Rising Rates Will Boost These Online Brokerages

2018 should be an interesting year for online brokerage firms wide-moat Charles Schwab and narrow-moat TD Ameritrade. We forecast both of them having double-digit percentage point growth in earnings from the dual effect of U.S. tax reform and a rising interest-rate environment.

It’s important to remember that asset-based fees, like net interest income and fees related to assets under management, are the main drivers of online brokerage revenue going forward. In the fourth quarter, less than 10% of Charles Schwab’s revenue was from trading while less than 40% of TD Ameritrade’s was transaction-based.

Three of the main factors to look out for regarding interest rates for the online brokerages and other financial institutions are 1) likely multiple increases in the fed funds rate that will increase revenue yields on variable-rate and short-term duration instruments 2) any further climb in long-term interest rates like the 10-year Treasury note that affects the revenue yield on longer-dated securities and 3) changes in deposit betas or, in other words, how much banks increase what they pay on client deposits.

One specific factor each for Charles Schwab and TD Ameritrade in 2018 that are interesting parts of their investment thesis is the trajectory in Charles Schwab’s asset growth after passing a key regulatory threshold of $250 billion in assets and updates on TD Ameritrade’s realization of synergies related to its integration of Scottrade.

Charles Schwab and TD Ameritrade are currently about fairly valued. However, that compares favorability to many financials that we evaluate as being fairly valued to overvalued. Even if the stock market were to fall and client assets were to also fall, the earnings of Charles Schwab and TD Ameritrade will likely still go up along with rising interest rates.