Motley Fool Hidden Gems Investing - Big Banks Roll On

Episode Date: July 18, 2024

The traders are making money and credit card delinquencies are hopefully plateauing. (00:21) Matt Frankel and Ricky Mulvey discuss: - Bank of America’s comeback story. - What big financial institutions are counting on from the Fed. - Why commercial real estate giant Prologis is getting into the data center business. Then, (17:58) Motley Fool contributor Rachel Warren interviews Dhruv Nagrath, a director at Blackrock, about fixed income trends for investors to watch. Companies discussed: BAC, WFC, PLD, DLR Host: Ricky Mulvey Guests: Matt Frankel, Rachel Warren, Dhruv Nagrath Producer: Dylan Lewis Engineers: Desiree Jones, Kyle Carruthers Learn more about your ad choices. Visit megaphone.fm/adchoices

When WestJet first took flight in 1996, the vibes were a bit different. People thought denim on denim was peak fashion, inline skates were everywhere, and two out of three women rocked the Rachel. While those things stayed in the 90s, one thing that hasn't is that fuzzy feeling you get when WestJet welcomes you on board. Here's to WestJetting since 96. Travel back in time with us and actually travel with us at westjet.com slash 30 years. The banks are back, and you're listening to Motley Fool Money.

I'm Ricky Mulvey, joined today by Matt Frankel. He keeps an eye on the banks. Matt, it's good to see you. Good to see you, too. It's actually been a surprisingly good year to be a bank stock investor, you wouldn't think that by looking at some of the numbers and interest rates and stuff like that. But the stocks have done well. If you think about the global situation, the macro situation, the banks are chugging along. And one of them is one I know you keep an eye on, and that's Bank of America. Reported a couple of days ago. But because you followed it closely, I wanted to check in on it with you. A few of the highlights are that it's another record quarter for their equities traders, rising about 20% there to almost $2 billion. Net interest income,

They're still saying it's in a trough. Bank of America is not unique in that situation with higher for longer interest rates. They're now managing about $5.7 trillion. That's a lot of money and worth noting. They're also expecting credit card delinquencies to improve in the second half of the year. That's the menu of what's going on with Bank of America. Anything in there really stand out to you? Maybe the fact that you used the word expectation a few times, which I'm sure we'll talk about that in a little bit. It's interesting because they've been saying for a long time, and it's not just this quarter's prediction, they've been saying for a long time that net interest income would bottom in the second quarter. I don't think it's

as surprising as the market seems to that they say it's going to go up at the second half of the year, because that's what a bottoming is. But you mentioned the equities trading, which was really strong, their investment banking fee growth, which was 29% year over year, which came from a very low bar. But now more companies are going public, more M&A activities happening, and the banks are a big beneficiary of that. But yeah, asset management fees are up 14%. And a lot of that's because the amount of money they managed swelled to $5.7 trillion. And just so I'm setting the table a little bit, net interest income, that's basically the difference that a bank pays out to its depositors and takes in with loans, the remainder of that

goes back to the bank. Investors seem to be celebrating the certainty that Bank of America is offering, but I would say it's on an uncertain promise, which is that Bank of America is now counting on three rate cuts this year. I have no idea what the Fed is going to do. That seems a little optimistic. It even seems a little optimistic inside Bank of America, where its chief economist, a guy named Michael Gapin, is saying, you're going to get one rate cut. When they're talking about the growth of net interest income, which is really reliant on interest rates, and they have a lot of certainty about the Fed will do, while most people have a little bit less, help me bridge the disconnect here. What happens if Bank of America is wrong

here? Well, if they're wrong, the short answer is it'll take their thesis a little longer to play out with the rebound in net interest income. It could be a negative factor for credit card delinquencies, because credit card interest rates, as you know, are directly tied to what the Fed's doing. Right now, people are paying significantly more interest than they were a few years ago. The baseline expectation now seems to be the three rate cuts. I know one of their economists says one. But if you look at what the market's pricing in right now, it's three rate cuts. It's pretty clear that we're going to get one by September. That's pretty much a given at this point, unless something really crazy happens with the inflation data over the next

month or two. But it is based on an assumption that we're going to get three rate cuts. Absolutely not a given. We're going to get one. We might get two, we might get three, but that's not set in stone yet. If we got any more than three, or three or more, it might not even be a good thing. Generally, when you get accelerated rate cuts, it's because the economy is not doing so well. So, you know, it could go wrong one way or the other. And if they're right, if you get the rate cuts, though, you might have some more loan activity, financing activity. All of those things are good for a very large bank. Another point from CEO Brian Moynihan that I want to I want to just run by you. This is straight from the earnings call

