Financing in the United States: an Economic Overview
In the past 18 months the United States economy has witnessed an unprecedented amount of economic and financial instability in the sense of us not really knowing what to do next. It seemed as if we were going to have a lot of unanswered questions because of the amount of variables that a pandemic can affect, and considering that the magnitude of COVID-19 would still be largely unknown even now it has seemed that the financial sector stocks haven’t even flinched. As a matter of fact, the SPDR Financials ETF ($XLF) has performed almost in-line with the notorious outperformance of the Invesco NASDAQ 100 ETF ($QQQ) with a 15% and 17% respectively in the past 6 months.
In the basic formula of valuation we expect that a company’s present valuation is the risk-adjusted amalgamation of all of its future cash flows:
And seeing the economic indicators for the “risk” in the financing industry we should be expecting a lower discount rate considering that the financial stress index is at a recent low.
We should also consider the fact that the financial stress indicator is based largely on interest rates and yield spreads which have been under the strong influence of the Federal Reserve for the past several months. In order to understand the situation of the financial industry it’s imperative to understand federal reserve policy and how interest rates will affect the economy and in turn financing going forward.
Fed Policy and Actions Summarized:
The reason this is the “real” interest rate is because if the overall economy grows faster than your interest payments, your debt should become cheaper. Debt after all, is a fixed income instrument, and if the interest rate is 5% but the inflation rate is 3% then that means your project will grow in assets by at least 3% if not more, therefore you will be able to achieve sufficient profitability with just 2% growth. Currently, we’re experiencing both low interest rates and high inflation, so this could lead to another debt bubble. However, if there’s anything I’ve learned from finance it’s that history repeats itself, and things we’ve never seen happen all the time. The financial system is kind of like outer space, there’s a vast abundance of information and it sometimes doesn’t subscribe to all of our pre-established laws of economics because no two situations are ever exactly the same.
The economists at the Fed ensure that a very basic condition of macroeconomics is met: market equilibrium. The supply or the output of the economy is equal to the sum of consumption, investment, and government spending. Government spending, of course, is fixed by policy. Consumption is fixed by the output subtracted by taxes. The only factor left is investment, which is again, highly influenced by the interest rates. This is why the markets react so violently even when the interest rates change ever so slightly.
In an economy that’s so fixated on the future because there’s nothing to look forward to in the present, all you’re concerned about is investments, which are primarily influenced by interest rates (all other factors held constant).
This is a gross oversimplification, because of course investments are decided rather emotionally and irrationally at times as well. For example, a lot of investment is based on projected return. Earlier we used arbitrary numbers for expected ROIs, and that’s exactly what investors have to do. If the expected return on investment is 20%, and inflation is at 5%, interest rate will have very little effect.
This is what leads to investment bubbles. Irrational exuberance, a term coined by Yale Professor Robert Shiller, means that the projection for investments is so high that literally nobody will miss out on them. This is just one of the numerous factors that influence investment quantity, but from a very strict macroeconomic supply and demand standpoint, the good is loanable funds, and the price of the goods is the interest rate. There has to be an equilibrium interest rate, meaning that the savings of Americans should be equivalent to a firm’s desire to invest. But with central banking, the government decides how much households will want to save, and how much firms will want to invest. As you can see with now record-low interest rates, households are spending more and firms are investing more. This is what was needed to save the economy, and we can credit this fix to the economists in Washington.
How Commercial Banking Is Affected
It clearly took a long time for consumers to finally buy back into the whole idea of debt considering that loan circulation always decreases drastically during times of economic uncertainty, however one factor that may have prevented many people from taking on loans immediately was the fact that the government was directly paying people a lot interest free through stimulus and unemployment. Once these benefits started getting rolled back, consumers went right back to commercial bank loans for regular spending (The CARES act fully ended in July and consumer loans had a turnaround right around May).
The valuation of commercial banks is ultimately judged by the healthiness of their balance sheet, which is why P/E ratios are rarely used to evaluate banks and other financial institutions. Tie this back to what valuation means at its core again: all of the future cash flows discounted for risk. This isn’t reflected in immediate revenues but rather the healthiness of assets in the balance sheet of banks that can generate cash flows in the future. Banks are inherently investment vehicles that need to have sustainability just like any mutual fund so it’s valued not based on the earnings this year but rather on the anticipated interest earned from loans and credit facilities. Bank of America for example was unable to grow revenue (-3%) or profitability this past year but shares of $BAC are up 58% in the past year. One reason this may have happened is because deposits actually grew 10% YoY for their wealth management division, implying that their future potential is really just as potent as that of a tech company. (The main reason I used BofA as the prime example here is because nearly three quarters of their services are domestic where Fed policy has taken full effect).
