The Wall Street Journal - 14.11.2019

B12| Thursday, November 14, 2019 THE WALL STREET JOURNAL.

Why Falling Rates Haven’t Sunk Banks

Investors are bidding up shares of large lenders, hoping that a small decline in deposit costs is a taste of things to come

HEARD

ON

THE

STREET

FINANCIAL ANALYSIS & COMMENTARY

Analyst estimates for 2020 net interest margins at Bank of America have ticked up since the end of October.

LUCAS JACKSON/REUTERS

SmileDirectClub shareholders

have had their teeth kicked in. But

there should be a limit to the

gloom and doom.

The company, which sells ortho-

dontics directly to consumers, has

encountered nothing but trouble in

its short history as a public com-

pany. The stock is down more than

50% since its initial public offering

at $23 a share in September, in-

cluding a 28% plunge on its first

day of trading.

Its first earnings report Tuesday

didn’t help matters. Third-quarter

sales of $180 million topped analyst

expectations, while an adjusted net

loss of 89 cents a share wasn’t as

bad as feared. However, its full-year

revenue guidance implied a weaker

fourth quarter than analysts were

hoping for. Meanwhile, the com-

pany didn’t issue any guidance for

2020. Shares plunged yet again on
      Wednesday.
      While things certainly look bleak,
      a turnaround is possible. Sales
      grew by 50% from a year earlier,
      while gross profit margins of 77%
      actually improved by 7 percentage
      points over that same period.
      Sales, marketing and administra-
      tive expenses topped $500 million
      in the quarter, which is way too
      high. While much of that tally is a
      one-time equity compensation ex-
      pense related to the IPO, cutting
      spending while maintaining sales
      growth rates will be SmileDirect-
      Club’s key challenge going forward.
      Winning back investors will neces-
      sarily be a long process. Wall Street
      analysts don’t expect profits until
      2021, according to FactSet.
      But the overwhelmingly negative
      sentiment could prove useful to
      bargain hunters. Including net debt,
      the company trades at less than
      three times trailing revenue, ac-
      cording to FactSet. Rival Align
      Technology , which is a strong
      grower and consistently profitable,
      trades at more than eight times
      sales. Credible signs of progress in
      future quarters should help narrow
      that gap.
      Meanwhile, nearly 20% of avail-
      able SmileDirectClub shares were
      sold short as of Oct. 31. Pressure on
      the stock could very well ease as
      investors close out that successful
      trade.
      After all, even the angriest scowl
      doesn’t typically last forever.
      —Charley Grant

When it comes to bank stocks,
there is a lot riding on deposits.
The KBW Nasdaq Bank index is
up 9% over the past month, more
than double the gain of the S&P

500. Behind that rally isn’t so much
     confidence that rates or the econ-
     omy will suddenly zoom higher, but
     a belief that banks can manage
     through the Federal Reserve’s eas-
     ing, thanks to some help on funding
     costs. Analyst estimates for 2020
     net interest margins at Bank of
     America and Wells Fargo have
     risen since the end of October.
     Banks now get a historic propor-
     tion of their funding from deposits,
     the cheapest form of liability, ver-
     sus bonds or short-term borrowing.
     Overall year-over-year deposit
     growth was 5.8% across the largest
     U.S. banks in the third quarter—the
     fastest pace since the start of 2017,
     according to Federal Reserve fig-
     ures. The upshot is that some 89%
     of large U.S. banks’ total liabilities
     are now deposits, the highest pro-
     portion since 1985, according to
     Federal Reserve figures.
     Importantly, banks’ so-called
     golden deposits, the noninterest-
     bearing ones, ticked higher. These
     are typically day-to-day checking
     accounts for people and corpora-
     tions on which they expect no inter-
     est—making them nearly free fund-
     ing for banks. Depositors had been
     shifting this money into more pro-
     ductive places for a while, drawn by
     higher rates on offer elsewhere. But
     these deposits actually grew by a
     median 0.1% from the second quar-
     ter to the third across the biggest
     banks, the first sequential jump in
     at least five quarters, according to
     JPMorgan Chase analysts.

