25 September 2018

Market Swings Sting Brokerages

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Turbulence in financial markets can be great for Wall Street trading desks—not so much for the firms’ brokerage arms.

Income from advisory fees at their asset-management businesses—typically 1% of the value of client assets—surged as balances ballooned during the stock market’s nine-year rally. But rising interest rates and the specter of a trade war have punished markets over the past two months, pulling the S&P 500 down 7.5% from its last closing high in late January.

Several brokers say the selloff has knocked stock-portfolio valuations down, dragged asset-management fees lower and even led to some margin calls for investors. That is threatening to disrupt the steady rise in revenue and profits that the brokerages enjoyed in recent years as they distanced themselves from the volatility that accompanies a commission-based business model.

Morgan Stanley to discount online brokerages like Charles Schwab Corp.

“It has been almost a perfect backdrop for these companies,” said Devin Ryan, brokerage industry analyst at JMP Securities LLC, of a set of factors that have together helped Wall Street’s wealth-management businesses boom in recent years. But “a little bit of volatility goes a long way,” he said.

However, a hit from lower fees won’t show up in banks’ next batch of earnings that kick off in coming days with Bank of America Corp. , which houses Merrill Lynch, and Morgan Stanley reporting. Banks that post quarterly results for their wealth-management arms, as well as stand-alone brokerages, assess fees to clients on a quarter lag, measuring balances at the start of a quarter rather than the end. That means first-quarter fee revenue should approach record levels, as the S&P 500 rose 5.7% in the fourth quarter of last year.

Fees now make up more than half of total revenue at Wall Street’s biggest brokerages as clients increasingly opt for advisory accounts that the firms have long preferred for their steady, and often higher, pay. Roughly 55% of Morgan Stanley’s wealth-management revenue last year came from the asset-management fees investors paid to their brokers, as 44% of the brokerage’s $2 trillion in assets were in accounts that paid steady fees, up from 24% in 2009.

“Sustained volatility is generally bad,” said Jonathan Pruzan, Morgan Stanley’s chief financial officer, at an industry forum in February. “As markets [go] up...we make more money managing more assets.”

Meanwhile, the U.S. wealth management arm of UBS Group AG , which uses different metrics, earned 62% of its operating income from fees, with accounts that levy a fee making up about 37% of its $1.2 trillion asset base.

Industry analysts at Nomura Instinet say the recent pressure on fees could spell trouble for those businesses. A 10% decline in the S&P 500 this year would shave 3.6% off Morgan Stanley’s per-share earnings for 2018, the analysts warn, while reducing earnings at Goldman Sachs Group Inc. by 6.8% and at Bank of America by about 1.1%. Smaller brokers are also at risk. Stifel Financial Corp. and Raymond James Financial could see earnings fall 2.8% and 2.9%, respectively, if markets decline at least 10% this year, Nomura said.

If the recent volatility persists and returns are more muted this year, brokerages won’t be able to count on their asset stockpiles growing on autopilot as they did for much of the past decade. Instead, they will be forced to put an even greater emphasis on attracting new investors or encouraging clients to take on debt—a growing and lucrative business for Wall Street’s biggest wealth-management firms as interest rates climb.

Higher interest rates should help boost brokerage’s net interest income and soften the impact from a broad decline in stock prices, analysts said. That has become a growing source of income as firms refashion their brokers as financial advisers who counsel clients on both sides of the balance sheet, offering more traditional banking products and charging interest on cash, from stock pickers who mainly sold investments.

Net interest revenue at Morgan Stanley, for example, jumped 16% in 2017 from a year earlier, as the Federal Reserve raised rates three times last year, boosting how much money the bank earns on cash deposits and loans. The Fed is planning at least three, if not four, rate increases this year, which should push net interest income among firms up even higher.

A corresponding increase in cash balances as investors derisk will help soften the blow, said Steven Chubak, brokerage analyst at Nomura, of brokerages’ earnings if markets fall 10% or more this year. Still, “it’s going to be a net drag if you have a market correction,” he said. “History shows when equity markets undergo a sustained correction, more often than not, volatility is bad.”

Click here for the original article from The Wall Street Journal.

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