Wells Fargo: Still a Well Positioned Directional Play on the Economy

Analyzing the prospects for banking stocks like Wells Fargo  $WFC  isn't really as hard as many people think.

The fortunes of the banking sector tend to follow the direction of its underlying assets, which, in turn, tend to follow the economy. If you are bullish on America, then you should be bullish on Wells Fargo.

Wells Fargo reports results
The bank's fourth-quarter diluted earnings per share increased 10%, but as always with banking stocks, the devil is in the detail. Essentially, Wells Fargo has done very well growing its net interest income over the course of the year, despite its net interest margin, or NIM, falling. The NIM is the difference between its interest income and what it pays out to its lenders, all over interest-earnings assets.

Source: Company presentations.

This was no small feat considering that core deposits (including retail deposits) have gone up significantly more than it managed to increase its loan book.

Source: Company presentations.

It's somewhat of an anomaly to view a rising deposit base as a problem, because raising deposits is what banks are supposed to do! Indeed, in traditional recoveries, deposit growth is highly sought-after because it gives banks greater ability to extend their loan books. However, this recovery has been relatively anemic, and loan demand has been slow to take off. In short, Wells Fargo needs a more positive environment for loan demand, but the good news is, it has the deposit base to benefit should this happen.

So, how has Wells Fargo been generating income growth?
Given the dramatic decline in the NIM, Foolish readers might be wondering just how the bank has increased its overall net income? The answer is that credit quality has improved so much that its provisions for credit loss have declined massively.

In other words, Wells Fargo set aside nearly $1.5 billion less in the most recent quarter compared to a year ago.

Not all good newsThe mortgage refinancing market had been very strong leading into 2013, and Wells Fargo had previously positioned itself to benefit. However, with rates rising this year, the refinancing market has slowed, and Wells Fargo has been inordinately hit. In the words of its CFO, Tim Sloan, on the recent conference call:

Our market share, over the last couple of years was disproportionately high, primarily because the biggest driver for origination volume until the last couple of quarters was refinances, and the reason for that, again to remind everybody, is that we are the largest servicer and the quality of our servicing book was the highest in the industry. 

Indeed, Foolish investors can see the effect of the refinancing slowdown when looking at Wells Fargo's non-interest income. Note how the reduction in mortgage banking income has reduced non-interest income.

Source: Company presentations.

Putting the pieces together for Wells Fargo
In a typical economic recovery, an increase in credit quality is usually followed by an increase in loan demand, and then the NIM starts expanding while interest rates rise at the same time. However, this has been anything but a normal recovery.

In short, Wells Fargo needs to see a pick-up in loan growth in 2014. History suggests this will happen, and given its exposure to housing, and its growing deposit base, Wells Fargo is ideally placed to benefit.

On the other hand, should the economy stagnate, it can't really boost its net income via reduction in credit loss provisions. Moreover, a slow economy implies sluggish loan demand growth. The NIM would probably decline even further in this scenario.

The bottom line
In a sense, the stock remains a key barometer of where you think the economy is headed. Moreover, Wells Fargo gives you specific exposure to the U.S. and to housing, two of the more positive aspects of the global economy.

All told, investors everywhere can discuss this stock to death, but it still remains a cyclical play on the economy. If you think the U.S. housing market will continue to recover and increase loan demand with it, then Wells Fargo is ideally placed to benefit, and the metrics discussed above will all get better.