The Finance sector has been missing in action lately, both in terms of stock price as well as earnings performance. A discussion of the sector’s recent price performance will provide a good context for the earnings question, which we plan to discuss at some length a little later in this write-up.

Finance sector stocks have held up somewhat better relative to the harder-hit sectors like Energy and Industrials, but they have lagged the broader market as a whole. Over the last four weeks, Finance sector stocks in the S&P 500 have declined -3% versus the flat finish (actually down -0.3%) for the index as a whole in that time period. The sector’s price under-performance has been less pronounced in the year-to-date and last one-year periods, but it has nevertheless lagged the broader market.

Finance isn’t one monolithic group of companies; the constituent industries in the sector range from large money center banks to regional S&Ls, insurers, brokers and specialty finance operators like credit card issuers. The real estate investment trusts (REITs) also get grouped in the Finance sector. Not all industries have performed the same.

Except for REITs, all Finance industries came short of the S&P 500 in the year-to-date trailing 52-weeks periods, though the performance of insurers and regional S&Ls has been notably weak. Over the past one- and 3-month periods, REITs have been the weakest in the sector while the major banks have held up better than others.

Earnings Expectations

The Finance sector is the biggest earnings contributor to the S&P 500 index, expected to bring in 18.5% of this year’s estimated earnings for the Index as whole. Expectations for the sector remain low, with total earnings in the quarter expected to be down -3.9% from the same period last year. This follows the +0.9% earnings growth in the preceding quarter and -7.3% decline in the first quarter of 2014.

Digging a bit deeper, earnings are expected to be down in the two largest industries in the sector: Major Banks (down -21.6%) and Insurance (down -2.8%). The big decline for the Major Banks primarily reflects the big settlement at Bank of America (BAC - Analyst Report), which results in a roughly $4 billion negative swing in the bank’s earnings from the same period last year. Excluding the Bank of America estimates from what is expected for the Major Banks industry, the decline rate improves to -3.7%.

The chart below provides a summary view of growth expectations for the 6 Finance sector industries.

As you can see in the above table, earnings growth is expected to decline for only two of the six industries, with strong growth for the investment brokers, thrifts (S&Ls), specialty finance (credit cards, exchanges) and REITs. But as the chart below of different industries’ relative earnings contribution to the sector total shows, the major banks and insurance industries combined will be bringing in an estimated 69% of the sector’s total earnings this year.

Adjusting for the tough Bank of America comparison, the overall level of total earnings for the sector as well as the Major Banks industry would be modestly up from the same period last year. But the reality is that the Finance sector as a whole and the major banks industry in particular is faced with a growth challenge. The chart below of 8 quarters of total earnings data for the major banks industry -- four quarters of actual earnings through 2014 Q4 and estimates for Q3 and the next three quarters -- spotlights this growth challenge.

Notable Earnings Reports

This coming Tuesday (10/14) is particularly notable for Finance sector earnings as that morning will bring Q3 results from J.P. Morgan (JPM - Analyst Report), Wells Fargo (WFC - Analyst Report) and Citigroup (C). Bank of America will be releasing results on Wednesday (10/15), while Goldman Sachs (GS - Analyst Report) and Morgan Stanley (MS - Analyst Report) will report on Thursday (10/16) and Friday (10/17), respectively.

• Citi had the strongest results in Q2, handily beating EPS and revenue estimates and showing progress on a number of restructuring initiatives. They are expected to report $1.13 in EPS on $19 billion in revenue, up from EPS of $1 on $17.9 billion in revenue in the 2013 quarter (they missed on both fronts in 2013 Q3). The stock was up +4.9% in the two-day period around the Q2 earnings release, has lagged the market year to date, but held up better relative to the market in recent days.
• Bank of America is expected to report a loss of 9 cents on $21.4 billion in revenue vs. EPS of 28 cents on $21.5 billion in revenue in the 2013 quarter. The loss reflects a $5.3 billion impact from the Department of Justice settlement, which has helped improve visibility for the stock (up +4.6% in the past month and +11.1% year to date). Bank of America is a cost-cutting story, where we will likely see gains in this report (adjusting for the DoJ settlement). No major gains are expected in the loan portfolio and net interest margin is expected to remain flat at best.
• JP Morgan is expected to report $1.39 in EPS on $23.9 billion in revenue vs. EPS of $1.42 on $23.1 billion in 2013 Q3. No major surprises are expected from the industry leader, though they could come out with a lower provision expense as they did in Q2. Strong capital position and disciplined cost controls will likely be the key aspect of the JP Morgan report.
• Wells Fargo is expected to report $1.02 on $20.9 billion in revenue vs. EPS of 99 cents on $20.5 billion in revenue in the year-earlier quarter. The company has indicated recently that mortgage volumes will be in-line with the 2014 Q2 levels, though there is room for positive surprise on the mortgage front.

The Final Take

The one variable that has an outsized bearing on the sector’s earnings outlook is the level of interest rates in the economy -- specifically the yield on the 10-year treasury bond, which averaged just under 2.5% in Q3, roughly 20 basis points below the level in the year-earlier quarter and roughly 50 basis points below the level where we started the year. A steepening yield curve, particularly when reflective of positive economic momentum, is the perfect operating backdrop for the group. It will address the group’s net interest margin issue even as it helps drive loan demand.

Capital markets have also been a weak spot for the group over the last couple of years, with many suspecting that the best days of high trading volumes in the fixed income, currency and commodity markets are unlikely to ever come back in the current environment of stringent regulatory oversight. That said, increase volatility in Q3 should help trading volumes in this reporting cycle, partly offset by seasonality factors. Citi, J.P. Morgan and Goldman Sachs will likely be key beneficiaries of improved trading volumes this quarter. Advisory services, particularly on the M&A side, have been a bright spot for the group and should show up in Q3 results, particularly for Goldman Sachs and J.P. Morgan.

All in all, the group remains hostage to the low interest rate environment, with the earnings outlook not expected to improve til the macro backdrop changes.