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Big Banks Bracing for a Recession

Also, Disney strikes back in a proxy fight, and two 529 plans earn top marks.

Big Banks Bracing for a Recession

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton.

Let’s get started with a look at the Morningstar headlines.

Disney Strikes Back in Proxy Fight

Disney is pushing back in the proxy fight against activist investor Nelson Peltz and his Trian Partners.

Peltz wants a board seat to address perceived issues including weak governance and financial underperformance. In a securities filing, Disney said, “Nelson Peltz does not understand Disney’s businesses and lacks the skills and experience to assist the board in delivering shareholder value in a rapidly shifting media ecosystem.”

Morningstar believes this proxy fight was basically inevitable.

Morningstar doesn’t agree with all of Peltz’s concerns but thinks his perspective would add value to Disney’s insular board. We expect that he’ll continue to fight until the shareholder vote, or he is placed on the board.

Peltz outlined Trian’s six objectives. The list includes ensuring a successful CEO succession within two years instead of replacing Bob Iger now. Morningstar still believes Iger will extend his stay once again.

We maintain our $155 estimate of what we think Disney’s stock is worth.

Hanesbrands Begins CFO Search

Hanesbrands closed the fourth quarter with some positive news for shareholders as it begins a search for a new CFO. Net sales came in slightly ahead of the company’s most recent estimates while operating income was in line with expectations. The numbers are less than 2021′s results.

Yet, investors should see the news as a mild positive considering Hanes’ weak cash flow, tough market conditions, and elevated inventories. Hanes is also looking for a new chief financial officer. Michael Dastugue announced he will leave next month for family reasons.

Longtime chief accounting officer and controller Scott Lewis will take over for the time being. Morningstar’s $22 estimate of what we think the stock is worth shouldn’t change.We view shares as significantly undervalued.

Coinbase Plans Layoffs

Coinbase is planning another round of layoffs.

The cryptocurrency exchange platform says it will eliminate 20% of its workforce by the second quarter. It’s expected Coinbase will continue to report steep losses in the fourth quarter. Weak cryptocurrency markets and the chaos following the collapse of fellow exchange FTX have pressured the company.

Coinbase’s other cost-cutting efforts include lower marketing, technology, and other expenses this quarter. Morningstar sees the cost reductions as a necessary and positive step as revenue has declined from its 2021 peak.

We are sticking with our $90 estimate of what we think shares are worth. We see the shares as undervalued, but caution investors that Coinbase’s results are deeply intertwined with volatile cryptocurrency prices.

Big Banks Prepare for ‘Mild’ Recession

Hampton: The banks have kicked off earning season, and we’re in a time of high inflation. What do JPMorgan, Bank of America, Citigroup, and Wells Fargo’s results tell us?

Eric Compton: Definitely a lot we could dive into there. A lot going on with all four of those banks, but I’ll pick on, I would say probably two themes that most investors have focused on. The first one is related to net interest income, and the second related to just a lot of the talk about is there a recession or not? With net interest income, we’re at an inflection point, and so at any sort of inflection point, everyone’s trying to time that. And with net interest income as rates have risen, as the Federal Reserve has risen rates, banks’ net interest income has gone up quite a bit over the last several quarters. And as the Fed raises rates, banks earn more on their loans, but especially at the start of a cycle, they don’t pay out as much on their deposits. That’s what allows net interest income to go up so much.

However, eventually you reach an inflection point where banks start paying people for those deposits. I’m sure some of our listeners may have noticed savings rates have gone up on their savings accounts or the rates on CDs have also improved. As that happens, banks pay out more and more on those deposits, and eventually that catches up and it starts to eat away at that net interest income growth. Results show that we have indeed reached that inflection point. Q4 results were indeed roughly the top for net interest income for the banks. Earnings from that are going to, I would say, stall out or even go down a little bit for some of the banks from here.

That was a key one. On recession, I’m sure we’ll get into this a little bit more later, but on recession, banks did indeed increase their provision for loan losses. You did see some changes in, for example, delinquencies on certain loans. I think we are starting to see a little bit of a normalization in the credit markets. However, I would say certainly nowhere near recessionary levels of strain just yet.

Hampton: You mentioned that the banks are building up their reserves in anticipation of loan losses. How do their current actions compare to what they’ve done before previous recessions?

Compton: It’s actually a trickier question than people realize on face value. And that’s because one, every recession is a little different. Then two, I think a point that a lot of people miss, and I think that if you read a lot of the other headlines, I’ve seen where people have taken this to mean that the banks are definitely seeing a recession going forward. I think it’s important to keep in mind a lot of these reserves, changes in reserves are just related to their economic forecasts, and their economic forecasts are just as good or I would say maybe just as bad as everyone else’s. Predicting the future is just as difficult for everyone. It’s really hard to predict the timing of a recession. In the quarter, we definitely saw the banks change their macroeconomic forecast to make them slightly worse.

