© 2024 Alpha Spread Limited. All Rights Reserved.
www.alphaspread.com is not operated by a broker, a dealer, or a registered investment adviser. Under no circumstances does any information posted on www.alphaspread.com represent a recommendation to buy or sell a security. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. In no event shall Alpha Spread Limited be liable to any member, guest or third party for any damages of any kind arising out of the use of any content or other material published or available on www.alphaspread.com, or relating to the use of, or inability to use, www.alphaspread.com or any content, including, without limitation, any investment losses, lost profits, lost opportunity, special, incidental, indirect, consequential or punitive damages. Past performance is a poor indicator of future performance.
You don't have any saved screeners yet
Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good morning and welcome to the State Street Corporation's Fourth Quarter of 2018 Earnings Conference Call and Webcast. Today's discussion is being broadcast live on State Street’s website at investors.statestreet.com. This conference call is also being recorded for replay. State Street's conference call is copyrighted and all rights are reserved.
This call may not be recorded for rebroadcast or distribution in whole or in part without the express written authorization from State Street Corporation. The only authorized broadcast of this call will be housed on the State Street’s website.
Now, I would like to introduce Ilene Fiszel Bieler, Global Head of Investor Relations at State Street.
Good morning and thank you all for joining us. On our call today, our CEO, Ron O'Hanley will speak first, then Eric Aboaf, our CFO will take you through our fourth quarter and full year 2018 earnings slide presentation, which is available for download in the Investor Relations section of our website, investors.statestreet.com. Afterwards, we'll be happy to take questions. During the Q&A, please limit yourself to two questions and then re-queue.
Before we get started, I would like to remind you that today’s presentation will include results presented on a basis that excludes or adjusts one-on-one items from GAAP. Reconciliations of these non-GAAP measures to the most directly comparable GAAP or regulatory measure are available in the appendix to our slide presentation.
In addition, today’s presentation will contain forward-looking statements. Actual results may differ materially from those statements due to a variety of important factors such as those factors referenced in our discussion today. Our forward-looking statements speak only as of today and we disclaim any obligation to update them even if our views change.
With that, let me turn it over to Ron.
Good morning, everyone. As you know, this is my first opportunity to address you since becoming State Street’s CEO at the start of 2019.
Let me turn to slide 3. We announced our fourth quarter and full year 2018 financial results this morning and I want to start by providing some context in terms of the overall environment, addressing our performance and then importantly, focus the bulk of my comments outlining what we’re going to do differently going forward. Market dynamics are changing for our clients. The shift from active to passive means thinner fees as well as more competition amongst managers who are increasingly challenged to outperform their peers and consequently face lower volumes and thinner fees themselves.
The resulting margin compression for investment managers has led them to increase pressure on their providers. Asset owners, facing inadequate returns, are similarly pressuring providers to do more for less. In turn, these same clients need better technology and streamlined operations to increase their ability to generate alpha more efficiently and reduce operating costs.
Given these headwinds for our clients, we are adapting strategically to become increasingly more competitive, offer greater functionality and be the essential partner to our clients. I have made it clear to my colleagues at State Street and want to make it clear to you, we want to better drive our own destiny and more effectively manage our exposure to market headwinds. That means change, real change that I will talk about today and in the year ahead. Year-over-year, our revenue growth in the fourth quarter was driven by strong performance in net interest income and FX trading as well as the contribution from the recently acquired Charles River development business.
We are encouraged by the continued interest we are seeing in CRD with a total of 98 client engagements since announcing the deal. These positive trends were offset by unfavorable market conditions, including the significantly down markets during the fourth quarter and ongoing fee compression, which impacted our servicing fee revenues. Assets under custody and administration decreased quarter-over-quarter, reflecting lower equity market levels and client transitions. Fourth quarter new servicing business wins were 140 billion.
Additionally, at quarter end, AUCA yet to be installed totaled approximately 385 billion. At 1.9 trillion for the full year of 2018, we experienced a record level of new servicing wins. State Street Global Advisors was also impacted by the market environment as our business has a disproportionate exposure to equity markets and other risk on asset classes, such as high yield. Assets under management decreased quarter-over-quarter, primarily driven by weaker equity markets as well as institutional and cash outflows, partially offset by ETF net inflows.
While SSGA results are not yet where we would like them to be, we have been working to diversify our business mix, leverage relationships across State Street and fill in offerings as we take advantage of the shift from products to solutions. These offerings include asset allocation, exposure management and outsourced CIO as well as demand for a range of ETF products. For example, this quarter, we saw good organic growth in our European ETFs and our low cost US ETFs and remain confident that our strategy of targeted growth in areas such as ETFs, OCIO and other multi asset solutions and ESG, just to name a few, will drive future growth.
Regarding our overall bottom line performance simply put, we need to and can do better. That means reigniting servicing fee growth in a sustainable way, reducing costs across our organization and building upon the advances that we have made in digitization and automation. Collectively, this means being faster and smarter about how we deliver solutions that solve our client's greatest challenges. Our capital position is strong. Moreover, we are optimistic the balance sheet repositioning actions completed during 2018 better position us for the 2019 CCAR cycle, supporting stronger levels of capital return for our shareholders.
In light of our recent results and ongoing industry dynamics, we are taking immediate action on expenses to ensure that we become a more efficient organization for our clients and shareholders alike. I have implemented a firm wide hiring freeze for all non-critical roles. We are rolling out a rigorous new performance management system and are structurally compressing and reducing the senior management pyramid by 15%, while improving spans and reducing layers across the bank by 25% to create a more agile and accountable organization.