Another reason for optimism is

that deposit costs didn’t fall as

much as they could have in the

third quarter, suggesting there

could be pent-up declines to come.

Interest-bearing deposit costs at

the biggest banks ticked down only

0.01 percentage point sequentially

in the third quarter, according to

Autonomous Research figures. That

is despite a drop of half a percent-

age point in the effective fed-funds

rate. There is usually a lag after Fed

actions, as banks take some time to

push through pricing changes. So

the pace of decline has plenty of

room to accelerate, if historical pat-

terns hold.

Autonomous’s Brian Foran says

big banks seem to be pointing to a

roughly 0.15-percentage-point de-

cline in deposit costs from the third

quarter to the fourth.

There are still some good rea-

sons to be cautious going into next

year. For one, banks are competing

as intensely as ever for customers,

and the biggest banks are thinking

longer-term than just 2020 net in-

terest margin. JPMorgan Chase

Chief Financial Officer Jennifer

Piepszak, for example, said the bank

wouldn’t risk a relationship with a

corporate customer over “a few

ticks” of interest by demanding

they accept a lower or zero rate.

Banks might also give corporate cli-

ents breaks on fees to retain depos-

its, sacrificing noninterest revenue.

“Clients are...going to continue to

be disciplined” about seeking the

best deals from their banks, State

Street CFO Eric Aboaf said in Octo-

ber when asked by analysts if he ex-

pected noninterest-bearing deposit

growth to rebound.

Plus, if customers were to start

keeping money in checking ac-

counts at no interest, that might

not be a great sign. Mr. Aboaf also

warned that clients are more likely

to leave cash in noninterest ac-

counts “in a quick recessionary en-

vironment.”

Finally, the usefulness of cheap

deposits is lessened if banks have

nothing to do with the money. Se-

quential loan growth dropped from

1.1% in the second quarter to 0.7%

in the third quarter for the biggest

U.S. banks, Fed figures show.

Bank investors have seemed

happy with “not as bad as feared”

lately. But they would be smart not

to get too giddy here, either.

—Telis Demos

U.S. banks' deposit growth, year over year

Source: Federal Reserve

6

0

1

2

3

4

5

%

2016 ’17 ’18 ’19

SmileDirect

Can Still

Straighten

Itself Out

Fed Gives Investors a Green Light on Risk

Until inflation rises by a lot, the central bank will clear the way for asset prices to flirt with bubble status

The only thing that seems likely
to get the Federal Reserve to raise
rates again is a lot more inflation.
Until that happens, it will be giv-
ing investors a green light to buy
stocks and other risky assets. Sim-
ilar occasions have had very un-
happy endings.
The Labor Department on
Wednesday reported that core
consumer prices, which exclude
food and energy items to better
track inflation’s trend, were up
2.3% in October from a year ear-
lier. That was a bit less than Sep-
tember’s year-over-year gain of
2.4%, but it is significantly higher
than it was earlier in the year.
Moreover, October’s consumer-
price level was pushed lower by
declines in apparel and lodging
prices—two volatile categories
that will likely reverse themselves
in the months ahead. Throw in
businesses’ urgency to raise prices
to offset rising wages and tariff
costs and inflation seems likely to
get warmer.
The Commerce Department in-
flation measure that the Fed pre-
fers runs cooler than the Labor

Department’s, showing core prices

up 1.7% on the year in September.

But it, too, seems likely to pick up

in the year ahead, with many

economists projecting it will rise a

bit above the Fed’s 2% inflation

target next year.

A bit above 2% might not be

enough to move the Fed to take

back any of its three rate cuts this

year. After years of low inflation,

the central bank is worried that

inflation expectations—which

economists believe help to shape

inflation’s path—have slipped to

the point that it will be hard to

keep inflation at its target. Indeed,

in congressional testimony

Wednesday, Fed Chairman Jerome

Powell noted that measures of lon-

ger-term inflation expectations

“are at the lower end of their his-

torical ranges.”