Basically the trend for consumer banking is showing us that banks are improving their efficiency ratios by making smart investments while all of the clients of the banks are bent on saving because of economic instability. Usually, a high amount of deposits signifies doom for a commercial bank because now they may not have many people to lend to. But thanks to the invisible hand of the Federal Reserve boosting corporate America and the repeal of Glass-Steagall, banks were able to find record levels of trading, investing, and financial services profits. At a time where the regular consumer would have to second guess buying groceries or toilet paper (or perhaps couldn’t even access them) corporations went on an unforeseen buying spree.
Investment Banking, Trading Operations, Wealth Management, Advisory
With that being said, let’s jump into the investment banking side of things! According to PWC, the second half of 2020 and the first half of 2021 saw record deal flow and transactions especially in M&A activity: “The record levels of deal-making, both in terms of deal volumes and values, continued from late 2020 into the first six months of 2021. The volume of deals was roughly the same across Asia-Pacific, EMEA and the Americas, although deal value was more heavily weighted towards the Americas, a similar trend to 2020.” :
This data illustrates just how many deals have accumulated since fiscal stimulus took full effect, and it’s safe to say that the cyclicality and dependence of Wall Street on the government could not be made any clearer. Out of all types of transactions, the harrowed Special Purpose Acquisition Company or SPAC has been the leader of all major corporate level transactions regardless of size according to PwC:
“The first half of 2021 saw a continuation of the growth in deal size, contributing to record global deal values in excess of US$1tn per quarter over the past 12 months. Fresh capital inflows led by SPACs have been an important catalyst, as has been the increase in PE investment and corporate acquisitions — particularly those focused on technology assets. Technology, media and telecommunications companies accounted for a third of all megadeals in the first half of 2021. However, this number increases to over a half when companies with a technology-orientated business model — regardless of their sector — are considered.”
The SPAC model has been the notoriously fast route to the market that exists solely for the purpose of getting to market fast in case future circumstances change too much. A traditional IPO takes more than a year of planning, sometimes stretching to two or three years after the project starts. SPACs have been able to take any company public simply by buying an existing entity and changing their names. This process has been aided heavily by PE/Buyout firms as the involvement of PE has increased from 27% in 2019 to 38% in 2021. While PE firms already get a bad name for their often hostile corporate transactions, the SPAC has given an outlet to potentially change this reputation by being creators in the economy rather than firms that focus on cutting headcounts. However these SPACs typically result in negative investor returns once they make their way to the public, and almost always profit the sponsor with multiples more simply because of the nature of the transactions and how warrants work. Sponsors buy these at a deep discount and almost always profit while investors pay a hefty amount of the difference (this Stanford & NYU study shows the resultant profits best: https://corpgov.law.harvard.edu/2020/11/19/a-sober-look-at-spacs/). Not only this, but the rapid-fire nature of the SPAC has caused unforeseen levels of stress in junior bankers as well: https://www.cnbc.com/2021/03/18/goldman-sachs-junior-bankers-complain-of-crushing-work-load-amid-spac-fueled-boom-in-wall-street-deals.html
And where does all of this lost capital and stress go? Straight to the bottom line, of course.
To top all of this transaction activity off were the newfound trading profits that boosted revenues to unprecedented levels while also being the cheapest types of revenues to occur, with bulge brackets like Goldman Sachs going out of the prestigious transaction market to focus more on trading:
“Goldman thrived in that environment. Trading revenue rose 47% from a year ago to $7.6 billion, thanks to a 31% increase in fixed-income, currency and commodity trading revenue and a 68% increase in stock-trading revenue”. Of course, Goldman wasn’t alone in this arena and some commercial and investment banks such as BofA, Wells Fargo, Citi, and JP Morgan all saw significantly improved trading profits. These evidently transition to wealth management and private equity profits because let’s face it: the stock market performed insanely well and the past 18 months have been a ball for investors.
Conclusion:
Finance as a sector appears to be healthy when we’re in a state of consumer worry and investor exuberance, a condition that’s rarely ever satisfied. This is why many investment banks especially have had returns previously unheard of, including boutique banks like Evercore, Jefferies, Piper Sandler, and Greenhill. There’s a great deal of profits to be made in this economy, especially with the right people and right management. This is the case with any service-sector companies because they are driven by strong leadership and experienced analysts/associates. In addition to this, banks are expected to have innovation in all aspects of client services and innovate new products, a niche that Goldman Sachs has been on top of for quite some time now. Value-added propositions mean everything in terms of differentiation, however the essence of the borrow cheap and lend expensively business has grown in revenue streams and profitable ventures in general.
