Recovery In FICC Trading Is Good For Goldman In The Long Run, Especially With The Volcker Rule Deadline Nearly Here

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Goldman Sachs

Goldman Sachs (NYSE:GS) reported strong operating results for the third quarter last week, with the premier investment bank making the most of increased activity in global currency and interest rate trading markets to boost its securities trading revenues. [1] While improved market conditions helped trading revenues for all major investment banks in Q3, Goldman Sachs gained in particular from its decision to retain a full-service FICC (fixed income, currencies, and commodities) trading desk over recent years as opposed to peers like Morgan Stanley and UBS who have shrunk these operations due to their capital-intensive nature.

Notably, an important source of revenue for Goldman this time around was its Investing & Lending operating division (which primarily generates money by investing directly in securities and loans), as improved market valuations across asset classes led to considerable mark-to-market gains after a particularly tough start to the year. A bulk of the revenues for this division comes from investments in hedge funds and private equity funds – something Goldman has to wind down by July 2017 to be compliant with the Volcker Rule.

While these exits will lead Goldman’s overall revenues (and profits) lower in the future, we believe that the bank is doing the best it can to make up for this by expanding its services to retail clients. The bank’s exchange-traded fund (ETF) offerings have seen strong growth over the last few quarters, and we believe that there is also sizable value to be added from Goldman’s recent push in the online lending space. Moreover, the bank remains a global leader in the securities trading and M&A industries. This is why we stick to our $200 price estimate for Goldman’s stock, which is around 20% ahead of the current market price.

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GS_Ear_PBTDiff_16Q3

Fixed Income Trading Desk On A High, But Will It Continue To Deliver In The Long Run?

The table above summarizes the factors that aided Goldman’s pre-tax profit figure for Q3 2016 compared to the figures in Q3 2015 and Q2 2016. Notably, trading revenues jumped by more than half a billion compared to the year-ago period, and were also higher than the already elevated figure for the previous year. The FICC trading desk generated almost $2 billion in revenues for Q3 2016, while the equity trading desk chipped in with another $1.8 billion.

The third quarter of a year is usually a lukewarm period for the seasonal securities trading industry. The elevated revenues this time around stemmed from macroeconomic conditions triggered by the unexpected Brexit vote. While fluctuations in interest and forex rates over the quarter helped FICC trading revenues, equity trading revenues benefited from the recovery in equity markets from the slump in late Q2 immediately after the Brexit vote. So the exceptionally strong revenues this quarter, especially for the FICC trading desk, may not be replicated in the fourth quarter. That said, a hike in benchmark interest rates by the Fed in the near future should result in an improvement in debt trading activity early next year.

Payoffs From Increased Focus On Investment Management Also Visible

Goldman Sachs’ investment management unit is important to the bank not just because of its growth potential, but also because it is a stable revenue stream in a largely volatile business model. In fact, the division reported a larger quarter-on-quarter increase in revenues compared to the lucrative trading desks as improved market valuation and strong inflows helped revenues jump to almost $1.5 billion in Q3 from $1.35 billion in Q2. The table below summarizes the factors that contributed to the change in size of investment management assets from the end of Q3 2015 and Q2 2016.

GS_Ear_AUMDiff_16Q3

Inflows into Goldman’s long-term funds topped $14 billion in Q3 2016. Fixed income funds gaining the most with net new cash of $11 billion. Strong overall inflows are good news for the division in the long run, as they should boost both fee-based as well as performance-related revenues. The inflows coupled with a recovery in market valuation helped Goldman’s total asset base reach a record high of $1.35 billion at the end of Q3 2016. You can see how changes to the asset base impacts our estimate for Goldman’s shares my modifying the chart below.

Compensation Expenses Increase, But Goldman Does Well To Cut Other Operating Costs

In the third quarter of 2016, Goldman incurred total employee-related costs of $3.2 billion. Although this was lower than the $3.3 billion figure for the previous quarter, it represents a 36% jump from the figure from a year ago. The y-on-y increase can be attributed to the fact that Goldman slashed compensation expenses sharply in Q3 2015 in response to weak trading revenues then. Considering the fact that Goldman usually reports compensation expenses around 40% of total revenues, the compensation-to-revenue ratio of 39% for this quarter looks fine. As for other operating expenses, Goldman appears to have done extremely well, considering the fact that the $2.09 billion in non-compensation expenses for the period is the lowest since the economic downturn of 2008. A combination of improved revenues and lower expenses should help Goldman report strong operating margins across its operations for full-year 2016.

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Notes:
  1. 2016 Third Quarter Results, Goldman Sachs Press Releases, Oct 18 2016 []