Forget the fact that the U.S. federal government is stumbling towards its longest shutdown in history. Forget that two auto sector companies in the same country have gone under. And lest we forget, China is holding some pretty tough hands at Trump’s own trade casino. No, equity markets don’t seem to care and all it took was for U.S. bank earnings coming strong out of the gate this week to get the bulls running again. While we are early in the season, you can smell the elevated optimism that things might just be better this past quarter than previously expected. If banks can deliver strong results, then perhaps this is a leading indicator of good times, not bad.

The analogy of the canary in a coal mine can be applied to many things, including the state of an economy or financial markets. Typically, though, we don’t look to the banking group as a bunch of canaries. They tend to reflect what has happened as opposed to what is going on today. Analysts look at things like transportation companies for clues as to whether economic winds are shifting. Specifically, if those companies that transport goods and people start to exhibit weakness, then this will be picked up in the valuations of those stocks. A sharp turn lower may be a leading indicator of a slowdown in macroeconomic activity, and vice versa.

The above chart shows the Dow Jones Transportation Index back over the last 15 years. In early 2020, the index fell sharply as the pandemic took hold, although the economic contraction that emerged was short-lived and also captured in the sharp rebound in the index. A more representative example was back in 1999, when the index fell from May of that year into March 2000 – the start of the tech bubble implosion. The S&P500 peaked in March 2000, fell back and then recovered into September, followed by a two-year bear market. So far this year, Dow transports are down close to 2% even though the S&P is up 13%. True, this is largely attributed to the leadership of tech in the S&P and transports did stage a rebound from April, but they peaked in July and been faltering ever since. So, can we look at the banking sector for signs that the economy is causing sickness? If so, the third quarter earnings released so far are suggesting that no ailments exist either among businesses or consumers.

Third quarter results for the U.S. big 6 skewed much better‑than‑expected on investment banking and markets, while net interest income held up broadly, and credit losses were mixed but manageable. JPMorgan reported earning per share (EPS) of $5.07 and revenue of $46.4B. There was broad‑based strength across consumer and business lending, although management struck a cautious tone on the economy and consumer, flagging idiosyncratic losses at Tricolor. Bank of America beat on investment‑banking fees and markets revenue; again, with consumer credit trends viewed as stable.

The results are reflected in the fact that the banking sub-group of the S&P has outperformed the broad market for most of this year, as shown in the chart above. Even though banks saw a larger pullback from late September into last week than the overall index, this week’s reports have been a shot in the arm, lifting the group back to a year-to-date gain of close to 20%.

The reason why I don’t believe this sector makes for a good canary is because of the bifurcation of their revenue and earnings streams. In almost every case, we saw strong performance from market trading, wealth management and investment banking. The first two are intuitive. After the rebound that started in April, risk assets have basically gone nowhere but up. True, volatility has remained subdued, which can detract from trading revenue, but the momentum in equities has still made for a healthy environment in which to generate revenue from trading. And it hasn’t just been the stock market that has helped. Bonds have also had a good run during the quarter. Looking at the S&P US Aggregate Bond Index (in the chart below), it advanced by close to 2.6% from its low in July to the best level in September. And, as markets improved, portfolios did as well over the summer and that means the wealth management arms of the large U.S. banks saw stronger revenue from fees.

The strength in investment banking is coming mainly from the open floodgates in mergers and acquisitions. In the last several weeks alone, we have seen a surge in deals, again mainly in the tech sector. As we wrote the other week, these deals are also taking on a circular nature, where companies are injecting capital in other companies that in turn are investing in or being invested in by other related companies.

With respect to market-driven trading revenues, wealth management and even mergers and acquisitions, the obvious question is what happens to the large U.S. banks if we run into even a mild correction? At the same time, the somewhat healthy climate for consumer lending and still relatively low delinquency and default rates during the third quarter will have to be reconciled against weakening labour force conditions. Indeed, stronger retail sales activity in the summer was peculiar given a significantly slower pace of job growth and even a declining rate of increase in total consumer credit. There has been a pick-up in recent weeks, likely because of lower short-term rates but also perhaps because of a need for cash as employment weakens. When labour market conditions begin to cause a deterioration in consumer credit conditions, is when banks might start sounding a little more concerned.  One of the problems we have, of course, is that as the U.S. federal government shutdown drags on, our access to a full set of information on the state of the labour market has been limited. ADP payrolls data and the weekly jobless claims figures do point to a moderate downshift in labour demand.

Which brings me to the final point. If the markets are correct and the headwinds against the economy are scarce, then why would the jobs market be moderating at all. One answer might simply come down to the allocation of capital. Companies have two main inputs – labour and capital. If you recall from your intro economics class, a production function shows us how the combination of these two inputs leads to a maximum level of output. At the crudest level, firms decide how much to allocate to staffing and how much to allocate towards investment in plants, machinery and equipment. Given the massive amount of capital being deployed to AI infrastructure, it would stand to reason that there would be less available for increasing staff. Now some argue that the productivity gains created from increased AI usage will allow firms to generate more output with less staff and this could explain the dichotomy we have today between macroeconomic growth and payrolls growth. The chart below shows the annual percent change in U.S. private fixed investment against the quarter-to-quarter change in non-farm payrolls. Note, for the latter, we are only going to May as there is only second quarter data for investment. The divergence will likely look even more stark for the third quarter based on the payrolls data up to August.

Possibly, but this ignores a key feature of the U.S. economy. It is driven by consumer spending. I don’t believe that we have reached a stage where AI adoption is at a level sufficient to demonstrate significant productivity gains across the board. But let’s assume this buildout gets to a point where job growth can remain stagnant. There is an end user somewhere in the AI food chain that is making that last widget for a consumer to buy. The problem is if the consumer isn’t there because he/she lost their job. This could cause a reverse domino effect, where demand for AI-applications falls, leading to less demand for data centre infrastructure and ultimately to less demand for chips. Take that one step further and you arrive at a situation where capex slows, market enthusiasm wanes and banks lose a couple of the remaining engines for growth. You can also think of this a possible reconvergence of the two arms of the so-called “k-shaped economy”.

Conclusion, the U.S. banking canary looks like it’s still breathing right now, but it might be that this is not the canary in the coal mine that we should be looking at?

On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.   

Andrew Pyle