The PNC Financial Services Group, Inc. (PNC) Earnings Call Transcript & Summary

Thank you, everyone, for joining us for the PNC presentation. As many of you know, PNC is the 6th largest bank in the United States with just over $560 billion in assets, over just about 2,400 branches. Their market cap now is almost about $60 billion, and they put up in the fourth quarter. An ROTC number of just over 16%. With us today is Gagan Singh, who heads up the investment -- Chief Investment Officer role at PNC. He's been at PNC for 20 years, and he's had his extensive experience in this area has presented here at our conference in the past and also at the BancAnalysts Association of Boston Conference up in Boston in November. Gagan has a presentation that I'm going to hand it off to him and have him go through the presentation, and we might have some time following that for a couple of questions. But with that, let me hand it over to you, Gagan.

Thank you, Gerard. Good afternoon, everybody. Thanks for having us here. I think we have an ambitious agenda. Let me make sure I get the clicker going. We like to cover a little bit about our economic outlook, what that means in our view, for the Fed and the outlook for rates. And we'll briefly talk a little bit about both the short-term view and -- but maybe more importantly, the medium-term view, which in some ways, I think, is a bit easier if there is such a thing as easy in forecasting. We'll also talk a little bit about how PNC has fared in this very tumultuous and relatively unprecedented rate environment that we've been in. And what -- how we are positioned looking ahead. And then briefly, we'll talk about -- we at PNC actually do a fair amount of work thinking about the banking sector overall, what macro and Fed-driven policies are doing to the liquidity environment, which has a huge bearing on the deposit outlook, which has obviously a huge bearing on both liquidity and rates and in general interest rates, interest rate risk profile, but in some cases, as we saw spectacularly solvency as well. Okay. So before I get into the outlook for the economy, I was thinking about it as I was putting this deck together, and I was like this past year, forecasting the economy felt a lot like my golf game. In your head, and in your dreams, you thought you're going to get a hole in one, you're going to hit the green, get it close to the ball. In reality, you were just spraying it all over. Now you could argue the elements had a big role to play. But the reality is the U.S. economy defied our forecast of a recession, we were not alone but we were pretty wrong in being negative for most of last year thinking that the economy was headed into a recession. We had good reasons for that outlook, good reasons grounded in historical experience, primarily the fact that periods where the Fed hikes interest rates by a lot and rapidly have almost always been followed by a recession. And the statistical historical evidence is really strong with good economic basis. And this past Fed hiking cycle was actually one of the most dramatic both in terms of the magnitude and speed of hiking. And you can see that in the bottom right-hand chart. Through this rapid and unprecedented hiking, the U.S. economy not only did not go into a recession, but after slowing down pretty steadily through the course of 2022, throughout 2023, actually gained same and gain momentum. And that was both confounding and impressive. And we will talk a little bit about as we look back and try to analyze and understand why that happened, which I think is a worthwhile exercise what caused that. What was equally surprising and this time, we were on the right side of the call, albeit for slightly wrong reasons, is that inflation actually surprised on the downside, Inflation came down quickly and despite the fact that we did not have an economic slowdown or recession, we had inflation coming down to levels that most people would not have expected, including the Fed. We did expect rapid declines in inflation, primarily driven by rental inflation and used car prices, which still are going to play a factor in the next 6 months. But part of our inflation forecast was also predicated on an economic slowdown, which is what I meant by saying albeit for slightly wrong reasons. Now what was equally impressive was these inflation gains were, one, what happened despite -- and without, I should say, any or very little damage to the labor market. That has important policy implications. One of the big reasons why we have become more optimistic on the economy is that by inflation coming down and labor market not weakening, the Fed actually has a fair amount of room to be able to react to weakness in labor market or even preemptively ease policy and bring it to levels that can sustain and be consistent with the soft landing. I think that's kind of the near-term outlook. But the medium-term outlook is actually even more interesting. And I want to get into it, which is where -- if we think about long-term drivers of growth and consumer spending and corporate spending, how does that look? Energy, obviously, has become an important factor. All your tools look at Europe and realize how big a role energy prices are playing in constraining Europe's growth going forward. And all of those things, we think, bode well for the U.S. economy medium term. We can still have hiccups by the way, in the short run. I don't think we are completely