saying, quote, simply put, Zelle is becoming a dominant way to move money. End quote. Zelle is their competitor, along with six other banks, to Venmo. I don't know a whole lot of people on Zelle. That seems like a pretty bold take. They're pointing out that 23 million people are on that platform. I'll point out that about 60 million are on Venmo. You buying that from Moynihan? Yes and no. This is totally anecdotal evidence. But in my experience, the only people I ever Zelle are my parents and other people who are around that age group. I'm not the only one who says this, this is in a lot of other expert articles, it says that the older generation seems to trust Zelle more than they do PayPal or Venmo because

they're hesitant to give a third party their banking information. If you didn't grow up with things like Venmo and Cash App and things like that, it makes sense that you might not want to give your banking information to somebody else. I don't think it was you, but I had a conversation with somebody at FoolFest, said older people use Venmo, or older people use Zelle, then it's Venmo, then it's Cash App, and it's very age-separated in a lot of ways. Yeah, we'll see. And the older generation does have a little bit more of that cheddar. So, you know what? It might be good to own the digital banking app with them. You've been talking Bank of America

for a while and a few months ago you're on the show you pointed out that it was trading for less than book value i think you said it was basically a buying opportunity saying that that was like that's a little bit weird for this massive of a bank book value being basically assets minus liabilities for for a bank and the bank has gone on a run since then now trading well above its book value what's what's changed in the meantime over those past few months for bank of america The business has changed. Maybe some sentiment. Maybe a little bit of both. First of all, you're saying I made a good call. Yeah. We can do that sometimes.

It turned out to be good timing. It's absolutely a change in sentiment. It's not a big change reflected in the numbers. In fact, as we're probably going to talk about in a little bit, credit card delinquencies are higher than they were when I said that. Nothing's happened with interest rates since I said that. The Fed hasn't raised or cut interest rates since I made that call. Net interest income has actually declined since I made that call. A couple of weeks ago, the mean expectation was for one rate cut by the end of the year. Their economist who said one rate cut, he was the norm a couple of

weeks ago. But now, the mean expectation is for three rate cuts. So, the sharpness of the turnaround that's expected has definitely changed. And that's really what you're seeing priced into the stock. Let's talk about the delinquency trend, because Moynihan on the call saying that he expects it to plateau and then go lower throughout the year. For me, at least, that was surprising. I'm struggling between two things. It's good that it's not going up, but I also don't think the two data points make a trend. What are you making of the plateauing of credit card delinquencies for these big banks? There are a couple of things here. Credit card delinquencies have been very low for a very long time. It's been artificially low.

It has to do with the COVID pandemic. Banks were letting consumers, not just credit cards, but auto loans, mortgages, whatever, postpone payments if they needed to. Kind of more of a safety net. It was really easy to postpone your credit card payments for the longest time. That just started to end like a year ago, really, where banks are like, okay, we're not doing any COVID forbearances or anything like that. The question is, is the spike you're seeing a reversion to pre-COVID levels, or is it an uptrend because of consumer economic fears and things like that? That's the big question mark right now. I think it's a combination of the two, if I'm being honest. We are just getting back to pre-COVID

levels. The default rate has been going up. If it stays exactly where it is right now, we're at pre-COVID levels. I'm not willing to bet that it's going to stay exactly where it is. I think there will be some uptick in auto loan defaults in particular. People are overpaying for vehicles during the pandemic. I saw some car dealership ads where a market adjustment added $10,000 to $20,000 to a car's price. People are overpaying for a depreciating asset. They might run into trouble. Credit card debt continues to get higher. It's not just delinquency rates. The debt itself is getting higher. I mentioned it's more difficult to postpone payments now than it was a couple of years ago, and people weren't counting on that changing.

