Wells Fargo Sr. Analyst Mike Mayo joins Yahoo Finance Live to discuss the expectations for big bank earnings and market uncertainty.

Video Transcript

- But our next guest says that structural changes and more stable funding will make this cycle, quote, "very different." Wells Fargo Senior Analyst Mike Mayo joins us now. Mike, as you parse through what we've already seen from the banks over the course of this year, add on top of that the rising rate environment and where the banks are signaling that they're going to move forward from here, what are your broad expectations for the bank earnings this season?

MIKE MAYO: Well, I'd say there's good news and bad news as it relates to bank earnings. Second quarter earnings should be a little yucky. You have anything connected to the stock and bond markets getting hurt. Investment banking revenues should be down one third to one half year-over-year. There's tough earnings comps for all banks.

And the big question is the R-word, recession. And to the extent that there's a greater chance of a recession, then banks starting the second quarter would have to increase reserves for problem loan losses. Now, this has not been guided by any bank, but the new accounting rules implemented two years ago mandate that if there's a greater probability of an adverse scenario, than banks need to set aside extra reserves.

And that's what we did with our numbers. We took our numbers lower. We're about 5% below consensus for the quarter for that reason. And today's CPI number, if you have more aggressive Fed rate hikes, that certainly increases the discussion about the chance of a recession.

Having said that, for all the negatives out there in the short term, there are some very big positives. And if you're looking for evidence of the economy being hot, hot, hot, look no further than the bank earnings coming up. You're seeing commercial loan growth here in the second quarter growing at the fastest pace in 14 years. That's really incredible.

You're seeing spending increasing at the banks. You're seeing evidence of onboarding of the economy postpandemic. So that still is the most dominant factor. And so you're seeing, you're likely to see a dichotomy of really good growth and little evidence of a recession now combined with discussions and questions to bank managements about their expectations for a recession ahead and what they might do to prepare for that.

- Mike, I love that you've been challenging JPMorgan on its costs, how much it is spending on various tech investments. What do you think we'll hear from them tomorrow? And do you think Jamie Dimon will reaffirm his economic hurricane comments?

MIKE MAYO: That is the question of the earnings season, because you cannot have it both ways. You cannot say one thing with your words and do something different with your numbers. You cannot say a hurricane is coming. And if that risk of hurricane has increased, then you are mandated, you are dictated by US accounting rules to increase the reserves for problem loans down the road.

So either he can soften that or walk that back a little bit. I don't think that's likely. In the first quarter they did increase extra reserves for the uncertainty. The big question is if and how much they do so here with second-quarter earnings, especially after the hurricane comment.

- And, Mike, JPMorgan for such a long time has been seen as best in class, right, and Dimon could do no wrong. The stock is now down some 29%, 30% year-to-date. Is that reputation still intact?

MIKE MAYO: Well, we downgraded the stock in January after seven years of recommending it. And there's a very simple algorithm that we've had in analyzing JPMorgan for the last two decades. And that is when revenues grow faster than expenses, great things happen. And last year and this year, they're guiding for expenses to grow faster than revenues. And that's even before the discussion of a potential recession.

In addition, we favor banks that are more Main Street banking, because Main Street banking has tailwinds, whereas they are overexposed to Wall Street banking, which has headwinds. We favor banks that are more US centric, whereas they're a bit more global overall. And as I stated, we favor banks that grow revenues faster than expenses. Right now this year, these couple of years, that's not the case at JPMorgan. So we're on the sidelines with JPMorgan.

- For the consumer banks and those that are looking across some of these savings rates of their end consumers, how much could that actually be foretelling about where individuals, where households and even businesses, perhaps, on their accounts are bracing for a potential recession?

MIKE MAYO: You know what's really amazing here, the two biggest questions for this bank earnings seasons are one is an accounting question. The balance sheets of consumers and corporations look strong. We don't expect much higher delinquencies. We expect the loan loss levels to look good.

Credit quality is good. This is not the global financial crisis. This is not 2007, 2008, 2009. But so even with everything looking so great, do banks go ahead and increase those reserves for problem loans when everything right now looks good?

The other big question for bank management is do they go ahead, despite the terrible investment banking environment, do they go ahead and cut jobs, cut compensation with the risk that things come back if and when markets settle? So those are the two big questions for the environment.

Now, having said that, you have to understand, all investors need to understand how much risk has been pushed out of the banking system to the nonbanking system or shadow banking system. And banks are holding generally higher quality credits. It's not the same banking industry that you had 15 years ago. You have a lot less subprime. Your banks lend to more solid borrowers. You don't have some of this subprime risk that you have elsewhere.

So actually, my colleague today downgraded a few companies with lower-quality consumer lending. So we understand that. And that's where you're seeing weakness. But banks are dealing more in the higher quality lending.

And to some degree, the global financial crisis, banks have made victory out of defeat. And that victory is to derisk their operations, derisk their loan portfolios, derisk their overall operating framework. And I think that is not appreciated, it's not likely to be appreciated over the next few months. We hear from investors that they're going to wait this out to till maybe the fall to buy bank stocks more aggressively.

But the big picture, though, is when we look at over 60 years of banks and inflation, banks tend to have really good revenue growth in periods of inflation. But historically, they also had lousy expense growth. What's different this time, and with very high conviction-- we're looking over the next three years-- is that with inflation, banks will have that strong revenue growth, the best Main Street banking growth in four decades.

But they will not, banks will not have too high expense growth. And that's due to the tech revolution at banks. All this retooling over the past decade pays benefits as you can layer on more revenues at lower marginal cost. And that's what you should start to see more in earnest I'd say in the third quarter and especially the fourth quarter of this year.

- Mike, real quick before we let you go, so investment banking revenue likely weak, volatile markets. Do you think we'll start hearing about Wall Street layoffs?

MIKE MAYO: That is a big question for these big Wall Street banks. And they tout, they brag about their variable cost structure. When the revenues don't come in, they can cut costs. All right, well, let's see that happen.

On the other hand, we are hearing about a tremendous backlog, especially in mergers, if and when these markets settle down. So that is a big management dilemma I think these banks will have. But we'll certainly see compensation decline, perhaps not commensurate with the level of revenue decline, because I think some of these large investment banks do see the potential for almost an explosion of mergers if and when the markets settle down, which is uncertain.

- Mike Mayo, Wells Fargo senior analyst, enjoy earnings week. We look forward to hearing you on the earnings calls. Talk to you soon.