These actions are enabled by the beacon work and the consolidation of work into our global hubs. Thus, we are confident in our ability to execute quickly. In fact, initial reductions have already occurred. Additionally, we are focused on addressing inefficiencies across our entire expense base and have launched a new cost savings program that will continue through 2019 to reduce structural expenses, while also enabling us to invest in the business appropriately. As part of that program, which Eric will cover shortly, we recorded a 223 million pretax repositioning charge, the benefits from which we expect to fully realize within 12 to 15 months.
Let me turn to slide 4. Slide 4 outlines my vision for State Street. We intend to be the leading asset servicer, asset manager and data insight provider to the owners and managers of the world’s capital. This vision will be driven by five strategic priorities.
One, we will increase core fee growth by becoming an essential partner to our clients, gaining share of wallet and building enduring institutional relationships. The issues faced by our clients have moved services, technology and operations to the C suite agenda. Thus, we are upgrading our client coverage model to meet these needs. These changes, including new senior leadership, are already underway.
Two, we must deploy the industry's leading front to back asset servicing platform as a technology driven scale provider. Three, we will continue to innovate to grow diversified revenue streams, including new markets and NII opportunities. Four, we must generate structural expense saves by automating key processes to reduce unit costs and by leveraging our global hubs and scale among other initiatives. And five, become a more high performing organization through flattening our structure, increasing the speed of decision making and evolving our employees’ skill base around our technology and data priorities.
Executing against the strategic vision will require concerted action and select investments, which I'm driving forward across the business. At the same time, we need to do more to improve performance in the short term, which is evidenced by our actions announced today.
And with that, let me turn it over to Eric to take you through the quarter in more detail.
Thank you, Ron and good morning, everyone. Before I begin my review of our fourth quarter and 2018 results, I'd like to take a moment on slide 5 to discuss notable items and how they impacted our financials. In 4Q 18, we recognized 223 million of pretax repositioning costs, consisting of severance and real estate write offs. This charge is in response to the challenging industry conditions and includes the organizational streamlining and de-layering actions that Ron announced last month. I'll have more to say on how we are tackling expenses later in the presentation, including details in our new 350 million expense initiative announced today.
In addition, we also had 24 million of acquisition restructuring costs related primarily to Charles River, which was below our original estimate, 24 million related to the sale of a small alternative servicing business in the Channel Islands and 50 million of legal and related costs. In total, we recognized notable items of 321 million pretax or $0.64 a share.
On page 6, we show our GAAP results in the top two panels as well as our results ex the notable items I just described for those of you who want to see some of our underlying trends. On this basis, we didn't achieve our fee operating leverage goal, but we did deliver a positive operating leverage overall in 2018.
Now, moving to slide 7, 4Q18 EPS of $1.04 was down 44% quarter-on-quarter, but up 17% year-over-year, primarily reflecting the impact of our 4Q18 repositioning charge and the 4Q17 tax reform costs. For the full year 2018, our GAAP EPS of $6.40 was up 22% over 2017.
Looking at 4Q18, return on equity was down 6.5 percentage points sequentially, primarily related to the quarter's notable expense items. For the full year 2018, ROE was up 1.6 percentage points from full year 2017. Overall, we saw growth in both EPS and ROE on a full year basis, driven by NII growth through active balance sheet management and higher interest rates, FX trading, where we continue to gain share, the acquisition of CRD and lower taxes. We are however disappointed by our performance in several of our fee businesses and I'll describe the drivers and our additional actions on the next few pages.
Turning to slide 8, our end of period AUCA and AUM levels were significantly impacted by the sharp sell-off in equity markets during the end of the fourth quarter as well as the cumulative effect of industry flows in the past year. As you know and as we have summarized on the right side of this page, global equity markets were down 6% to 17% in 2018, after posting double digit gains in 2017. At the same time, cumulative industry flows were dramatically down after significant inflows during last year and client transaction activity was muted, as investors sat on the sidelines. As a result, we saw AUCA levels fall 7% quarter-on-quarter and 5% year-on-year, while AUM levels fell 11% and 10% respectively.
Moving to slide 9, I want to spend some time unpacking total revenues, which were up 1% quarter-on-quarter and up 5% year-on-year. Servicing fees, shown in the dark blue piece of the stacked bar on the left side of the page were down 4% quarter-on-quarter and 7% year-on-year. Let me give you some color. On both the sequential quarter and year-over-year basis, we had a 2 to 3 point reduction in servicing fees due to falling global equity markets. In addition, we've recently been seeing industry pricing pressure of about 1 percentage point per quarter over the last year.
The cumulative effect has caused a material year-on-year downdraft in servicing fees. And we also had one previously disclosed client transition, which was worth about 2 percentage points year-on-year, which was offset by net new business and client activity. To put these numbers in context, the long term appreciation in equity markets has typically lifted servicing fees on average by about 2 percentage points annually over the last 5 years. Positive client flows and client transactional activity have added another 2 percentage points annually and net new business has also generated 2 percentage points of annual growth, all of which have been partially offset by typical pricing headwinds of just under 2 percentage points annually.
This year has been particularly challenging though, since we've seen twice the average historical pricing headwinds. Without the tailwind of market appreciation nor client flows and activity that are inherent in our pricing structure. We have thus undertaken meaningful initiatives to combat these headwinds, such as upgrading our client coverage program and strengthening pricing discipline through our new pricing governance process. And since we need to focus on what we can control, we are even more resolute that we need to actively manage our expense base lower, which I'll discuss further in a few minutes.
