Will Strong Q4 Debt Trading Revenues Force Morgan Stanley To Rethink Its Focus On Equity Trading?

With the outlook for the debt trading industry improving substantially over the last few quarters, and regulatory requirements for U.S. banking giants expected to soften under the Trump administration, Morgan Stanley (NYSE:MS) may look to grow its debt trading desk going forward. A string of stricter regulations previously prompted the bank to slash its sizable presence in the debt trading industry in the first place – choosing instead to focus on the less capital-intensive equity trading business, and the less volatile wealth management business which it acquired in parts from Citigroup. Finally, Morgan Stanley’s industry-leading capital position with a common equity tier 1 (CET1) capital ratio of 15.8% (fully-phased in) has ended up weighing on its return on equity (ROE) figure which has struggled around 8% – below its target figure of 10%. ^[1] Measured growth in the debt trading industry may also hold the key for Morgan Stanley to hit the 10% ROE target going forward.

In view of an expected growth in debt trading operations, an improved outlook for the U.S. economy, faster increase in interest rates over coming years, and also Morgan Stanley’s recent success in the traditional loans-and-deposits banking business, we have increased our price estimate for Morgan Stanley’s stock upwards from $37 to $44. The new price estimate is slightly ahead of the current market price.

See our full analysis of Morgan Stanley

The table above summarizes the factors that aided Morgan Stanley’s pre-tax profit figure for Q4 2016 compared to the figures in Q4 2015 and Q3 2016. Notably, each of the bank’s core revenue streams (securities trading, advisory & underwriting, and wealth management) reported an increase in revenues compared to both comparable quarters. The y-o-y jump in trading revenues stands out in particular. “All other revenues” represents gains/losses from investments and revenues for the investment management division – both of which had a weak Q4. Although the $433 million increase in compensation expenses compared to the year-ago period seems large, it is justified given the fact that revenues have grown 17% y-on-y while the compensation only increased 12%. Higher operating expenses were also higher because of one-time litigation charges, which are not expected to be much of a problem going forward.

The FICC Trading Unit Staged A Comeback, Looks Poised To Grow

Unlike its other major competitors in the U.S., Morgan Stanley’s new business model relies much more on equity trading operations than fixed income operations to generate value due to a conscious decision by the bank to scale down the latter. The only other global banking giant to pursue a similar strategy is UBS, which also aims to focus on wealth management and equity trading to grow profits. Last year, the bank had announced additional cuts to its already lean FICC (fixed income, currencies and commodities) trading unit. ^[2] Our analysis of Morgan Stanley then estimated that the FICC trading desk accounted for roughly 10% of the bank’s total value.

Although the bank implemented the proposed cuts to the FICC unit over 2016, changing market conditions resulted in FICC trading revenues jumping considerably, as captured in the table below.

Morgan Stanley may look to gradually grow its debt trading business over coming years to be able to benefit from the expected increase in global debt trading activity. Factoring this into our analysis for the bank, we believe that FICC trading is now responsible for 17% of the bank’s total value. You can see how changes to the bank’s FICC trading portfolio impacts our estimate for its share price by modifying the chart below.

Wealth Management Will Remain The Cornerstone Of Its Business Model

Over the last few years, Morgan Stanley has relied heavily on its wealth management operations to provide a stable source of income in what was once seen as an extremely volatile trading-driven business model. Having achieved the self-imposed 17%-margin target for the business well before the 2014 deadline in Q4 2012, Morgan Stanley is now looking to achieve the steep target of 25% in 2017. The margin figure touched 23% in Q3 2016 – allowing the division to achieve pre-tax profit margins of 22% for full-year 2016. And we believe that the bank will see a steady increase in the margin figure going forward.

The primary reason behind this is Morgan Stanley’s increased focus on retail banking offerings over recent years. The bank has seen its loans and deposits grow at a strong rate – simultaneously granting it access to a cheap source of funds and also providing it with an efficient cross-selling channel. This has helped the bank increase its revenues, while cutting down on the number of wealth management representatives. Notably, Q4 2016 was the first time in the division’s history that annualized revenue per representative cross the $1-million mark – a 7% increase compared to the year-ago period. Client assets also increased to a record $2.1 trillion. Although we expect Morgan Stanley to begin adding to its workforce in the near future in order to maintain steady growth in revenues, we believe the top line will grow at a faster rate compared to expenses – helping margins trend higher.

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1. Q4 Earnings Release, Morgan Stanley Investor Relations, Jan 17 2016 [↩]
2. Morgan Stanley 4Q15 Strategic Update, Morgan Stanley Press Releases, Jan 19 2016 [↩]