Investors prefer their Wall Street firms served without lumps. Of all the ways that the biggest U.S. financial companies generate revenue, investors have sent strong signals that stable, recurring fee revenue is hot, while choppy, hard-to-predict lines of business are not.For chief executives that means forging into wealth management, credit cards, and services to try and mute the swings in advisory and trading income. But the anti-volatility pendulum might have swung too far.Advising on deals is an example of a business line that is mostly moribund. There are high-profile exceptions, like recent mega-bids by Exxon Mobil and Chevron for oil-drilling rivals.Mostly, though, the conditions for companies buying one another have been less than ideal. Geopolitical volatility, unpredictable borrowing costs, and a general sense of economic uncertainty are the opposite of catnip for executives wondering whether to commit to corporate marriages.Worldwide merger announcements hit a decade low in the first nine months of 2023, according to LSEG data, a tragedy for banks like JPMorgan, Goldman Sachs, and Citigroup who earn fees from such deals.That has led to some rapid reversals. Morgan Stanley’s investment banking revenue in the third quarter was its worst since 2009, at just over $1 billion. Exactly two years earlier the business had registered its best result in a decade.The rapid rise in interest rates, which makes traditional lending more lucrative for so-called universal banks, adds to the glum aura around investment banking. Deal fees made up 4% of JPMorgan’s revenue in the quarter. In the same period of 2021, when interest rates were near zero, they accounted for 11%.
Investment banking isn’t the biggest part of any bulge-bracket firm’s revenue, but it’s disproportionately profitable. And because it doesn’t require much capital, the returns on equity, which investors watch closely, are high.Goldman made nearly $8 billion more from investment banking in 2021 than in the last four quarters. Assume a 50% profit margin, and a repeat of the previous bumper year could have added 3 percentage points to its return on equity, enough to boost its most recent, substandard 7% annualized return to a more respectable 10%.Deal activity tends to be cyclical, and a few weeks ago, a turning point loomed. Volatility was declining, as measured by swings in currencies like the yen, euro, and dollar and by oscillations of stock markets.But the war between Israel and Hamas ratcheted up uncertainty. It’s no coincidence that the two big oil deals launched in recent weeks are both in stock, since the value of all-share offers can flex up and down with the market, making them more resilient than all-cash transactions.Even so, the quarterly gyrations distract from the fact that, over time, advising on deals and underwriting securities is a remarkably stable business. Track investment-bank income for Goldman, Morgan Stanley, Bank of America, and JPMorgan, and what emerges is a fairly clear growth path that follows the increase in global GDP. In general, the annual value of global announced mergers and acquisitions has tended to average about 20% of U.S. economic output in that year, according to Morgan Stanley analysts.So far in 2023, activity is running at about half that level, suggesting that a big upswing could be due. The global reshaping of supply chains – driven by companies reducing their dependence on China – and governmental support for the transition away from fossil fuels will fuel deal-hungry executives.Private equity firms, which tend to make up around one-fifth of merger volumes, still have over $2 trillion to deploy on acquisitions, assuming they don’t want to hand it back to their fund investors.
This implies banks should sit tight and wait for things to pick up. But that leaves room for difficult decisions. Even those firms which believe that dealmaking volumes will “explode” when interest rates start to ease, in the words of Morgan Stanley’s outgoing chief James Gorman, have been laying off staff.Shareholders are intolerant of bankers who don’t earn their keep. Barclays is a grim example. The British lender reported a near-50% fall in advisory fees on Tuesday. Since fewer staff than normal are decamping to rivals, many banks are overstocked with dealmakers, especially at more junior levels.Even if investment banking will eventually pick up, some bank CEOs could use a pick-up sooner than others because they are falling short on promised targets for return on equity. Jane Fraser at Citigroup and Goldman’s David Solomon are two who could end up with egg on their faces if they are sitting atop underperforming divisions. At Citi, the dealmaking and advisory business can bring in nearly 10% of revenue in a great year, or 3% in a poor one.Moreover, while greater geopolitical stability and more predictable interest rates would help to revive the investment banking cycle, they could bring problems of a different kind for big firms. Declining volatility in markets is great for deals, but it’s nowhere near as good for banks’ trading desks, which tend to thrive on choppy conditions.Investors tend to attach even less value to trading profit than to deal-related revenue, as bank executives often lament. But shareholders will still miss those windfall profits when they’re gone. The five biggest U.S. banks made $26 billion in combined income from financial markets in the last quarter, roughly $8 billion more than the same quarter of 2019, and quadruple what they made on deal fees.That leaves Wall Street CEOs hoping for a world where dealmaking activity reverts to the historical mean, but revenue from trading does not. It remains to be seen whether they can have their cake and eat it.More By This Author:S&P 500 Earnings Dashboard 23Q3 – Friday, Oct. 27Halloween Inflation Is Not Spooking The U.S. Consumer UniCredit’s Surge Is A Pipe Dream For Barclays