Turning to slide 10, let me briefly discuss our other fee revenues. Beginning with management fees, 4Q revenue was up 5% year-on-year, primarily driven by revenue recognition adoption, but down 7% quarter-on-quarter, driven by lower equity markets as well as net outflows in our equity focused institutional business. SSGA continues to focus on expanding our relationships and product categories that offer higher margin. 4Q FX trading services saw continued strong performance, up 19% year-over-year, driven by higher FX volumes and volatility. We continue to differentiate our FX offerings with clients, driven by the breadth and depth of our capabilities.
4Q securities finance revenues were down 6% quarter-on-quarter and 18% year-on-year, reflecting lower assets on loan and lower spreads as clients de-leverage and industry demand fell. I would note that the business continues to evolve after the CCAR related counterparty adjustments. We've navigated these changes quite smoothly in FX, but continue to work through the effects in agency lending. Finally, we saw a significant step up in processing fees with the addition of CRD for the first time in our fourth quarter financials. We continue to be excited by the acquisition, we're pleased with its performance and remain confident in our previously announced revenue and cost synergies.
As you can see, on the lower right of the slide, CRD saw net new bookings of 14 million for 4Q18. We have announcer our new client advisory board and delivered higher than expected fourth quarter revenues of 121 million on 39 million of expenses. We also incurred 18 million of amortization costs and 24 million of acquisition costs associated with CRD this past quarter. While CRD is enjoying real momentum, I would caution you against simply annualizing these 4Q results, given the lumpiness inherent in the 606 revenue accounting reporting standard.
Now on to slide 11, we saw continued NII growth and NIM expansion during the fourth quarter. Our NII was up 4% quarter-on-quarter due to the Fed hikes we saw in September and December as well as a one-time benefit of approximately 6 million from hedging activities. 4Q NII was up 13% year-on-year, driven by higher US interest rates and discipline liability pricing, while NIM expanded 7 basis points quarter-on-quarter and 17 basis points year-on-year. As you can see on the bottom right of the slide, our average level deposits remained fairly steady and our betas remained similar to last quarter at just over 50%. We were also pleased to see an increase in our lending activity during the quarter. All of this bodes well for a full year 2019.
Now turning to expenses, as we indicated earlier in the call, we are extraordinarily focused on managing expenses in this challenging revenue environment. I'll start by summarizing our expenses on an underlying basis, excluding notable items in Charles River and then discuss our efforts during 3Q and 4Q to keep our second half expenses flat to the first half on that basis. I'll then summarize the new expense savings program we just announced today.
Beginning on slide 12, you can see that our underlying basis 4Q18 expenses were up 5% year-over-year and 1% sequentially, driven largely by the year-over-year adoption of the new revenue recognition accounting standard as well as technology investments. From a line item perspective, and relative to 4Q17, comp and employee benefits were well controlled, increasing just 1%, reflecting technology contractor and annual merit increases, partially offset by beacon savings and lower performance based incentive compensation, given our disappointing results.
Information systems increased reflecting infrastructure enhancements as well as additional investments to support growth. Transaction processing costs were down as we renegotiated sub-custodian savings for a second quarter in a row. Occupancy costs were down as a result of continued progress in optimizing our global footprint.
Now turning the slide 13, as the extent of the challenging revenue conditions became clear last spring, we committed to actually managing our quarterly expenses, so as to keep second half expenses flat to first half on an underlying basis. As you see on the left side of this page, we deliver on this commitment, but we know we need to do more. On the right side of the page, we summarize the progress in our Beacon savings, which totaled 245 million in 2018 as well as additional tactical actions and savings, which included a down payment on our 2019 program. These savings include the start of management de-layering, contracts under savings, the renegotiation of certain sub-custodial relationships and better control of discretionary spending.
Now to slide 14, in light of our current macroeconomic and industry conditions impacting revenues, we have launched a significant new expense savings program. In total, this program is designed to achieve 350 million of in year expense savings during 2019 or approximately 4% of our expense base, which is larger than our previous efforts. On the right side of the page, you'll see the two major categories we've identified, resource discipline and process engineering and automation, with expected savings of approximately 160 million and 190 million respectively.
Resource discipline includes a previously announced 15% reduction in senior management, the rollout of a more rigorous performance management system to better control headcount and further vendor management savings and the continued tackling of our real estate footprint. Process engineering and automation benefits are expected to include the reduction of approximately 6% of our workforce or 1500 roles in high cost locations. Staffing assessments were recently done as part of our shift to a more globalized model and we are now able to take further advantage of automation, and standardized processes and lower cost per person.
We also intend to streamline three operational hubs and two joint ventures as well as continue the drive towards common technology platforms and the retirement of legacy applications. The initiation of certain portions of this program results in the 4Q repositioning charge that I mentioned, which we described in the left side of the page. Even though this charge is good payback, we know we need to reduce the size of these charges going forward, which is why we've rolled out a new performance management system and headcount control.
Moving to slide 15, our capital ratios ended the year, similar to those of a year ago with tier 1 leverage of 7.2% and a standardized set 1 of 11.5%. We also undertook certain balance sheet and counterparty actions in the fourth quarter to be better positioned for the 2019 CCAR process. As you see on the left side of the page, we shifted the investment portfolio during 4Q to further increase the percentage of HQLA securities and adjusted the held to maturity holdings, thus reducing the associated AOCI volatility to our capital under stress.
