A "new normal" of near-zero U.S. interest rates will limit the earnings potential of discount brokers this quarter and offset a boost in fee income as investors step up trading to keep up with wild market swings.
The surge in stock market activity in the past week has come as a welcome bonus for Charles Schwab Corp., TD Ameritrade, E*Trade Financial and other brokers.
But analysts see the benefits as short-lived. Many retail investors are likely to take cover again soon, waiting for clear signs that the economy is on the mend. That could take months.
"The current volume spikes represent 'good' volume," UBS analyst Alex Kramm said in a note to clients. "That said, we believe a prolonged period of market stress could ultimately drive investors to disengage."
Even more importantly for brokers, rates are not likely to rise any time soon. That depresses income from assets that they hold and hurts net interest margins -- the spreads between earnings on securities loans and the cost of getting the funds.
For most of the summer clients had been sitting on their hands, paralyzed by an unsteady economic recovery and concerns over U.S. and European debt woes.
The tipping point came with the deadlock in Washington over raising the debt ceiling and the possibility of a U.S. default. That tempted many retail investors back into the market. The stream became a flood when Standard & Poor's stripped the United States of its top AAA credit rating.
At Charles Schwab Corp , where client transactions account for about 20 percent of revenue, daily average revenue trades, or DARTs, rose 11 percent in July over both the previous month and the previous year.
"The trading numbers are far in excess of what anyone has in their model," said Macquarie Capital analyst Ed Ditmire.
TD Ameritrade generates more than 40 percent of its revenue from client transactions. It recorded four of its five busiest client trading days ever in the span of a week, including a record of about 900,000 stock trades on Monday.
Its July DARTs rose 9 percent from June and 11 percent from a year earlier.
RATE OUTLOOK DAMPENS POTENTIAL
The economic expectations that are driving trading volumes higher also signal an extended period of low interest rates. For Raymond James analyst Patrick O'Shaughnessy, the overall scenario contains more bad news for brokers than good news.
"We are lowering our estimates to reflect a pushback in our assumption for future interest rate hikes as well as lower-margin balances that will likely result from the recent market sell-off," he said in a note to clients.
O'Shaughnessy lowered his 12-month share price targets for Ameritrade to $19 from $21, and for E*Trade to $17 from $20.
The U.S. Federal Reserve said on Tuesday that in response to stagnating economic growth, it would keep the Fed funds rate at rock-bottom levels through at least mid-2013.
That prompted a rally in equities, but it also caused Macquarie's Ditmire to lower his price targets for Schwab to $16 from $20, for Ameritrade to $18 from $20, and E*Trade to $15 from $16.
Schwab is the most sensitive of the retail brokers to interest rates. Its earnings potential would double with a rise of 1 percent to 2 percent in the Fed funds rate, said Michael Wong, an analyst at Morningstar in Chicago.
"There really is a lot of dry powder in that net interest earning base," he said.
Higher interest rates would also eliminate the need for Schwab and other fund managers to waive fees on money market mutual funds. They have been doing that for a couple of years because the near-zero interest rates being paid could result in negative returns if fees were charged.
Schwab expects to waive about $150 million in both the third and fourth quarters of 2011.
VALUE FOR LONG-TERM INVESTORS
TD Ameritrade has said a rise of 100 basis points in the Fed funds rate in the next 12 months would add 28 cents a share to the firm's annual earnings. Analysts expect TD to earn $1.09 a share for fiscal 2011.
With a "new normal" of near-zero interest rates for at least the next couple of years, shares of retail brokers will come under pressure, and that could represent a buying opportunity for long-term investors, said Wong.
Schwab's shares are down nearly 30 percent year to date, at $12.10 on Friday around midday. Ameritrade is down around 23 percent this year to $14.64, and E*Trade is down more than 27 percent at $11.60.
"You would need a Japan-type scenario where the markets rebase lower and interest rates almost don't rise forever, in order to justify the current market price in our opinion," Wong said of Schwab's share price.
(Editing by Frank McGurty)