As usual, the biggest US banks will unofficially kick-start the second quarter earnings parade, with JP Morgan Chase and Morgan Stanley reporting their financial results on Thursday before Wall Street’s opening bell, followed by Citigroup and Wells Fargo at the same time on Friday. This earnings season will gather a lot of attention as it will assess companies’ performance amid a continuously deteriorating macro environment, which has driven stock markets lower. For banks, an environment of rising interest rates should normally be considered beneficial, but fears that those rate hikes will lead to a recession have given a blow to their financial as well as stock price performance. What should investors look out for?

Monetary tightening a double-edged sword

At the beginning of 2022, banks were expecting that the upcoming monetary tightening cycle would give them a boost as they would capitalize on higher net interest margins, which are essentially the difference between the interest income generated by long-term assets such as loans and the interest expense paid to short-term liabilities such as deposits. However, concerns about slowing economic growth and a potential recession have weighed on bank shares, with most lending institutions preparing to set aside more capital to cover non-performing loan losses.

Although the financial sector has underperformed against the S&P 500 so far in the year, the banks proved their resiliency and financial stability by easily passing the Fed’s annual stress tests last month. Therefore, despite recent woes, bank stocks will probably remain a shelter during a period of economic distress.

Mounting headwinds cast shadows over banks outlook

There are many reasons why financial institutions are not expected to have fared well during the last quarter. Firstly, the constantly increasing fears over a recession have applied upward pressures on short-term yields, flattening the yield curve and even causing an inversion between the 2- and 10-year Treasury yields. Moreover, in the eyes of a recession combined with sticky inflation, investors have reduced their borrowing for retail spending meanwhile, companies have scaled down their loan-granting to fund new investments. Overall, these developments might have offset the benefits of a higher net interest margin.

Additionally, Russia’s invasion of Ukraine flooded markets with uncertainty, causing many IPOs and M&As to be postponed or even cancelled, reducing investment banking fees. Furthermore, wealth management commissions are also anticipated to have taken a hit due to the recent stock market decline, while mortgage originations, which are also an important source of income for banks, are expected to have dropped as macro jitters have seeped into the housing market.

Last year, the financial damage caused by the non-performing loans proved to be smaller than expected, enabling banks to amplify their earnings by releasing significant amounts of their reserves. Therefore, as liquidity from stimulus checks is evaporating and economic uncertainty is increasing in 2022, banks would need to start accumulating reserves again by trimming down their earnings. This would result in extremely harsh year-on-year comparisons, which could eventually lead to disappointed shareholders and to a broader sell-off in banking stocks.

Solid segments exist

Despite the worrisome outlook, financial institutions are also expected to exhibit strength in some areas. Initially, banks are projected to experience growth in net interest income enabling their core lending business to stage a comeback after being incredibly pressured for the past decade by very low interest rates. Also, transaction fees and brokerage commissions are expected to have risen as investors rushed to rebalance their portfolios to hedge against the sharp downfall in stock markets, which triggered a vast rotation from growth to value.

JP Morgan retains revenue growth but earnings drop

JP Morgan is set to post a mixed performance as modest improvements in margins and loan volumes have been offset by weakness in the mortgage business and rising expenses. On the capital markets side, the investment banking business is down significantly compared to the same quarter last year, whereas the heightened volatility in all asset classes would probably lead to increased trading volumes and consequently fees.

Therefore, the bank is anticipated to post revenue of $31.96 billion, according to consensus estimates by Refinitiv IBES, which would represent a year-on-year increase of 1.8%. In addition, Earnings per share (EPS) are estimated at $2.90, decreasing by 23.20% on an annual basis.

Morgan Stanley braced for negative results

Morgan Stanley was one of the outperformers in the Fed's latest stress test, which enabled it to raise its quarterly dividend to $0.775 per share, while announcing a $20 billion buyback. This development helped its stock price experience some gains, especially against its sector peers.

However, the New York City-based investment bank is expected to report earnings of $1.54 per share in the second quarter of 2022, which would mean a 16.90% year-on-year decline. Moreover, revenue is also projected to decrease by 8.70% on a yearly basis, to $13.47 billion.

Citigroup exhibits mixed performance

Citigroup struggled in early 2022 for a wide range of reasons. Firstly, the bank shut down its operations in South Korea and other emerging markets to focus on higher-growth areas. This action might eventually prove beneficial, but it has not yet led to an acceleration of revenues and earnings.

Consequently, the banking behemoth is expected to announce revenue of $18.15 billion, which would produce a 3.88% annual growth. However, EPS is projected to decline by 35.89% on a yearly basis to $1.69.

Wells Fargo to post weak figures despite stock outperformance

Wells Fargo is primarily a lending financial institution. Thus, the bank should normally benefit from the ongoing rate hiking cycle to a greater extent than its competitors. This information appears to be already reflected in the stock price as Wells Fargo has outperformed both its competitors and the S&P 500 in 2022, but its financial performance lags.

The major US lender’s revenue is projected to reach $17.58 billion, down 13.27% compared to the same quarter a year ago. Moreover, EPS is also expected to fall to $0.83, representing a massive 40.14% decrease on an annual basis.

Valuations in attractive territory

All the four examined banks have forward 12-month price to earnings (P/E) ratios that are lower than the banking services sector’s average of 10.0, indicating that they are attractively priced. Moreover, their valuation remains cheaper than that of the S&P 500, indicating that the recent sell-off might be a chance for investors that bet on the companies’ prospects to step into the market.