This portfolio rebalancing, including turning over about 10% of the book and is not expected to have a negative impact on further NII growth. Lastly and consistent with our previous announcement, we will resume share repurchases this month and intend to repurchase up to 600 million through June 30, 2019.
Turning now to slide 16, I'd like to focus on our 2019 outlook. Before I start though, I'd like to first share some of the assumptions, underlying our current views. At a macro level, we are assuming continued, albeit slowing global growth. Market interest rates forward and only
a modest uplift from equity markets, but with continued volatility, which will keep investor flows muted and transactional activity light.
I would note that this operating environment is materially worse today than it was just 45 days ago when I presented at the Goldman Conference. Since then, we've seen a significant selloff in equity markets for the year end 2018 with the US equity indices down almost 10% in December versus the first two months of the fourth quarter. This sell off has put a material drag on our quarterly fee revenue run rate since it is geared off of the 2018 year end step off of AUCA and AUM levels. And over the same period, the rates picture has markedly changed too, with the consensus moving from two Fed hikes in 2019 to nearly none.
Amidst this uncertain revenue environment, we will be laser focused on expenses. As you can see in the walk, we believe we can achieve approximately 4% in productivity saves, driven by our larger than usual 2019 expense program, which includes both resource discipline and process re-engineering improvements, partially offset by an approximately 3% of ongoing business and necessary IT investments. This should yield a net 1% reduction in 2019 total underlying cost, aside from the full year effect of CRD and notable items.
In addition, given the severe market environment, we currently expect to reduce expenses 2 percentage points from 4Q18 to 1Q19, excluding seasonally deferred compensation via our recent hiring freeze and senior management exits. While material percentage of our revenues informed by markets and not in our control, we can control expenses. We will intervene further if necessary.
Turning to fee revenue, with the December market selloff and increased volatility, there is a scenario where 1Q19 total fee revenue could be down quarter-on-quarter by 3 to 4 percentage points, driven by known factors including the market step off, the higher than historical pricing headwinds and the fiscal effects of lumpy revenues in CRD and trading. And because of the year end 2018 step off, even with a modest linear uptick in equity markets during 2019, we could see this 1Q fee revenue as our quarterly run rate for several quarters.
At this point, we’re operating the company under this scenario and we see sustained market uplift or further retreat, however, this picture could change. For example, in terms of market sensitivity, a 5 percentage point instantaneous uplift in markets is worth about 25 million per quarter to our servicing fee revenue with a lag of half a quarter. In regards to NII, we expect to see low to mid-single digit growth for the year. For 1Q, we expect a downtick, which would be fully accounted for by two fewer days and the absence of the 4Q episodic hedging benefits I mentioned earlier. Taxes should be in the 15% to 16% range for the year, though we expect 1Q19 to be higher at 18%. And finally, given the balance sheet repositioning undertaken in the fourth quarter, we are optimistic that we are better positioned for the 2019 CCAR process, subject of course to the Federal Reserve scenarios and associated approvals. Depending upon the specific CCAR scenarios, we would expect to target a total payout of over 80% for the upcoming CCAR cycle.
Finally to slide 17, in summary, full year 2018 was a mixed year. We had a solid start to the year with record new servicing wins of 1.9 trillion, which reflects our distinct servicing capabilities. Revenues started strong, but we had a difficult second half, given our exposure to weaker equity markets and challenging industry conditions. We continue to distinguish ourselves in FX trading as well as how we've effectively driven NII growth, as we've engaged with clients. All told, EPS increased 22% and ROE increased 1.6 percentage points. On the capital front, we are better positioned for the 2019 CCAR cycle and one of our top priorities is to return substantial capital to shareholders this year.
Finally, as I outlined a few moments ago, we are taking immediate action to adjust our expense base for this new revenue environment and we're confident the actions we announced today position us well to reduce our 2019 underlying expense base, relative to last year.
And with that, let me hand the call back to Ron.
Thanks, Eric. Operator, we can now open the call to questions.
[Operator Instructions] Your first question comes from the line of Glenn Schorr with Evercore.
Further comment on the pricing, because I think we all get that the market drops and so fee start out lower. That's, I don't think a surprise at this point. The worst pricing, what I'm curious about is, how it manifests itself, in other words, I think you used the phrase this year, I mean, this year is like 2 weeks old. So are we talking about each new contract that comes up as it comes up and it kind of rolls over like the next five years, I just wanted to get -- understand a little bit more about what's new about the -- because pricing has gone down like the last 30 years straight?
This is Ron. Let me start on that and then Eric will probably want to say something on it. The way pricing works in there or historically has worked in this business and particularly for us since our business is disproportionately for asset managers is that when you reprice, there are some assumptions built in around market and as importantly around flows. I mean, if you serve asset managers, you get the business and then over time it accumulates. We've gone through -- the industry has gone through a very large number of repricings for all the reasons that I've outlined earlier in terms of the pressure that clients are under and those same assumptions, at least on our part have been applied and I assume on everybody else’s part.
We had a year of very sharp down market and as importantly no flows. So between the volume of pricing and the fact that the usual kind of assumptions haven't yet played out, that's what's led to one, our results, particularly towards the latter half of 2018 and second for our outlook. Now, it's obviously -- we have to, as part of the pricing discipline that we've talked about, we’re rethinking these assumptions in terms of market and how much, if at all, to rely on flows, but that's really what we're referring to here.
Do you want to add anything?
