Morgan Stanley names top bank stock, says worst far from over for sector

Morgan Stanley names Wells Fargo as its top pick even as it lowers its EPS estimates on the US banking sector

Morgan Stanley said the worst is yet to come for US banks despite the pullback we've seen in share prices so far this year. Still, some will do better than others, Morgan Stanley analysts said, as they named Wells Fargo & Co. (WFC) as their top pick.

"It's hard to argue for buying the dip because the credit cycle has not yet really started to play out," Morgan Stanley analysts including Betsy Graseck said in a research note Tuesday.

They lowered their earnings estimates on banks by a median of 7% and their price targets by 15% to account for the impact of an economic downturn on financial companies' balance sheets.

Commercial loan losses will rise near the 2019 levels when the US market was on the cusp of a recession, the analysts said. The Federal Reserve's move to keep raising interest rates and pare its bond purchases will result in higher lending standards and slowing loan growth, hurting banks' earnings outlook, they said.

Banks could fall further if the US economy enters into a recession, the analysts said. In that case, shares could drop a median 51% under Morgan Stanley's bear case scenario.

Morgan Stanley's top pick

Wells Fargo will benefit most from rising interest rates, the analysts said, citing the reasons why they chose WFC as its top pick. Each half percentage point increase in the federal funds rate drives about a 12% increase in earnings per share for Wells Fargo, the analysts said.

"WFC is in a strong position to monetize higher rates, as cash stands at 14% of earning assets, double pre-pandemic levels," they said.

The San Francisco-based bank has seen a turnaround since getting fined by regulators in 2016 for the widespread illegal practice of opening unauthorized deposit and credit card accounts without customers' consent. In 2018, the Federal Reserve issued a consent order, limiting Wells Fargo's assets from rising above its 2017 level of US$1.95 trillion.

The bank is restructuring its business mix and working to exit the Fed consent order or asset cap and reduce its expense base, Morgan Stanley, citing its overweight thesis on Wells Fargo. Still, the analysts acknowledged that risks around the timing of the asset cap removal and further regulatory action remain.

Morgan Stanley also maintained its overweight rating on State Street Corp. (STT), Ally Financial (ALLY), Regions Financial Corp (RF), Citizens Financial Group (CFG), M&T Bank Corp. (MTB), Signature Bank (SBNY) and SBV Financial Group (SIVB). That means the analysts are recommending investors add more of these stocks to their portfolios.

Cutting price targets for money center banks

Morgan Stanley slashed its price targets for Bank of America (BAC), Citigroup (C), Goldman Sachs Group Inc. (GS), and JPMorgan Chase & Co. (JPM) by 15% to 19%.

The analysts expect these banks to report lower investment banking revenue and see a decline in trading revenue. They cut these banks' earnings per share estimates by 7% to 12%, with the price earnings ratio target for Bank of America and JPMorgan seen declining by about 0.5, and Citigroup and Goldman down about 1.

Morgan Stanley analysts maintained their "equal-weight" rating for Goldman and Bank of America, while keeping JPMorgan at "underweight." Equal-weight means investors' allocation to a stock should not exceed the percentage that's allotted to it in indexes. Underweight means the allocation should be lower than their weighting in indexes.

Amex, Capital One downgraded to equal-weight

Morgan Stanley analysts downgraded American Express (AXP) and Capital One Financial Corp. (COF) to "equal-weight" from "overweight" on expectations consumer spending will slow as inflation eats into households' disposable income, while credit losses rise in unsecured consumer loans.

The analysts expect slower revenue growth for Amex. That's partly why they lowered their price-earnings outlook to about 13 times, from 19 times, reflecting the uncertainty. They also cut their price target for the stock to US$143, from US$223.

In the case of Capital One, Morgan Stanley analysts expect the bank's financials to take a hit as subprime consumer loan losses climb, while inflation stays elevated in the second half of the year. A significant portion of the bank's loan book is exposed to subprime, with 30% of card loans and 49% of auto loans, they said.

"The average consumer savings rate is currently ~5%, which is a 12-year low," they said. "As consumers' savings cushion continues to decline, the risk of higher loss rates rises."