I do think a lot of consumers are going to start running into trouble paying their bills, especially if we don't get the rate cuts that are expected. We've also seen Morgan Stanley report this week, Goldman Sachs. We talked about Charles Schwab a little bit a couple of days ago, as well as Wells Fargo. Any other big trends you're seeing from the parade of bank reportings this week? Pretty much the big trend is investment banking incomes up and net interest income is down. That's pretty much across the board. It's just a degree of how bad or how good it was. Their net interest income was down just like Bank of America's, but it was down 9% instead of 3% year over year. It was more of a disappointment

to investors. We saw that reflected in the immediate price reaction. We're seeing a lot of buybacks, again, the extent of which varies, but that's management telling you that it's still an attractive place to put money to work. All of the banks, I think Morgan Stanley, they're the only one I haven't really checked out so far, but Wells Fargo, JP Morgan, Citigroup, Goldman Sachs, all beat expectations on the top and bottom line, mainly because of non-interest income, like investment banking fees, trading revenue. Things like that have been very, very strong, and it's helped to offset the decline in net interest income. Let's move on to Amazon's landlord, Prologis. This is a REIT that owns a lot of warehouses.

About 3% of global GDP rolls through Prologis warehouses. Nothing really too shocking in this report to investors. Revenue is down, but in line with expectations. One thing that you pointed out in writing about it on the premium side that I want to talk about with you is that this landlord is raising rents a lot on its customers. I'll basically paraphrase you, but in the second quarter, Prologis reported an average cash rent change of more than 50%, 5-0. I can't imagine my landlord doing that to me where I live in my rental. But what's going on here? How are they pulling this off?

So, two things. One, there's a lot of a surge of demand for industrial properties that was kind of led by COVID. A lot of e-commerce demand was pulled forward. E-commerce, as you just mentioned, Amazon, uses a lot of fulfillment space. So, we saw market rents really just skyrocket during COVID. Unlike what you said with your landlord raising rent on an apartment, things like that, these leases tend to be seven to 10 years in length, so they don't reset for a while. If somebody took out a lease in a Prologis property seven years ago, so 2017, they took out that lease based on what rent was at that moment in time, with a 2% annual increase or whatever standard in the commercial real estate market.

Now, the market rent is 50% higher. As these leases expire, you're seeing it immediately reset to the market value. It was like if you had a 10-year lease on an apartment. Obviously, apartment rents have gone up considerably over the past few years, but it's been more of a gradual, every year when your lease renews, you pay a little bit more. But imagine if all of that rent growth hit you all in one year. That's what we're seeing with Prologis tenants. And the interesting thing is, Prologis is often thought to be an expensive REIT on any price-to-earnings multiple or anything like that. But the big reason for that is, we haven't seen a lot of the rent growth. Their average lease was started before the pandemic

era explosion went in. So, over the next few years, we're gradually going to see this, what I call embedded rent growth, come to the number. You're going to see these 50% cash rent chains for at least another year or two. And it's going to start being reflected in the numbers. So I'll concern troll a little bit. The occupancy was down a skosh. I mean, even though it makes sense that rent has gone up over the past seven years, if I were a big e-commerce giant, I might be a little upset at a 50% change in rent. Are they seeing more customers packing up and leaving? Do they have other options other than Prologis? They have seen some increase in occupancy. It's more due to overbuilding than the increase in

rent. If your landlord raised your rent by 50%, you might initially say, oh, I'm out of here, I'm not paying that. But then if you went to every other apartment building nearby and the rent was 50% higher than you were paying, why would you leave? Occupancy is down from 97% to 96%. Let's Put that in perspective. That's pretty good for a 50% rent increase. The biggest culprit is overbuilding, and that's really slowing down. Their CEO in the earnings release said that demand is subdued. Any type of commercial real estate, when there's a surge in demand, you see a surge of building. It's starting to slow down. Look at these numbers from this quarter. $2 billion worth of development stabilizations, meaning newly delivered

properties. Only $300 million of development starts during the quarter. They're really picking their opportunities better. You're seeing a slowdown in new builds. That should help stabilize the supply-demand dynamics. It's not that rent's gotten too expensive. It's that there's just more to choose from. Let's talk about the spending on data centers, because Prologis is spending about $7 billion to $8 billion there. CEO Hamid Moghadam goes on CNBC and reminds investors that this is not an AI stock, and they could do a lot of things with the data centers. They could continue to lease them out. Maybe they'll build them and sell them. But what do you think about the growth story for data centers with Prologis from here?