Yeah. Glenn, I’ll just add that historically we've seen pricing headwinds for decades in this business, just part of the underlying assumptions or some pricing headwinds offset by flows and activity and market appreciation, as well the structure the contracts are set up and those have historically been in the 1.5% to 2% range. Literally, over the last half decade, we've gone back a decade and we've got that history. We've seen closer to 4% headwinds this year.
And if we think about the coming year, we expect about the same. That said, we've been renegotiating our contracts, right, and extending term. We've been putting in place some clarity around expectations on volumes and market levels and so forth. And while we're a bit more than halfway through those contract negotiations, the negotiations happen, then the fee changes occur and then we actually have to live through that. So we're just a bit below the majority of what we are going to need to live through and that's just part of what we have to navigate.
I will say that the fee headwinds tend to hit a little more in the earlier part of the year than the latter part, just because of the kind of calendarization. And so that's incorporated in our forecast. The net is that, at the end of the day, this is part of our industry. We feel like this is a wave, it's a larger wave than we've seen in the past and -- than usual – and we think there will be some reversion to the mean. But that said, it strengthens our resolve that we've got to work on expenses. We've got to take expenses out, we've got improved productivity and we've got to adjust our cost structure to be in line with what the revenues are that we can earn.
That actually leads to just my other follow-up is, if you could talk about the timing and ramping of, say, both the cost save program, because it's more headcount than comp focused and then also, while we're at it, the timing and ramping of the one, but not yet funded pipeline, because those could be partial offsets as well obviously.
Yeah. Let me start on the expense side, because that's, I've been putting a lot of my time personally with Ron and the management team on that and I think you saw in my prepared remarks, I gave you a sense of what we expect to do in terms of expenses for the year on an underlying basis, down 1% and because we've been intervening month by month and quarter by quarter, we expect total expense to be down on an underlying basis by about 2 percentage points from 4Q to 1Q. But we're trying to just adjust and that just comes in stepwise the increments.
I think at the same time, there are some ramping of some of the ongoing investments that we need to do and so that's what -- that's what will get the lines to meet at about that 1% down for the year. But, we're trying to peel off expenses, we've got a relatively fixed cost base, so we've got to take it down in steps and at the same time, we got to do it carefully, so that we continue to serve our clients well and deliver the services in the highest quality manner.
Your next question comes from the line of Ken Usdin with Jefferies.
Hey, Eric, I was wondering if you could help us flush out the point you made about not run rating CRD? And can you help us understand just what your expected contribution would be, if possible, both on the revenue side for more of a full year ‘19 basis and also on the cost side? I think what you've given us is the underlying on the expense, but it would be helpful if you could give us a sense of how you're thinking about the CRD adds? Thanks.
Sure. Let me describe CRD in a little more detail and I think we provided the fourth quarter P&L here on page 10 of the materials. Think about it this way, revenues have a seasonality in CRD, because of the kind of natural calendarization that happens in sales, in a software oriented business and I think you'll see that in most of the software business that you or some of your colleagues may cover. We disclosed that we -- that the fourth quarter is typically 30% to 35% of full year revenues, that's a rough amount. It will vary a bit, but that's probably at least something to start with and so part of the guidance I gave on total fees for 4Q to 1Q includes the natural downtick that you’d see after that fourth quarter seasonal position. And I think you can kind of build models off of that.
In terms of expenses, these are first quarterly expenses, what we are doing in CRD is all the things you'd expect and we've described, right, we're tackling those 80 or 90 engagement -- client engagements. We've begun to build out the sales force further that was part of our intention. We've added and we're adding product engineers for installation, because that tends to be the bottleneck, not just sales, but actually the ability to install and to install in a timely manner. So the expenses for CRD will ramp during the year as we integrate. That's all part of the accretion dilution analysis that -- and commitments we made.
And so I think you've got to assume some ramp that would be representative of what you might do, were you to run a software company, where you are trying to effectively double the revenue growth rate, because that is the underlying goal. Remember, the original -- the growth rate in this business historically over the last four or five years has been about 7% top line. The kind of on Charles River synergies should take that through a series of different actions to double that and so we need to invest in the earlier quarters and years to deliver on that.
And then if I just take that back up to the top of the house, I think the comments you gave us on the fees were on an all-inclusive basis, so if I think about what you just added on the CRD, what's your concept of just -- and I know it's harder, given your opening comments, but just the ability to deliver positive operating leverage and given the tougher market environment and some of the pricing points and how are you going to -- how you're trying to balance that, can you do positive fee operating leverage with this outlook or is it just going to be one of those, hey, we've got to make it through this and then the longer term, we come back to it as the market improves?
Ken, it's more the latter to be honest, right. I've been real clear about the change in the market environment just over the last month and a half, right, whether it's equity market levels, whether it's even lower flows, I think, December long term outflows between US and Europe were, just in December were $100 billion negative. Through November of the year, they weren't even $200 billion negative. So this -- and then we have all the geopolitical and macroeconomic and trade questions. And so that makes us feel that we should be conservative and careful in how we run the company. And as a result, I think what we've done here as part of our prepared remarks is be real clear about what we can do and should be doing on expenses. We are -- we think there's a ranges, I think there's a range of scenarios on revenues and what I'd rather do is just give you good visibility into the coming quarter or quarters on revenue as I get that and then a real commitment on the expenses and just be in touch as developments change.
