% in Q3'23, showing an increase of 5.2 PP year over year.
But this earnings picture (high ROEs, strong Y/Y earnings growth) is set to deteriorate next year. The reason for this is that the Federal Reserve is poised to recalibrate its tightening policy in a world that is seeing much lower inflation rates. With inflation falling rather drastically in October and U.S. inflation falling back below long term interest rates, the Federal Reserve is set for a major pivot with regard to its tightening policy in 2024.
Wells Fargo’s net interest income totaled $13.1B in Q3'23 but it also was the third straight quarter of falling net interest income and rates likely already topped out this cycle.
Before the Federal Reserve raised benchmark interest rates aggressively in 2022, Wells Fargo achieved net interest income, on a quarterly basis, of approximately $9.2B. With inflation coming down as much as it did lately, the Federal Reserve is now, next to commercial real estate risks and a rising trend in credit provisions, a potential new headache for Wells Fargo and other large Wall Street banks.
Wells Fargo set to trade at a discount to book value
Bank of America ( BAC ) is a key Wells Fargo rival in the U.S. banking market and both banks are subjected to the same forces in the market: their earnings power chiefly depends on the strength of the U.S. economy, consumer spending and the level of benchmark interest rates.
Both banks are trading at roughly the same valuation level, with shares of Bank of America currently trading at a 5% discount to book value while shares of Wells Fargo trade at a 1% premium to book value. Shares of WFC trade slightly above the 1-year average P/B ratio of 0.98X, but the risks outlined in this article pose significant headwinds to both Bank of America's and Wells Fargo's valuation multipliers. Given that I expect a material change in the interest rate environment to occur next year, I believe shares of large, cyclically-sensitive Wall Street franchises could start to trade at (higher) discounts to book value again in 2024.
Risks with Wells Fargo
The trajectory of interest rates is what determines Wells Fargo’s net interest income potential. With inflation dropping off quite significantly lately, chances are that the Federal Reserve will lower rates in FY 2024... which is set to put pressure on Wells Fargo's NII as well as return on equity. The persistence of high inflation and an acceleration of growth in the U.S. economy in FY 2024, on the other hand, could change the interest rate landscape for Wells Fargo and investors, however.
Final thoughts
In light of the latest inflation data points, the Fed appears to be done with rate increases this cycle for good. As a result, the net interest income outlook for Wells Fargo and other banks is deteriorating which is set to negatively affect Wells Fargo’s earnings prospects next year, especially if we were to also see a slowdown in the U.S. economy as well. Because I believe that interest rates have already topped out, the odds are in favor of Wells Fargo's shares trading at a discount from book value a year from now, not at a premium. With Fed appearing to be done with rate increases for the foreseeable future, I am changing my rating for Wells Fargo’s shares from hold to sell!
For further details see:
Wells Fargo: The Fed Is Done (Rating Downgrade)