out of the woods. In fact, as more and more people fold in their view, which results in more euphoria in financial markets and maybe a final burst of spending in a way that worsens the outlook for inflation, potentially worsens the outlook for rates. So there is some risk here that the final chapter on the recession story is yet to be written. I warned you there is a wide dispersion in our views, which is both a sign of the times and an acknowledgment of how tricky this particular moment is. What is less tricky is really thinking about where the finances of the country really stand, consumers, corporations, to a certain extent, government. But I think one of the most interesting things that we have seen over the last decade, decade and a half is the sheer magnitude of household wealth creation. When I started compiling the numbers, I haven't done this in a couple of years, recently, I found it staggering that almost $100 trillion of household wealth has been created in the last 12 years or so. To put that in perspective, it's about 400% of nominal GDP. I don't have a chart here, but take my word for it that not only the sheer magnitude of the wealth creation has been staggering, the pace at which we are creating wealth which typically tends to be about 25% to 30% of GDP every year is running about 50% higher than that. And that has been an important reason why the U.S. economy is actually performing really, really strongly even in a rate environment that would be deemed and we agree with that assumption to be quite restricted. The other reason why we think the medium-term outlook is good and why the U.S. economy was able to withstand this onslaught of rate increases is both at the corporate level and at the consumer level, our balance sheets are extraordinarily sound. Household balance sheets have been in a good place for more than a decade. There was considerable deleveraging that happened post the great financial crisis, households reduce their level of borrowing debt and also increase the level of savings. And now with the gains in the wealth, just the debt levels are in absolute terms as in not even relative to the asset wealth, that's a debt service coverage ratios and the nature of that debt. So if you look at mortgage market and the housing market, that's been the other surprise. With a 400 basis point increase in 1 year in mortgage rates, home prices went down maybe 5%, 6%, 7% over 2 quarters. There was barely any homes for sale. And that big reason is people have over a decade of low rates cause people to refinance over and over and over again and existing homeowners have very low levels of coupon on their existing long-dated fixed rate mortgages. So even as mortgage rates went up, it impacted new borrowers and new buyers on the margin, but existing borrowers did not see any impact on their finances. Even corporations, which by the way, you feel like -- and 1 of the reasons I felt strongly about a recession is I felt this expansion has been going on for 13, 14 years. It's long in the tooth. And if vulnerable to shock, especially combination of inflation shock and a Fed tightening shock. But COVID actually had a very interesting role to play in repairing corporate balance sheets where a lot of growthflation, I think there is a term like that, which is inflation-driven profit increases, really had a big impact on deleveraging. As you can see, if you carefully look at the chart post-COVID balance sheets and corporate debt, which wasn't too high to begin with, just like consumers, went down. So it almost went from the late cycle or mid-cycle down to an early cycle phenomenon. So where does that leave us for outlook for rates? I think we very much why -- we are very much in the camp. We do a lot of work within my economics team of thinking about this elusive concept of a neutral rate. And by almost any historical measure, we think neutral rates somewhere in the vicinity of 3% to 3.5%, maybe 4% on a short-term basis. So at 5.25% to 5.5% short-term policy rate, we are fairly restrictive. Now I also get the point that I say that we are fairly restrictive and yet it seems to be having no impact on the economy. The economy is just accelerated throughout 2023, Q1 is shaping up. Why is that? I think a lot of that has to do with this concept that nothing else matters and if policy is restrictive, economy will go down if policy is combinative. In reality, there -- it's a multivariate world and things like fiscal spending over the near-term, wealth gains play a big role. And I do think that the behavior of the stock market has a lot to do with making restrictive policy feel fairly powerless, fairly ineffective in terms of its impact on the economy. So that tailwind from those other factors is negating the headwind of restrictive policy. And that can change. Markets can turn -- the euphoria can turn to the spare quickly, especially given some of the things that have been going on in the equity markets. So we do think this was all to kind of make the case that we do think monetary policy is on balance, restrictive. It's nice to see Chair Powell, say that in very clear terms. It's also generally important to pay attention to them because they are every bit as right or wrong as the rest of us. But unlike the rest of us, they actually have the power to set rates. So when they actually say they're going to lower rates, it was a pretty hard pivot but we take them at face value. And I believe the