Ken, what I would add to that is that we believe we need to manage the company with this somewhat muted outlook. There's so much uncertainty out there in terms of the macro environment, what it means for markets and what it means for investor flows. Having said that, we continue to be very encouraged by the client activity that we see, some of it Charles River driven, some of it driven simply by our increase in service quality and the drive for clients to think about more consolidation, but we really do understand that those macro effects can actually overwhelm anything that we might do and then I am actually confident we will do on the revenue side, so it makes sense for us to manage the company on the expense basis with that muted outlook.
Your next question comes from the line of Brennan Hawken of UBS.
Just want to try to think about this in the context of the medium term targets that you guys laid out in early December. I believe the targets included a 10% to 15% GAAP EPS and it was my understanding that that was the one medium term metric that actually intended to apply for each year, it would apply to actually 2019. So number one, now that we know what GAAP EPS for ‘18 is at 6.40, I want to make sure that that is still intact and then maybe help me understand how to get there, because to think about adding in CRD operating expenses of 160 and amortization and such to the expense guide that you give in the deck, with net of the cuts you’re making and then also layering in, Eric, your reference to some sustained fee rate pressure, which seems like we had stability in 4Q, but maybe you're indicating that that was -- that's temporary and we should think about some further fee rate pressure from here, so maybe, I might not be thinking about correctly, hopefully you can provide some clarity? Thanks.
Brennan, it's Eric. Let me take that. We made some very clear commitments for the medium term across a series of different financial elements from capital return to reigniting revenue growth, EPS and so forth. I thinks in the last month and a half, as I said in my prepared remarks, the environment has really changed for this year 2019 and whether it's the equity markets off 10%, whether it's long term flows racking, one of the worst months of the last few years, whether it's a geopolitical and economic environment, getting -- taking another step down or sideways, we now think there is a wider range of revenue scenarios than I think we consciously had in mind in early December, as we put up those medium term targets a bit.
So I think from my perspective is we are going to hold to the medium term targets, I think the 2019 year itself is going to be a more challenging one. And at this point, what I’d not like to do is be too optimistic. I think a year ago, in this call, we were a bit too optimistic, as the environment changed and didn't react quickly enough and I think our perspective is, we've got to take a more conservative perspective here and update you as it comes, but I think 2019 will be more challenging than we had expected just a couple of months ago.
Good to know that my math isn't totally way off. And then thinking about the deposit cost front for my follow up. You guys continued to show a 50% beta, which is encouraging. Looks like the likelihood of a further rate hike has deteriorated. So, can you walk us through maybe how we should think about deposit cost pressure and your expectations for deposit costs in a 2019, where we don't see further increases in short term rates, could we still continue to see upward pressure on that deposit cost and what are your expectations there.
Sure, Brennan. Deposit costs and betas will continue to float upwards. I think we've been, 2 years ago, early on, we were in the 20% range for beta as we moved into the 30% to 35% range for a while. This year, we’re right smack in the middle of the 50%, 55% range and we certainly expect that during the year that will continue to tick up and we've seen that in other firms and so that's inherent in our forecast. We think it will jump up to very, very high levels, not, we don't have any indication that that would be the case and so we just expect to continue grind up our betas and continued modest transition from non-interest bearing into interest bearing.
I think one of the things that gives us confidence in the NII outlook of low single digits to mid-single digits is that, just by virtue of the 4Q step off, right, we build off of that during the course of the year, as we've expanded our coverage program, one of the earliest efforts that Ron and I started, I'd say it was probably about a year ago was actually client engagement on deposits, right, the full suite of what they need to do with their cash and that in our minds has actually really solidified the deposit gathering with our clients and gives us some capability to put the right amount of volume of deposits on our balance sheet.
And so what we would like to do this year and obviously subject to ebbs and flows in the market is to not only hold deposits steady, but see if we can drive them up somewhat because that would be part of how we deploy the balance sheet in a positive way. And if we can do that plus get some of that high quality lending that the 40x leverage fund needs or the private equity capital call lending that they need, that would also be a positive. So, there are a couple of different dimensions there that we're working on to drive some growth in this coming year.
Your next question comes from the line of Alex Blostein with Goldman Sachs.
So I was hoping we can double click on some of the things we talked about here in more detail. So I guess starting with fee pressure, I guess, one, I guess what gives you guys confidence that the pressure will normalize beyond 2019, so sort of why doesn't the 4% annual drag doesn't continue beyond that period? And if you guys could provide a little bit of color in terms of customer segments in particular, client types, geographies, things like that to help us get a better flavor of where the pain points are?
Alex, this is Ron. I think that where I begin on that is that the -- much of the pricing discussions have occurred and started in earnest with the combination of the ongoing pressure on the big active managers or managers in general, but certainly the big active managers, while at the same time, markets were running up and clients were seeing that State Street and [indiscernible] gathering more revenues for doing really the same things. So it led to what we would view as an accelerated amount and a heightened amount of fee discussions. As Eric outlined though, as we've gone into this period, one, we've moved and pretty much insisted upon term for our pricing.
So in other words, to make it a little less variable than it's been in the past and second, in most cases, we’ve actually gathered more business as part of the pricing discussion. So the reason why we feel confident that it will abate, it's never going to go away, but that it will abate is, one, as Eric noted I think, we're through about, just over 50% of our clients in terms of discussions on this. A little bit more than that and for the ones that we've done it, we've extended term and gotten more business. So that's why we would feel that this is a bit of a cyclical low here, but feel confident that it should improve.