First of all, I'll put it into context. You correctly mentioned $7 billion to $8 billion worth of data center development they're planning. That's over a multi-year period. This is a company with over $200 billion worth of properties under its umbrella. It's not a giant Porsche. They're not doubling in size because of data centers. Having said that, it's a very in-demand property type. Prologis has some very big cost advantages over its competitors. It borrowed over a billion dollars in the second quarter at a rate just over 4%. Not a lot of REITs can do that right now. It makes sense that if they say, okay, we've overbuilt industrial properties, our bread and butter. The market for that is

saturated right now. We're going to see more vacancy if we build more of those. But data centers, they can't build them fast enough right now, the other companies. So, why not leverage our cost of capital into that property type? And you're right, I don't want to say probably, but they may not even hold them on their balance sheet. They may be a third-party developer and just build these high-quality data center properties and sell them to other REITs. That's their core competency. I don't think Prologis wants to be a data center manager. They're really good at what they do. If they can develop at a favorable cost and create value that way, then I'm all for it. But I don't see this as the next AI real

estate stock. If you want that, look at Digital Realty Trust. Real quick, because we got to wrap up. I own Prologis. I think of it as a sleep number investment, something that, honestly, I don't think I have to pay a ton of attention to, but I also don't think I will regret owning the shares I'm buying now 20 to 30 years from now. You think that's fair? Yeah, that's a fair assessment. It's a stock that I would be 100% confident almost that it will be worth more 20 years from now than it is today. Will it beat the market? Is it going to be terribly exciting? Shrug emoji. Yeah, I look at it as something

that's going to match the market over time, like a Berkshire Hathaway. They have great cost advantages, they have a lot of capital on their balance sheet, they have expertise in development, and there's a lot they could do with it to achieve market-matching, at least, returns. It's not going to be a 10-bagger or anything like that. I appreciate your time and your insight. Always fun to be here. All right, up next, Motley Fool contributor Rachel Warren speaks with Dhruv Nagrath, a director at BlackRock, about the rise of bond ETFs with retail and institutional investors.

year for bond ETF flows with over $300 billion pouring into fixed income ETFs. And iShares accounted for approximately $113 billion of that total. BlackRock believes that bond ETFs will be a $6 trillion industry by 2030. So to start today's conversation off, what can you share about the drivers of bond ETF adoption that you're seeing and where are you seeing the opportunity as investors are stepping out of cash this year? Yeah, thanks, Rachel. And that is a big lofty goal. It's a big, big number. $6 trillion is something that like mentally it's kind of sometimes hard to get a handle on. But it's really, it's a reflection of the fact that there's, it's a really great time to be a fixed income ETF investor or just to be a fixed income investor at

all. There's a huge opportunity set out there and there's more and more investors are using the ETF as the technology to kind of access those markets, to access bond markets. I'll talk about the longer term story and then I'll talk a little bit more about the near term. Why is it a good time? The longer term story of bond ETF adoption is one where if you think about what the ETF is, it's a technology, it's a container, it's a tool that lets you access different types of securities. So with the bond market, which has historically been a little bit more of an illiquid market, a little bit harder to access, what you have with the ETF is the opportunity to put portfolios of bonds into a wrapper, into a fund that

trades on the stock exchange. You can trade it throughout the day. And what it does is it gives you that access and efficiency of electronic trading that you're familiar with with the stock market, but you've got bond ETFs that are letting you do that. So that's actually driving, I mean, the three big drivers, I'd say, for what we think is going to be a $6 trillion industry is the fact that now, because of that technology that I talked about, you're able to build much more evolved, whether it's a 60-40 portfolio or a more customized portfolio, it's a lot easier to do it as an investor.

That's the first piece. it's just easier to build portfolios. You can do it with quite a bit of precision. So I represent a suite of 135 fixed income ETFs, and that's a lot to kind of keep my head around. But there's so much you can do, whether you're targeting maturities like interest rate risk, whether you're targeting levels of credit risk and fixed income, having multi-sector portfolios, there's a lot you can do with bond ETFs. The other thing I'd say, and this is not so relevant for your audience, Rachel, but it's worth noting that institutional professional investors in their portfolios, what they're doing is also using bond ETFs. So, this is,

you know, investors of all shapes and sizes are using these institutions, but the 10 largest asset managers in the world use bond ETFs in their portfolios. And then the other thing that I mentioned at the start about bond ETFs making it easier to access the bond markets, by doing that, by creating this greater trading and the billions of dollars that you mentioned, it's also actually modernizing the bond markets themselves. They're electronifying. I think that's not actually a word, but I just used it as a word. We're electronifying the bond markets and to make those markets more efficient as well. And so, that's why we have those lofty ambitions for what bond ETFs should be globally. But why does this matter? I mean,