Fed does want to lower rates, and the Fed does realize policy is restrictive, and they don't want to overstay their welcome, especially in the light of very impressive near-term inflation gains. Now that, I think, is the easier part of the call in the spirit of learning from the last few years, the hard part of the call is how much and when? And I really think they don't know the answer to that, let alone the rest of us more mortal beans. I think in my head, you can make a pretty convincing case. It's a trimodal distribution, more bimodal than trimodal, but you can have no landing. The economy continues to do well. And the near-term policy restrictiveness can continue to remain ineffective. In which case, inflation could start to accelerate in the second half. You see that in core services. And a lot of the rental and core goods used cars kind of disinflation that is in the pipeline runs its course by midyear. And then second half of the year, stocks are still doing well, then I think we are in for some shocks in growth and inflation and rates. On the other hand, if asset prices stall or reverse and restrictive monetary policy starts to bite some more, you could have a significant slowdown in growth which I think is long overdue. And election years tend to be volatile and full of surprises, and you could see the Fed cut 7,500 easy. I think those are the 2 more likely outcomes right now. There is a third outcome, which is a more dire outcome, which is that we have a much bigger shock coming from oil prices or equities or something that we don't see right now and this restrictiveness in policy starts to have a quick and nonlinear effect on the labor market. So we'll see. I guess, as I warned you it's like the golf game. I don't know if I'm missing left, right, center. I just have a bad feeling about it. Okay. I do think, again, just like the medium-term outlook for the economy, I feel more confident. I feel a little more confident. I've traded rates for 25 years. I think I always joke there are 2 types of rate traders, one who don't know what they are doing, but they know that they don't know what they are doing. And the second, who don't know what they're doing and they don't know what they're doing. We would like to think we are in the latter camp. We don't know where rates are going, but we know -- excuse me, first camp, we don't know where rates are going, and we know we don't know. And -- but having said that, I think even what I said about medium-term outlook for the balance sheet, medium-term outlook for productivity population growth, we feel good that 2% growth for the U.S. economy is not an unreasonable cruising altitude. And commensurate with that cruising altitude at 3%, 3.5% neutral level of short rate feels very reasonable, especially because we do understand a lot of the factors that all came together in the past decade, Central Bank buying trillions of long-term debt. Very, very large demand shortfalls post the destruction of wealth and the great financial crisis, terrible balance sheets at the household and the corporate level. A lot of those negatives are not there. There are certain other factors that have actually emerged over the last 5 years, things like fiscal deficits. Fiscal -- we've had fiscal deficits forever. I'm not 1 of those deficit mongerers, we will say just because we have x trillion blah, blah, blah, we're going to have a problem. But what we show here is a trend line of fiscal spending per capita. So as we get bigger and older, we are spending more on entitlements. I don't think that's the problem. The problem is that deficits have gone from being -- first of all, growing at a trend, we are now 30% below above-trend spending. I didn't even show the revenue side, where we basically at the lowest tax revenues we've ever had. But more importantly, I think on both sides of the aisle, the rule of thumb now is deficits don't matter. It's kind of back to the future what Dick Cheney said 30 years ago or more than 30 years ago. So I think there is going to be a period where deficits are going to matter. We saw a little snippet of that in October where rates shot up. It only lasted for a New York minute, but I feel like there is more of that in the future. So I think we're going to see higher term premium. So our construct of how we think about rates is a neutral level of real rates, a level of inflation and then a term premium. And we think that -- and this is important, just in case you think I'm doing this musing because -- musings because we like to trade or strategists. This is how we think about our balance sheet. We think about -- we'll share that with you in a second. We think about where rates are going, what is the balance of risk, how best to protect our balance sheet against unknown risks. So anyway, now that I've put it in paper, I'm sure that will give me a reason if next time Gerard will have me to come and do a mea culpa gain about how rates haven't done [ what we ] expected. Next page. On to simpler things, talking about what has happened rather than what will happen. I always like to say it's so much easier to predict the past. This is a picture of our balance sheet. I think it is a fact to say that PNC has benefited quite nicely from the rise in rates over the past 4, 5 years. We obviously don't disclose our economic value of equity. But I think it's fair to say that, that is an accurate representation of how we measure our economic value