Lost in Stagnation

Goldman's Edge Cuts Both Ways

The bank benefits from turmoil and struggles without it.
At Closing, May 25th
235.01 USD

Debt trading defines Goldman Sachs Group Inc.

The New York bank is known for catering to hedge funds and asset managers that maneuver in the shadowy and lucrative world of private bonds and loans. It has committed to fixed-income trading even as some of its biggest rivals withdraw from the field.

This explains Wall Street’s collective surprise Tuesday morning when Goldman reported fixed-income, currency and commodities trading revenue that missed analysts' estimates, coming in at $1.69 billion compared with the expected $2.03 billion.

Not only was this a relatively rare disappointment in this area for the investment bank, but it was the first big U.S. bank to disappoint in first-quarter debt-trading results. Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co. have all exceeded expectations. And it's not clear that Goldman is well positioned for a quick rebound.

Lagging Behind

Goldman lagged behind peers in the first quarter with respect to debt-trading gains

Source: Company filings

Goldman shares headed for the worst earnings-day reaction since the last three months of 2010, as Lu Wang of Bloomberg News pointed out. The firm offered some vague explanations for the tepid report, namely that good revenues in interest-rate products and mortgages were offset by lower revenues in currencies, commodities and corporate credit.

Deep Disappointment

Goldman's shares fell the most in almost a year after it reported earnings

Source: Bloomberg

In a call with analysts, Martin Chavez, Goldman's deputy chief financial officer, said there were very low levels of volatility in the first quarter, with the lowest volatility in dollar-euro and crude in almost two years.

This doesn’t give a full sense of the picture. Corporate-credit trading was robust in the first three months of 2017, and the other big banks are also significantly exposed to currencies and commodities volumes, which didn’t plummet.

Here’s a more likely reason for Goldman’s disappointment: The firm stands to disproportionately benefit from times of widespread turmoil in which hedge funds and other active managers can swoop in and buy distressed assets at discounts. The first quarter of 2017 was rewarding for the biggest banks with corporate clients, which sold a record volume of investment-grade bonds.

It wasn’t as good for scrappier firms. Junk-bond sales didn't hit at a record like issuance of higher-rated debt, leading to smaller gains in high-yield trading. Meanwhile, active fund managers continued to experience withdrawals, putting a strain on some of Goldman's clients.

According to data compiled by Alison Williams of Bloomberg Intelligence, 22 percent of Goldman's trading business comes from hedge funds. That compares with 16 percent of Citigroup's fixed-income trading. While these figures aren't a precise apples-to-apples comparison, it gives a sense of just how much more dominant hedge funds are to Goldman's business, especially because fixed-income volumes account for a significant proportion of Citigroup's overall trading revenues. 

Hedge funds just suffered their first year of net withdrawals since 2009, and withdrawals likely continued into 2017. These strategies have been underperforming broad indexes, prompting investors to question why they're paying such high fees.

Tough Spell

Hedge funds just faced the first full year of withdrawals since 2009

Source: HFR

Goldman also implied that it had some losing wagers on its trading desk, although none of them seemed catastrophic. Still, this doesn't bode well for its strategy of being smarter and better than other firms and their market-making units. 

It's clear that Goldman is poised to profit from a substantial dislocation in the market. It's not so clear that it's poised for a windfall in the current environment, which is a slow grind forward without a clear meltdown or melt-up on the horizon. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Lisa Abramowicz in New York at labramowicz@bloomberg.net

    To contact the editor responsible for this story:
    Daniel Niemi at dniemi1@bloomberg.net

    Before it's here, it's on the Bloomberg Terminal.