Alex, it’s Eric. I’d just also say that this is obviously a phenomenon that started in the US, the US asset managers were under more pressure sooner and earlier, right, because of the flows of active to passive. We've had now similar discussions in Europe. There we think it's not to be quite as difficult, partly because the kind of the ETF mutual fund differential isn't as sizable, but we'll see. So it's affecting primarily the asset managers as a segment that’s seeing where those are most intense and a little less so some of the other pension or in insurance type companies. That said, we have had run ups in the marketplace and oftentimes, these fee negotiations become more intense after run ups in the marketplace.
Why? Because if you just think about yourself being an asset manager, right, you're paying us fees that are scaled to market levels, markets appreciate, you look at your bill, your bill is going up and your natural inclination will be, well, let me go and talk to my bill provider about how can I get some of that back. And so we have seen, as we've gone back for half a decade, a decade or more, some connection between run up in markets followed by more severe adjustments in pricing. And so I think if we get some normalization to kind of more steady growth in markets, we think we'll get some reversion of the mean, whether this 4% level goes back to the 1.5% to 2%, we'll see, whether it goes back to somewhere between them, we'll see and obviously as we see more, we'll share more with you.
And then my second question was around securities lending, looking at $120 million run rate this quarter, can you help break out what's kind of still enhanced custody versus traditional agency model and again assuming environment stays roughly the same, is this sort of the low at 120 run rate or you guys are still working through how to reposition the enhanced custody business for CCAR? I thought you said earlier in the call that that’s still a bit ongoing, so I'm just trying to get a better sense of what the jumping off point is?
Yeah. At this point, the revenues in securities lending are, let’s see, about 120 for the quarter. It's roughly 60-40, 55-45, classic agency lending versus enhanced custody. So it's kind of in that – and in that range. I think there are two things going on right now in this area and it's really around the agency area. I think we've seen some stability, reasonable stability in enhanced custody. But on the classic agency lending, we've seen some real market, with markets levels falling, you have just assets on -- loans are lower. We've seen de-leveraging by some of the hedge funds who need to borrow.
So there's less demand out there and as a result, spreads have come down as well. And I think the question is, what happens, one question is what happens to market levels and demand in first quarter. And if you remember, we ended December, I think, at close to 10% below S&P levels for October-November. We've had a little bit of a bounce back, but if that persists, we're still likely to have a lower average, highly likely to have a lower average first quarter than fourth quarter and so that's going to create some dampening measures on demand and you still have some hedge funds continue to de-leverage. So there's clearly a market demand element here that makes us feel careful about the 4Q to 1Q and is embedded in my sequential fee guidance.
I think the other part is the counterparty work that we've had to do with CCAR does have more of an effect on sec lending and while I think we've been through most of it, I don't think we've been through all of it in the agency space, which is kind of just a little more than half of sec lending. In FX, I think we've done a terrific job in diversifying counter parties, innovating, doing compression trades, right, the tools are quite vast and the number of counter parties out there are quite significant and the team has really turned on a dime to kind of adjust their processes.
In agency lending, it's much more concentrated business. There is fewer kind of transaction types available to us and so it's something we're working through and need a little bit of time on. That said, I would tell you agency lending and securities lending and enhanced custody continue to be an area of innovation for us. The question is, how can you structure trades in various approaches to actually refine and actually connect counter parties as opposed to always be the intermediary and still earn a fee and effectively add innovation in what's been a historically unchanged marketplace. So more to come on that and we'll certainly talk more over the coming quarters.
Your next question comes from the line of Betsy Graseck with Morgan Stanley.
Eric, just to follow up on that. Could you give us a sense of, if you ran through your new positioning on last year CCAR, how much it would have changed the results?
I’m chuckling Betsy because that's the question we – our capital team would like to ask the Fed, right, that's the -- how do the models work. I'd tell you this that on the investment portfolio we and I think the other large banks have done quite a bit of work on the mark to market effect and how the mark to market on the OCI positions could be modeled and we've now got 5, 6, I think we've got 6 or more data points, their data points with changing portfolios.
So, how much is it worth, I think we've got a range of estimates. I think the reason we felt comfortable saying that we're optimistic about our capital position is if you think about it, if we have earnings of what it's been the 2.5 billion, 3 billion a year, we know how much we like to return and we know what every 10 percentage points of those earnings are in terms of capital return and so if 10 percentage points of capital return at $300 million, right, we have some sense for how much you’d have to adjust the mark to market impact to create another 10 percentage points or 20 percentage points of return and that's kind of the math we've done. So I don't really want to be in a position to predict AOCI impacts on our portfolio. We could all do rough estimates, but that's how we've thought about it and that's maybe the kind of the quantitative context I'd share with you.
And then just separately, the Fed has talked about proposing CCAR stress tests, it's only run on RWAs and not on leverage ratios, have you thought through what that could mean for you.
Yeah. I think we've done the modeling of that. I think there's been a fair amount of outside in modeling and right now, I think tier 1 leverage is our finding constraint and under the stress test. The difference between a tier 1 leverage binding constraint versus an RWA binding constraint, while it's not perfectly discernable, rough estimates, $1 billion range, maybe a 1.5 billion, but it kind of depends on exactly how the test is run, what the timing is of the various market factors and so forth, but that has some real material benefit and I think we are optimistic that with [indiscernible] having passed and the Fed working on the implementation of that and some of the Vice Chairman’s comments that there is some real movement is just a matter of time and hopefully months, not quarter is when we hear more, but it’s an important positive for us.