That was the major driver of those reserve increases. And you typically see a little bit of an increase in reserves prior to past recessions. Every recession’s a little different, some not as much as others. You didn’t see as much of an increase, for example, in the tech bubble in early 2000s, and that one didn’t hit the banks as hard. But you typically see provisioning peak towards the end of a recession or even after recession’s already over, which shows you that even the banks have a hard time predicting exactly when all of this stuff is going to happen. We are starting to see that go up. But I think an important point to keep in mind is it’s largely related to their economic forecast. Just understand how good or how much weight you want to put on those. And as far as actual deterioration and credit quality, we’re seeing a little bit of that but really nothing close to anything that I would call a recessionary level of strain just yet.

Hampton: Two banks, JPMorgan and Bank of America, surpassed profit and revenue expectations in the fourth quarter. And as you said earlier that they’re earning more off loans because of the rising interest rates. But both said that they’re expecting a mild recession. How could that scenario affect them in the short term and the long term?

Compton: For recessions there’s typically a few patterns you see play out for the banks almost every time. During any recession, credit costs are going to go up, and so provisioning’s going to go up, things like net charge offs are going to go up. That typically reduces banks’ profitability as those credit costs go up. Something else you’ll typically see as a slowdown in growth. The definition of a recession is the economy’s not growing anymore, at least for some period of time. Banks’ lending growth, banks’ fee growth will always—I shouldn’t say always—but will typically slow down in a recession. It’s not always as simple as it might seem. For example, during the pandemic, banks’ fee growth actually surged, I-banking was doing really well. Trading revenues are doing really well, which can be a little counterintuitive, so every recession’s a little different, but those are patterns you’ll typically see.

I think where a lot of the debate is now is what’s going to happen to interest rates even if we hit a mild recession. And a lot of that’s going to depend on where inflation’s at. If we start to hit a mild recession and inflation is actually retreating, I think you’ll see the more typical pattern where interest rates could actually start to come down. Some of that net interest income might also start to come down for the banks, which is what you typically see during a recession. However, if inflation is still high, if the Fed still feels like they need to fight that, there’s some debate about maybe they leave rates higher for a little bit longer to try to bring inflation back down again. I think there’s a lot of debate about what happens to interest rates this cycle.

Also, something else I would highlight is this recession is you could say almost well telegraphed, or I think a lot of people are thinking about it, a lot of people are expecting it, banks are already starting to bake it into even their own macroeconomic forecast. There’s some debate about what happens to bank stock valuations if everyone expects it and everyone’s prepared, do they get hit as hard as maybe some of the previous recessions that were harsher and maybe a little more surprising? I think there’s a lot of debate about that now as well.

Hampton: Well, let’s turn to Wells Fargo. Now, their fourth-quarter earnings shrank from a year ago, but they beat profit estimates, and they’re kind of in this comeback period. What’s going on with this bank?

Compton: Wells, like you said, they’re still in turnaround mode. Two of the big things that you already highlighted were one, they had that big settlement with the CFPB [Consumer Financial Protection Bureau]. So, they took another big charge during the quarter related to that. They’re also finally exiting the mortgage business. I would say on the mortgage business, it’s kind of about time. The mortgage business has been really tough for the banks for some time. Banks have lost share in that industry for over a decade now to a lot of the nonbank players such as Rocket Mortgage, which I think a lot of people are familiar with, it is a part of Quicken Loans. That’s been the big player for a while now. They’ve taken share from the banks. So, Wells has been one of the last kind of banks to try to hang on there.

A lot of the other banks have de-emphasized those operations for some time now, and I think Wells finally realized, “It’s time for us to do that as well.” I’d say about time for them there. Then as far as the settlement, obviously as a bank, you never want to be paying billions of dollars to regulators. On the surface, not a great thing, but I think underneath the surface it is a sign that they do continue to make progress. When you saw, for example, their estimate of future legal costs, that actually went down during the quarter, so a sign that some of these costs are finally starting to go through the snake, so to speak. And you saw also that some of the language that came out in the release, they described a lot of their efforts with the CFPB substantially complete now. I don’t think the asset cap is yet going to be lifted anytime soon. I think that’s probably on until 2024. But I think also it is at least a tangible sign of some progress for Wells.

Hampton: And Citigroup is also in a turnaround mode. What’s the upside and the downside from their fourth quarter?