So the Fed isn’t likely to raise

rates until its preferred measure of

core inflation moves meaningfully

above 2%—let’s call it 2.3%. As

Evercore ISI policy strategists

point out, that differs from the

late 1990s, when, after a series of

insurance rate cuts, the Fed moved

to raise rates again once it had an

all clear on growth. This trepida-

tion implies an even longer sweet

spot for stock-market investors.

They know that the Fed will cut

rates again if risks to the economy

emerge and that it isn’t likely to

take away the punch bowl soon.

A similar late-1990s sweet spot

helped fuel a technology stock

bubble that ended badly, contrib-

uting to the recession that fol-

lowed. The 2008 financial crisis

brought home even more clearly

the perils of bursting bubbles. As-

set-price excesses don’t appear

close to what they were in either

of those episodes, but that could

change.

—Justin Lahart

OVERHEARD

Lobster exports to China are

among the trade flows that

have been hammered by the

trade war that escalated in

mid-2018. U.S. lobster sales to

the Middle Kingdom, which ran

at nearly $90 million in the first

half of 2018, plummeted to just

$19 million a year later, after

China imposed a 25% tariff on

America exports of the shellfish

delicacy. China turned to Cana-

dian crustaceans instead.

However, things aren’t quite

as they seem. American lobsters

are apparently crawling up to

Canada instead, and then mak-

ing their way to China. U.S. lob-

ster exports to Canada were up

120% in the first quarter from a

year earlier, and nearly 220% in

the second quarter, according to

U.S. Department of Agriculture

data. The U.N. Food and Agricul-

ture Organization also notes

that U.S. lobsters are apparently

showing up in China, often la-

beled as Canadian lobster,

shipped through Vietnam.

Tencent Ought to Set Sights Abroad

With problems building at home,

China’s internet titan Tencent

might benefit from a few more trips

abroad.

The social-media and gaming gi-

ant, now worth $400 billion in mar-

ket value, on Wednesday reported

disappointing results for the quar-

ter through September. Revenue

grew 21% compared with the year-

earlier period, while operating

profit fell 7%—both below analysts’

expectations, according to S&P

Global Market Intelligence.

The profit decline was mainly

due to smaller gains from its invest-

ments. But a rebound from a disas-

trous 2018 was fully expected. Chi-

nese regulators froze new-game

approvals for nine months last year,

which hurt Tencent’s gaming busi-

ness. The company’s revenue from

smartphone games picked up steam

after regulators resumed approvals

in December, and last quarter grew

25% on the year.

Now, though, there are early

signs that governmental scrutiny of

games has tightened again. Regula-

tors approved only 71 games last

month, according to a tally by Gold-

man Sachs. Before the approval

freeze, more than 1,000 games

could be waved through in a month.

This development could mean

slower growth for Tencent ahead.

One thing the company could do

to offset headwinds at home is to

expand overseas. It made almost all

of its revenue in China last year. It

already owns minority stakes in

many foreign game makers, includ-

ing “Fortnite” developer Epic

Games and Activision Blizzard .And

Tencent developed the mobile ver-

sion of Activision’s shooting fran-

chise “Call of Duty,” which generated

more than 100 million downloads

world-wide in the first week after its

launch last month. The company is

responsible for publishing the game

only in mainland China, but has the

capability to develop products that

can succeed abroad.

Tencent may still require the

brand and marketing powers of for-

eign partners, though. Its “Arena of

Valor” game was a flop in the U.S.,

even though its Chinese equivalent

“Honor of Kings” has been a smash

hit. This could mean more foreign

acquisitions and partnerships are

necessary to spearhead its overseas

expansion. The company is also

looking to make more console

games for the U.S. audience in part-

nership with Nintendo.

Tencent is already the world’s

largest gaming company, based on

its strength at home. A more ag-

gressive push abroad could take it

to another level. —Jacky Wong

Number of new online games

approved in China, monthly

Source: Goldman Sachs

1,000

0

200

400

600

800

2017 ’18 ’19

The Federal Reserve's overnight target rate in the late 1990s

Source: Federal Reserve

5.5

4.7

4.8

4.9

5.0

5.1

5.2

5.3

5.4

%

1998 ’99