of equity, which has gone up, which is really the difference between the true value of each of our assets, more importantly, our deposits, which is where a lot of the extra value relative to our tangible capital comes. Over the last 4 years, deposit values have gone up immensely, even though fixed rate assets, loans and securities have had pretty large declines and people last year obviously couldn't stop talking about them. The reality is, in our case, they've been dwarfed by the increase in deposits. We measure our sensitivity of economic value of equity in the top right-hand chart, we call that duration of equity. And you can see for more than a decade, PNC was asset sensitive, which is just a nice survey of saying we were short, and we were short because we did not want to risk buying long-dated fixed rate assets when rates were between 1% and 2% or 0% and 2% for the longest time, and we were short forever. And we realized that we are giving up some amount of interest income, but we have a well-publicized consistent philosophy of saying balance sheet -- safety of the balance sheet precedes marginal additional short-term gains in income. In 2021, as rates started to rise, we started to cut down that asset sensitivity, arguably a bit early and a bit much. But overall, we were still benefiting handsomely from the rise in rates. That rise that increase in economic value is reflected in our net interest income, which notwithstanding the wiggles and the swooshes we'll talk about, has gone up very nicely, even adjusted for the growth in balance sheets. And we actually -- well, we go to the next page, we actually expect more gains to accrue to our balance sheet in the years ahead as a large portion of our fixed rate portfolio, which tends to be short, like I've said, we have a philosophy of safety first, which means that our loan books, our securities books and our swap positions tend to be a lot shorter than our peers generally and a lot shorter than our liabilities. We have close to $100 billion, which is almost 20% of our earning assets that we expect to run off over the next 2 years cumulatively, and we expect them to reprice at significantly higher yields. Now some of that embedded in that is that the current forward structure won't change or if it does, we manage some of -- to immunize and hedge some of that. So we do expect nice gains and our CEO and CFO have talked about it for a few months in the years ahead. Securities portfolio, which is kind of my -- one of my prime day jobs. Our securities portfolio, really, what we want to show is 2 things. One, it's simple. It's primarily based in very low credit risk treasury and agency securities. And there's a reason for it. I mean we, again, are very value driven. Last 4, 5 years, we've had such low level of credit spreads and relatively low volatility. We've had some periods post-COVID where we added a nice amount. We briefly had last year where we added some, but we haven't had a prolonged period of significant widening in credit. As a result, that portion of our book keeps shrinking, certainly, liquidity rules don't help. But we think this is the right posture for where we are, and we can be stubborn as you saw with respect to rates. If we don't think there is value, we will put safety first over marginal return. On the right side, what we show here is this is -- by the way, on the right side, this is not AOCI. This is the economic loss you've had on security. So if you have $100 billion portfolio and 8% loss is a loss of $8.5 billion pretax. So this is percentage loss across our peer group. You can see we are not best-in-class, but we are also at a reasonable different distance from being worse-in-class and worse-in-class is roughly 2x as bad as us, which is bad. We are certainly not happy with the losses we have. But we think given the magnitude of the rate increases we've had, and as I said, we probably bought a little too much, a little bit early in '21. But overall, we feel in the -- and all is said and done, we have fared okay within our peer group. Now our portfolio is short, like I've said, a gazillion times. That also means that it accretes back very quickly. So you buy a 2-year Note, you lose 2 points in 2 years, the 10-point loss -- sorry, you lose 10 points. In 2 years, 10-point loss is gone. You buy 10-year Notes and you lose 25 points, that's going to accrete back at half that or 1/4 of the pace of the 2-year Note. So we don't have 2-year Notes, but point is our portfolio is 3- to 4-year duration. And we have been publishing these numbers, and they've been tracking pretty well. We expect to accrete back close to 50% -- just under 50% of our losses, which have already come back from the peak within a couple of years. And that's important because, a, it allows you to reprice your book higher. It has income benefits, but it also has capital benefits because the new capital rules, AOCI is going to start getting counted in the capital. We think those rules are going to stick. And we feel that by the time, the time comes to phase those in, we will -- we would have burned off a lot of our losses without a rally in rates. If we have a rally in rates, it's going to help everybody, including us. And if we have a sell-off, again, this is accretion. You can put a linear function around it for rally or sell off. Same thing in the swap book, very, very short. We are already past the worst point in last year. We're going to start to