And what it matters is now it's easier for investors to access much higher yields in the bond markets. Right now, they can do it very easily using these instruments that trade on the exchange. And then you asked me, Rachel, where do we see opportunity? The flows this year, just to take this year as an example, it's been about $107 billion of inflows into bond ETFs this year. Off those $107 billion of inflows, and this is across the industry, not just iShares, $43.9 billion of that went into broad multi-sector, high-quality exposures to things like AGG,

which is a representation of the U.S. dollar-denominated investment-grade bond market. And then the next biggest category is $19 billion into Treasury exposures, and then 15 billion into investment grade credit. So what you've got is an up in quality bias. So basically 73% of those flows have gone into high quality exposures. And I think that's the kind of the punchline right now is that you don't need to take a lot of risk to make money in fixed income these days. But yeah, let me throw it back to you. BlackRock recently released a new paper about global fixed income ETFs called No Time to Yield. It had a lot of very valuable takeaways, which I think really relate to what we've been talking about so you know maybe share with me some of

the key findings from this report and then what are your thoughts on how those findings play into the thesis that investors you know really want to consider moving back into fixed income now and looking forward yeah i i love the name of this paper that we wrote by the way and and i think it's it's very easily accessible um for for your for your listeners um no time to yield it makes my job sound a little bit cooler than it is um you know i love a some something of a james bond type reference uh be fantastic um but uh it's it's not quite as exciting as a james bond movie but it is but it is exciting because there is a chance to um to really make money in fixed income um i think the key message if i had to give you the probably the most important um finding from

this paper. It's summarized in one great chart that I'm not going to visualize for you. But the key point that's made in this paper is that markets tend to price in rate actions from the Fed before they actually occur. And the point here is that although it feels nice and safe to sit in cash, there's two big reasons why you should consider moving a little bit out of cash and allocating to fixed income again um so so right now investors across the board are actually underweight fixed income and it's not to say that every that a 60 40 is for everyone but it is it is an important point to remember like why do we hold bonds in a portfolio anyway and one of the reasons we hold them is uh is is the idea of equity diversification and having a bit of a buffer

in your portfolio um using fixed income is is a big you know big reason for it the other reason you hold bonds is to generate income. And you've now got healthy yields across the yield curve. But the key chart that I alluded to and the key takeaway was that we're in the sweet spot of investing in fixed income right now, because you're in the period between the last hike and the first cut. And that historically, using our historical study of this, has been the time when you've made money in fixed income because of that insight that And I mentioned that markets tend to price in actions by the Fed before they happen. What we found was on average, core bonds represented by something like an AGG returned on average

14% in that sweet spot period, 14.8% relative to 5% in cash. Now, 5% is still great in cash. That's really good. But there's a lot more money to be made in those core bonds in that period of time. Now, core bonds do outperform in the six months after the first cut. They do outperform cash, but not by as much. It's only like 2%. So that's, again, this is historical performance.

We're just trying to illustrate the point that that's been a good time to kind of make money. So that's the big thing is getting past the inertia. For a lot of clients, sitting in cash has made sense. I'm not even going to talk about the equity side of things. I know everyone's been fascinated by the Mag7 and the NVIDIA hype and all that. And I don't want to have a view on that. I'm just going to stick to the relatively boring part of the portfolio and say that you can keep it fairly simple. You can use really high-quality exposures and then allocate in a sensible way.

You can have some exposure at the short end of the curve. And then you can allocate a little bit into what we call the belly of the curve. If you wanted to pick a point on the yield curve of maturity level, it's like five years. The idea there is that you can have, one, a bit of ballast. If equity markets sell off, you get a bit of a buffer there. You've got potential price appreciation when the Fed eventually does cut. Then the other thing is reinvestment risk, which is, yes, money market yields are high right now, but there will come a time when they come down.

happens when they come down is they come down quite quickly right and so again that that cash right now is only earning you a decent yield but you could be missing out on potential price appreciation if you have to you know take on liberal interest rate risk um uh and and you know you could be at the risk of of that kind of that reinvestment risk coming down um with short-term rates coming down um so yeah i think the the key thing is like you know getting getting some getting past that inertia, you know, starting to act in your portfolio, thinking about it from a portfolio context and trying to move a little bit, it's impossible to time interest rates and I don't recommend anyone tries to time it perfectly, but it is, going back to your

point about being long-term investors, we think it's prudent to kind of think about, okay, what does the next 12 months look like in fixing? as always people on the program may have interests in the stocks they talk about and the motley fool may have formal recommendations for or against so don't buy or sell anything based solely on what you hear i'm ricky balvi thanks for listening we'll be back tomorrow We'll be right back.