Compton: Citigroup, so much I could go into there, such a complex situation, so much going on with that bank. But a couple of high-level points. In the quarter, and this was a theme we saw for the year, is that what’s called their TTS business, or Treasury and Trade Solutions business, that continues to do pretty well. I think it’s actually surprised us. We didn’t expect it to do quite this well this year. And that’s really a key component of Citigroup’s operations. I’d say Citigroup’s key strengths, or one of their key strengths, is that Global Commercial Network. One of the things that makes them unique, and the core of that is this TTS business. That continues to do pretty well as far as just gathering some assets, taking some share, getting some incremental profitability from higher rates. On the downside, a lot of their businesses do still remain under some pressure.

Investment banking has not been good for anyone, including Citigroup. Their wealth unit, a unit they’re trying to make a turnaround in, has also been under some pressure, as it has been for the entire industry as asset levels tend to go down when market levels are lower. Those are some of the lowlights. Some of the highlights for Citigroup—I don’t know if I’ll call it a lowlight or a highlight—but just something that adds some complexity to the situation is they still haven’t quite broken out how the legacy franchises quite fit into that overall guidance.

It just makes it harder to predict exactly what’s going on underneath the surface for them. I think that a key item for a Citigroup remains its complexity and trying to forecast what the future looks like as they continue to sell off more and more of these units. That situation remains complex. We still think shares are too cheap at this point, but management’s timelines for getting to some of their profitability goals remain 2024 to 2026. Still a multiyear story, still in the middle of turnaround mode. I think more to come from them.

Hampton: If investors are looking for opportunities among the Big Four that we discussed today, what would you recommend?

Compton: For the banks, it’s been, I would say a little bit frustrating for the last, I’d say a good chunk of 2022, just because the banks have not gotten super cheap during that time. And typically when a recession happens, bank stocks tend to sell off as people kind of go into risk-off mode. Banks’ earnings tend to suffer. Banks’ shares as a sector haven’t really been fully pricing in a recession. However, they’ve been, I would say partially pricing in some of that risk. They haven’t been super expensive either. We’re kind of in this no man’s land, I would say, on a sector-valuation basis with that risk of recession kind of overhanging a little bit. may or may not happen in the future. I think with banks it’s been a little frustrating because there hasn’t been an obvious sectorwide call.

I think the individual stock-picking then starts to matter more. And within that, we tend to more idiosyncratic names among the Big Four, or actually I should say names with idiosyncratic value drivers. That would be basically the cheap turnaround stocks, Citigroup or Wells Fargo. We think there’s still some valuation disconnect there. We really liked JPMorgan at the start of 2022, but they’ve traded up a lot in the last three to six months. We think that opportunity has largely played itself out. That’s how I would look at the Big Four. Among the regionals, there’s some relative valuation opportunities. There’s some stocks that we think are fully priced, some that are a bit cheaper.

Among those, some of the cheaper ones would be like a Truist Bank. We think the market’s gotten maybe little frustrated with some of the progress they’ve made after their recent acquisition. I think there’s still some valuation disconnect there. Another one I would highlight would be KeyBank. KeyBank has some of the highest investment-banking exposure among the regionals as a percentage of revenues. I think the market just doesn’t love that right now, but that industry’s cyclical. It’ll come back eventually. I think eventually that valuation disconnect should close over time as well.

Hampton: Thanks, Eric, for your insights into the banks’ quarterly earnings results.

Compton: Great. Thanks for having me.

Best 529 Plans of 2023

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. 529 education savings plans have become popular vehicles for saving for college. Here today to discuss the two 529 plans that earn Morningstar’s top rating and to talk about some best practices when it comes to evaluating 529 plans is Patty Oey. Patty is a senior analyst with Morningstar Research Services and leads Morningstar’s 529 plan research.

Nice to see you, Patty.

Patricia Oey: Hi, Susan.

What Is a 529 Plan?

Dziubinski: Let’s start out with a brief definition of what a 529 education savings plan is and how it works.

Oey: Sure. A 529 savings plan is an investment vehicle, and one of the key benefits of it is that when you invest in this vehicle, your money grows tax-free, and then when you spend it on qualified education savings for college and room and board and books you’re not liable for capital gains. Typically, a plan, they’ll offer a menu. So, there will be a menu of different equity funds. There will be some bond funds. And then, the most common investment is typically like a target-date fund, and we call them either target-enrollment or age-based portfolios. And basically, what it is, is that depending on your child’s age, if your child is 5, they still have 13 more years of school. You pick that five-year-old portfolio. It will have a relatively high allocation to equities, and over time it will gradually derisk. The idea is that you let the money grow, it’s derisking, and then, just before you go to college, it shouldn’t have that much equity left because as we saw in this year’s market, you would take a big hit if you had too much equities.

State Tax Benefits

Dziubinski: Given that the tax benefits that you mentioned about these plans, it seems like the first step to take to figure out if your state offers a tax benefit before investing in a 529, right?

