Q1 Earnings Outlook: Grim Overall but Not for Financials

Underpinning even the slim increase for financials are expected increases in revenues from trading, especially in fixed income, currencies and commodities (FICC), and a drop in regulatory fines. (Bank of America reported a net loss of $276 million in Q1 2014 because of billions paid to settle lawsuits involving mortgage-backed securities.) Loan growth is expected to improve but only moderately, led by commercial loans.

On the negative side for financials are a continued squeeze on net interest margins – the difference between the interest rates bank charge for loans and the amount they pay on deposits — because banks can only charge so much when interest rates are so low. Margins could improve as interest rates rise but "only if the increase in long-term rates is higher than the increase in short-term ones," according to a recent report by Zacks analyst Kalyan Nandy. And it's not clear that will happen. The yield curve could even flatten, which would not help bank margins. "It's a tough environment fundamentally," says Anton Schutz, portfolio manager of the Burnham Financial Services Fund (BURKX) and Burnham Financial Long/Short Fund (BURFX).  "The yield curve creates a lot of challenges. Loan growth continues to be lumpy and challenging and the economy continues to limp along."  He says regional banks especially will be affected by the tough winter. "There were a lot of days that people couldn't even get to work…You'll see some real anomalies." Banks with large loans to the energy sector could also be hurt, says Schutz.

Banks have been relying on cutting expenses, improving credit quality, releasing reserves and buying back shares to boost earnings.  They "eked out earnings growth without much topline growth, but that's coming to an end," says Shannon Stemm, bank analyst at Edward Jones. "Banks need revenue growth."

One bright spot for the financial sector is wealth management, which has been growing because of positive demographics as more people save for retirement and gains in financial markets, says Stemm. But if markets pull back, she expects there will be pressure on those bank units.

So which financial companies are expected to best in the upcoming earnings season?

Schutz favors money center banks.  "The currency trading environment has been quite good for them, also M&A advisory fees."  

Among money center banks, Citigroup (C) seems to be a favorite. It has finally passed the government's bank stress test after previous failures, which sets the stage for increasing its dividend; cut expenses; and entered into a co-branding credit card with Costco (COST). And, despite all that its stock is still trading cheap, below 10 times forward earnings. 

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