Goldman’s Strong Results May Be Sustainable In The Trump Era, But Is The Market Being Too Optimistic?

Earlier this week, Goldman Sachs (NYSE:GS) managed to beat the already elevated expectations investors had for its Q4 results, as the investment bank made the most of strong activity levels in debt and equity trading markets for the last two months of the year to boost its top line. ^[1] Goldman’s profits were also directly aided by the rally in share prices across sectors for the period, as the bank realized mark-to-market profits on its investment portfolio. At the same time, the bank did well to keep a check on costs despite the significant increase in revenues compared to the year-ago period.

The outlook for the debt trading industry has improved substantially over the last few quarters, and regulatory requirements for U.S. banking giants are also expected to soften under the Trump administration. This will benefit Goldman considerably over coming years, as the bank bet against the overall trend in the banking industry of shrinking debt trading operations (as seen for peers Morgan Stanley and UBS) and retained a full-service FICC (fixed income, currencies, and commodities) trading desk. Goldman’s decision to patiently wait out the poor conditions which the industry went through in 2012-15 is likely to reap rich rewards for the bank over subsequent quarters.

While we believe that current market conditions are conducive for growth in Goldman’s profits, it should be noted that the bank’s business model still generates more than 60% of its profits from volatile sources – its trading desks, and its investment portfolio. Over recent years, the bank’s push into the more stable investment management business has helped stabilize earnings to an extent and the unit is forecast to grow steadily in the years to come. But the current market price still seems to be driven more by an overtly optimistic outlook for Goldman by investors.

We maintain a $225 price estimate for Goldman’s stock, which is slightly below the current market price.

See the full Trefis analysis for Goldman Sachs

The table above summarizes the factors that aided Goldman’s pre-tax profit figure for Q4 2016 compared to the figures in Q4 2015 and Q3 2016. The y-o-y jump in trading revenues stands out in particular, followed by the notable increase in investing & lending revenues. It should be noted that the securities trading business is highly seasonal, with the last quarter of the year being the weakest period. The increasing popularity of Goldman’s ETF offerings had a hand to play in higher investment management revenues for the bank. The reduction in investment banking fees was primarily because Q4 was an overall weak period globally for M&A as well as equity underwriting activity. As for the $388 million increase in compensation expenses compared to the year-ago period (a 19% jump in employee pay compared to Q4 2015), this was due to increased performance-related payments for a strong operating period. The non-compensation expenses for the year-ago quarter were elevated due to a one-time charge of ~$1.9 billion linked to Goldman’s $5.1-billion mortgage settlement.

Fixed Income Trading Returns As Goldman’s Primary Profit Driver

After remaining subdued for most of 2012-15, the global FICC trading industry saw a revival in its fortunes over 2016 as an improved outlook for U.S. interest rates coupled with the unexpected Brexit vote drove debt as well as currency trading volumes. Debt trading volumes were also particularly elevated last December, after the Fed announced only its second rate hike since the downturn. This in turn helped Goldman report FICC trading revenues in excess of $2 billion for Q4 2016 – the best performance since the seasonally pumped up Q1 2015. In fact, this is the highest Goldman has made through FICC trading in the fourth quarter of a year since 2012. This in turn helped the bank report a sizable increase in total investment banking revenues over Q4 2015 despite an industry-wide decline in advisory & underwriting fees.

The table below details the changes in Goldman’s investment banking revenues for Q4 2016 compared to Q4 2015 and Q3 2016.

Goldman’s FICC trading revenues were largely responsible for driving the bank’s profits before the economic downturn. To put things in perspective, these operations made more than $3.3 billion on average each quarter between 2005 and early 2008. However, stricter regulatory requirements and a slowdown in the industry reduced the average figure to just over $2 billion for 2010-16. With investors expecting some of the recently-enacted laws to be watered down by the Trump administration and with the Fed projecting a strong outlook for interest rates over the next three years, Goldman should be able to leverage its strength in the debt trading industry to grab a larger share of FICC trading revenues going forward.

The Investment Management Division Should Also See Steady Growth

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. The rally in the equity market and strong inflows into Goldman’s funds helped the division report record revenues of $1.6 billion for Q4 2016, as the total assets under management swelled to ~$1.38 trillion. The table below summarizes the factors that contributed to the change in size of investment management assets from the end of Q4 2015 and Q3 2016.

Inflows into Goldman’s long-term funds topped $17 billion in Q4 2016, with strong inflows of $21 billion into fixed income funds being mitigated by outflows of $5 million from equity funds. The interest rate change also resulted in solid inflows of $31 billion into liquidity (money market) funds for the period. 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. You can see how changes to the asset base impacts our estimate for Goldman’s shares my modifying the chart below.

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1. 2016 Annual and Fourth Quarter Results, Goldman Sachs Press Releases, Jan 18 2017 [↩]