Oey: Yes. Like with all tax issues, it’s very, very complicated and depends does your state even have state income taxes. So, if it doesn’t have income taxes, it’s not a question. But if it does have an income tax, you also have to check does it offer an income tax benefit. And those come in all different amounts. The easiest thing to do is that we have an article on it, which we will put a link to in the bottom of this video, but basically it can provide a benefit of $100 or so, but also it depends on how much you’re contributing, what your tax rate is, and what the state benefit is.

529 Plan Expenses

Dziubinski: Patty, one of the other things that investors should be considering when they’re examining 529 plans besides taxes is the idea of expenses of these plans. Talk a little bit about that.

Oey: Right. The sponsors have done a great job over the last few years. Fees have come down a lot. So, for a lot of direct sold plans, which are plans that you can just access on your own, usually through the internet, a lot of these plans, they offer mostly really cheap index funds. Their target-enrollment and their age-based portfolios hold low-cost index funds. So, those plans can actually be very, very cheap. There are some plans that offer an all-active lineup and those tend to be a little bit more expensive, but some of them are worth it, like the ones offered by T. Rowe, or Fidelity, or American Funds. They are more expensive, but the underlying holdings are these top-rated funds from those houses. So, we like those plans, too.

Dziubinski: What about investment options and processes? Do these tend to be similar across different plans? Or are there some significant differences? I mean, you mentioned some of them have actively managed funds versus index funds. What are some of the other differences you see?

Oey: Generally speaking, the ones that are direct-sold, they will tend to have a more index fund lineup. The ones that are advisor-sold, they tend to have a much bigger menu because you have an advisor helping you. They’ll have maybe more asset classes, and they’ll have a mix of active and index funds that you can choose from.

Two 529 Plans Earn Top Marks

Dziubinski: Morningstar, of course, rates 529 plans, and there are two plans that currently hold our highest rating of Gold. The first Gold-rated plan is the Michigan Education Savings Program, which is managed by TIAA-CREF. Why do we think so highly of this plan?

Oey: Yes. Very importantly, it’s a well-designed plan. It has low fees. We like that very much. And also, the state that sponsors it, their governance and their oversight over the plan is very, very strong. So, they recently moved to a target-enrollment structure. They used to have an age-based structure. Target enrollment is a smoother glide down. The equity trims are smaller. So, that is better. So, there’s less market-timing risk with a smoother glide path. And when they worked with TIAA-CREF to create this new glide path, they incorporated how their state investors, when do they usually open accounts, how much are they putting in? And so, they optimized the glide path using participant data, which we thought was very good. And another thing they also did was they also made an open architecture. So, they used a mix of funds. Sometimes from a certain provider, the provider will want to use their own funds. In this plan, they use a mix of Vanguard and other funds as well. So, an open architecture also is very good.

Dziubinski: Interesting. And then, the second Gold-rated plan is Utah’s my529 plan, and this is the only plan that has consistently earned a Gold rating every year for the past decade since Morningstar started rating 529 plans, which seems quite noteworthy. What is this plan doing right?

Oey: Right. So, similar to the Michigan plan, very, very strong state oversight. They use a progressive glide path. They use low-cost index funds as underlying holdings. One thing that’s different about the Utah plan is that they actually also have a feature where you can customize your own glide path. So, you can decide if you want to be more aggressive; you can create your own more aggressive glide path; and then, you can also pick the underlying funds to build it. They offer you a mix of Vanguard and DFA funds. So, that’s an interesting option. Actually, it’s the only plan that offers this kind of customizable feature.

Dziubinski: Well, Patty, thanks for your time today. We always enjoy talking with you about 529 plans.

Oey: Thanks, Susan.

Dziubinski: And for those viewers who are interested in seeing Morningstar’s 529 plan ratings, we will provide a link to those ratings at the end of this transcript. I’m Susan Dziubinski. Thanks for tuning in.

Read About Topics From This Episode

Trian Opens Proxy Fight With Disney; We Believe Peltz Could Add Value as a Board Member

Coinbase to Lay Off More Workers in Second Round of Cuts

Hanesbrands Alleviates Some Concerns by Reaching Modest Q4 Expectations; Shares Very Undervalued

JPMorgan, Wells Fargo, Bank of America and Citi Beat Earnings Expectations, but Worries About Headwinds Remain

Bank of America Beats Fourth-Quarter Earnings; Net Interest Income Outlook is Disappointing

Wells Fargo’s 2023 Outlook Shows That the Net Interest Income Boom May Be Over

Solid Q4 Results for Citigroup; Stock Remains Most Undervalued Among Banks

Solid Q4 2022 Earnings for JPMorgan; 2023 Outlook Is Good

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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