Commercial banks can be a good inflation hedge, because they’re able to raise interest rates as inflation increases, as long as the bank has anticipated inflation or moves swiftly to adjust its loans and other products to the increasing price level.

But a lot has changed in the banking sector since the 1970s, when we last saw extensive periods of high inflation. As noted in almost any discussion of the financial sector today, 21st century commercial banks are significantly bigger and more diverse than they were 30 years ago. They now offer more than just checking accounts and loans; they’re also heavily involved in investment banking, trading and brokerage services, credit cards, and much more.

That’s why an extended period of inflation would test for the first time the wherewithal of the new financial services model. The main issue to look at is how a bank’s non-traditional  businesses would perform. Those businesses are the most exposed to cyclical ebbs and flows, under which a bank may have little protection to hedge against inflation. Examples include a possible decline in the firm’s brokerage fees as inflation impacts equities investments, as well as the resulting decline in mergers and acquisitions activity in its investment banking division.

Further, what would happen if there were an overall decline in credit issuance? Would the bank’s fees on loans and from managing deposits be enough to offset earnings declines?

According to a Federal Reserve Bank of Cleveland research report, “Inflation, Banking and Economic Growth,” the economists’ empirical work suggests that “the size and profitability of the banking sector both are negatively associated with inflation. Further support comes from survey data, which seem consistent with the notion that banks may ration credit as inflation rises.”

The report predicts that the variability of rates of returns on assets may increase as inflation rises. Such volatility may enhance the probability of banking crises, which can have a long-lasting negative impact on real economic activity. The Cleveland Fed also found that higher inflation is associated with greater volatility of returns on a wide variety of assets and on returns for banks themselves. One way inflation might affect economic growth through the banking sector is by reducing the overall amount of credit that is available to businesses, the Cleveland Fed found.

Quoting the report again: “The story goes something like this. Higher inflation can decrease the real rate of return on assets. Lower real rates of return discourage saving but encourage borrowing. At this point, new borrowers entering the market are likely to be of lesser quality and are more likely to default on their loans. Banks may react to the combined effects of lower real returns on their loans and the influx of riskier borrowers by rationing credit. That is, if banks find it difficult to differentiate between good and bad borrowers.”

However, we can infer from the central bank’s finding that larger institutions with extraordinary access to high quality borrowers could more easily weather an inflationary period. Also providing a buffer against inflation would be exposure to assets, such as mortgages and other fee-generating businesses that experience less volatility of return.

The Case for Wells Fargo

Wells Fargo (NYSE: WFC) is the fourth-largest bank in the US by assets and the largest bank by market capitalization, as of July 12, 2013. Wells Fargo is the second-largest bank in deposits, home mortgage servicing, and debit cards. In 2012, Wells Fargo had more than 9,000 retail branches and over 12,000 automated teller machines in 39 states and the District (see Chart A).

The firm’s strong balance sheet and overall financial performance, particularly since the 2008 financial crisis, makes this bank a standout as an inflationary hedge. The bank’s robust mortgage lending exposure, though presently in a temporary lull, and large bank depositors would help the firm access high quality and diverse lenders, which in turn would allow the bank to pass through rate or fee increases in response to increases in the price level.

Securities markets would be adversely impacted by an inflationary period. However, we believe the overall trend of Baby Boomers retiring and the need for investment advice, as well as the size of the bank’s brokerage advisory, would to a great extent offset negative impacts from declining stock and bond markets (see Chart B).

The bank’s low exposure to investment banking, at only 5 percent of fees, would also insulate the firm from financial losses as compared to other banks, as business activity declines. Capital raising for expansion and mergers typically falls off during excessively high periods of inflation, when credit becomes rationed.

Chart A: Wells Fargo Serves More Consumers and Businesses Than Any Other US Bank.



Source: Wells Fargo

Chart B: Wells Fargo’s Exposure to Diversified Fee Income Generation



Source: Wells Fargo

A Value Investment

Wells Fargo has a unique designation as a value investment that also suggests the bank’s stock would perform better during an inflationary period. As we outlined in “The Sum of All Fears” (August 30), during inflation, value stocks have strong current cash flows that will slow over time, while growth stocks have little or no cash flows today but they’ll gradually increase over time.

As such, during times of rising interest rates, growth stocks are negatively impacted far more than value stocks when evaluating them under the Discounted Cash Flow approach, according to various financial studies. And we know Warren Buffett, the world’s foremost value investor has long had Wells Fargo in the Berkshire Hathaway (NYSE: BRK.A) portfolio. Value investing is an investment approach made famous by the aforementioned Warren Buffett that generally involves buying securities that appear underpriced by some form of fundamental analysis.

And the performance of the company in the last few years does bear out Mr. Buffett’s confidence in the stock. Wells Fargo, according to its annual report, delivered net income of $18.9 billion in 2012, up 19 percent from 2011. This was the fourth consecutive year of record profit. The firm grew its loans and deposits, despite an uneven economic recovery,  and grew revenue in a low interest rate environment that had pressured the bank’s margins.

In fact, each of Wells Fargo’s primary business segments grew its full-year segment net income year over year in 2012: Community Banking by 15 percent, Wholesale Banking by 11 percent, and Wealth, Brokerage and Retirement by 4 percent.

And in the most recent quarter, Wells Fargo reported record net income of $5.5 billion, or $0.98 per diluted common share, for second quarter 2013, up from $4.6 billion, or $0.82 per share, for second quarter 2012, and up from $5.2 billion, or $0.92 per share, for first quarter 2013. For the first six months of 2013, net income was also a record $10.7 billion, or $1.90 per share, compared with $8.9 billion, or $1.57 per share, for the same period in 2012.

Businesses generating year-over-year double-digit revenue growth included asset-backed finance, capital markets, corporate banking, credit card, personal credit management, real estate capital markets, retail brokerage, retail sales finance, retirement services, and small business administration loans, according to the 2Q13 earnings report.

Wells Fargo continues to show all of the hallmarks of what value investors seek. The bank boasts a price-to-earnings-to-growth ratio (PEG) of under 1 (which means it is fairly valued), while also sporting a dividend of 2.79 percent and low payout ratio of  57 percent, indicating the dividend has room to grow. Finally, the bank has continuously looked after its investors, returning earnings per share diluted quarterly year-over-year Growth of 19.51 percent.

As one of the strongest retail banks in America with little exposure to potentially problematic investment banking, Wells Fargo is the newest addition to the Thrive Portfolio as a buy up to 45.