see improvements in income. I don't know how much time I'm going to have to spend on it. I have a couple of minutes, but I want to talk a little bit about the work we do on thinking about system-wide deposit creation. I don't know how many people really have spent the time or realize that the deposits are created primarily 2 different ways. One is lending activities when banks make a loan, a deposit is born. That is the primary mechanism of creating deposits in the U.S. banking system. But in the last 10 years, when the Fed does grow its balance sheet and buy treasuries, our deposit is created because they buy it from a private sector entity who then uses that cash and makes a deposit at a banking sector. Needless to say, post-COVID, there were a lot of those QE-driven deposits created. And we felt it was going to be easy come, easy go. It had a big bearing on how we manage our liquidity, how we thought about interest rate risk associated with these deposits. The good news is that at its peak, we had, by our modeling and estimates and these are estimates, these are not statements of fact. They are -- we had about $3 trillion of these transitory surge deposits. We think we are left with just about $400 billion, $500 billion. So we are well past the prime and a few months away in our view from creating a much more stable deposit environment. I think that's going to be pretty beneficial. And rates can have a bearing. If rates rise again, that can make things a little bit worse but the fact remains that a lot of those non-core deposits have been run off and they've been replaced by lending-driven deposits that are trapped in the system. A couple of other comments on the banking sector trends. We think, by and large, through a lot of noise last year, this has not been that surprising a rate cycle, deposit behavior, both in terms of mix. As you can see, noninterest-bearing deposits rose very sharply when rates were 0, they've been falling. We think they have a couple of points more to go, which will take care of itself in the next 2 to 3 quarters. The betas overall have not been that different as the chart on the right shows. What was different was '22, the betas look very good. Everybody got really excited that this is -- this cycle is like 2017, '18. We didn't buy into that. And certainly, last year was a lot of catch-up going on where the betas were very high and people thought, oh my god, this is going to be the end of the deposit taking in the world. And this year, we think there's going to be some leakage. And -- but again, we are nearing -- I think balance sheets are normalizing. Cash levels are going to stay high. People have replaced a lot of the noncore deposits with borrowings. So I think we are in a good place overall, a couple of quarters away from much more stable environment. PNC, definitely, this is a slide we have shown before, so I'm going to skip through it. We do a lot of time thinking about and growing the right kind of deposits, both on the retail and the corporate side. We have a very high-quality deposit base. On the retail side, we have very granular deposits, low balance deposits, things that make them valuable and sticky relatively inelastic. On the corporate side, they are much more elastic, but they're still sticky because they're backed by very deep treasury management and other payment service relationships. This is kind of the last slide, the money slide. PNC's fared pretty well on the funding side of the balance sheet as well, just like it has on the asset side. Our deposit rates were very similar to everybody else in '22. In '23, we really shown when people really started caring about where that money sits, you can see there was a big separation between the big and small. Our CEO has talked about why scale matters. This is 1 of the reasons people feel safer in these megabanks, PNC more than held its own. We really did well in '23 on a relative basis. In '22, everybody did well. You see that on the debt side, all of you and your peers on the institutional side feel like we are a good balance sheet and afford us relatively good funding spreads. Thank you for that and that does make a difference in the banking business. And the last couple of points, we didn't talk much about credit risk. If indeed, we have that part of the distribution where the economy goes down, credit cycles have been known to happen pretty regularly, and we are due for 1. We think we stack up pretty well. That's on the right is the Fed stress test, and you can see our credit books are as clean, if not cleaner than everybody else. And we think on a relative basis, I'm not really praying for a downturn or looking for a credit cycle, but if one were to happen, we think we'll hold our own. And again, there's a lot of uncertainty on the capital side. But I think the capital rules on a relative basis actually stack up well. These are external estimates from -- which we agree with, by the way, at least for ourselves. And we think that on balance, our mix of businesses is not impacted very much by the proposed capital rules. It's a separate matter that those capital rules may not get implemented. So I will stop there. Thank you for letting me go a minute or 2 extra. But thank you.

Gagan, thank you very much, and we have run out of time, but it was a great presentation specifically about the industry deposits, a very good point. So with that, please join me in a round of applause thanking Gagan.