And then just a little bigger picture, I know you've talked a bit about, if then scenarios on revenues and expenses and I guess I'm just trying to understand if you have a more muted revenue outlook, Ron, maybe you could just give us a sense as to, do you have to invest to get further cost saves or do you feel like there still is opportunity because I know you did a big restructuring here. And I'm just trying to understand, is further potential expense opportunities really incremental or is there more that you can chop?
So what we've done is going after the expenses that one we just should go after and second, what we believe we need to go after, given what you're hearing from us is a cautious outlook going forward. If your question is, is there more to go after, of course there is and we've got -- we've noted a comprehensive program in place that we actually expect to be able to drive more. We also have the work that's been done in the past that I can't emphasize enough in terms of Beacon, the work that's underway in terms of consolidating our delivery and all of our operations and those efforts will continue to pay off in 2019 and beyond. And then finally, to the extent to which we saw an environment that was even worse than the cautious one that you're hearing from us, we'd obviously start to look at things like the pattern of investment. I mean, that's the last thing we'll go after because we do believe that it's important. What we have what we think is a sensible investment program, adjusted to the opportunities and market realities, but if we had to, we’d look at that again too.
Your next question comes from the line of Brian Bedell with Deutsche Bank.
Maybe I'll just start with expenses and then move on to revenue growth question. So first, just on expenses, just to clarify for 2019. I'm getting basically to about an 8.6 billion core expense run rate and what you exclude from that is the CRD amortization and any CRD acquisition related expenses. But it would also include delivery costs to achieve the revenue synergies that you outlined when you did the deal, which would be some portion of that 180 to 200 and maybe if you can – Eric, if you can talk about how you're looking at those delivery costs for 2019 and then the trajectory of expenses going into 2020, given that we're potentially guiding down on expenses and saves as the year?
Brian, it's Eric. Let me try to do this from a couple of different directions. I think page 16 of the deck is probably a helpful starting point, because we kind of define the underlying 2018 expenses as you know that’s ex CRD and so forth. And then where we expect those to end at the end of ’19. I think you do need to take -- put CRD in there. First quarter, scale it up and I think while we will be investing, I'd ask you to think through how quickly can you invest well in a business, right, there's little bit of a bounding limit there and if you're at a $40 million run rate in 4Q, it just -- think about, I think, there's a range, but I think you can quickly come to what's reasonable versus an unreasonable set of expense growth rate off of that level.
So I think you can work off of that. You do have to factor in the intangible amortization, which we've defined there and then the acquisition and restructuring costs will also flow through. I think this quarter is a good example of what a run rate should be on a quarterly basis, but we’ll obviously take those as they come, in line with the actions we’ve take and the appropriate accounting. So those are the pieces, happy to work with you and IR team to take a look at how you're modeling it out and take things from there.
Okay. We’ll do that offline. And then just on the revenue side, maybe Ron, if you could just characterize how those conversations are going, you mentioned the 98 client engagements with Charles River customers and if you could give some perspective, maybe some refresh perspective on the trajectory of revenue synergies, appreciate that that’s a 2021 goal, but if you could sort of give us a sense of how optimistic you are on winning new business from the game plan of talking with the CRD clients and the concept that you mentioned at the outset of the pressure that asset managers are facing and whether they're very receptive to the partnering concept?
So, let me start with the question on optimism. We're very optimistic about achieving, if not exceeding those revenue synergy goals. The nature of the conversations, let me give you some sense of those. Some of them are simply that the CRD clients, they like the new owner, the new owner is in private equity, so they see stability and there's just more CRD activity happening, more movement from shrink-wrap to cloud, all of which is good from a revenue and profitability perspective from CRD.
There's also a series of client -- a series of client conversations where it may be a State Street client with no CRD presence or a CRD client that sees the value of having more of their activities with State Street and CRD together and the attraction of those of course is a simplification of the internal operations and operating stack and technology stack. And then there's a set of conversations that we, in all honesty, hadn't expected to be having, which is clients, where we either don't serve them now or we serve them in a minimal way or even in a couple of cases where there was a competitive bidding situation and we lost typically for price that are all being looked at again. So it's pervasive, it's comprehensive and it's driven by all these -- all these things we talk about in the marketplace, which are real negatives to short term revenues, but we think are real positives to seeing more business consolidate with us and us having, in the end, a much higher share of the wallet.
And do you think you can -- based on those conversations achieve those revenue synergies in a potentially linear fashion over the next three years or is it more hockey stick towards 20 and 21?
It's a little bit too early to tell on whether the pattern is going to change, Brian, because these are pretty comprehensive discussions. You try and move them along as fast as you can, but they take time, because you're really talking about a once in a generation change in these firms in terms of how they're going to run their business. So right now, we're sticking to the timeframe, but I would emphasize that we're highly confident in achieving the amount.
Your next question comes from the line of Mike Carrier with Bank of America Merrill Lynch.
Good morning, so first question. Just on expenses, I guess I want to kind of step away from the expense program and the 350, but just thinking about sort of the core business, maybe like what has been done to make the cost structure maybe more variable, just given some of the uncertainties that you have on the revenue side, some of the pricing trends that you're seeing and basically, if it's -- the revenue is going to be tough to predict, I'm just trying to gauge, when we think about some of the lines like comp, transaction, other, like how much of that is variable that can kind of ebb and flow with the revenue backdrop versus what's fixed or more structural.
Mike, it's Eric. Let me start on that one because the nature of our business has actually become, in terms of expenses, more fixed than variable and partly that is, as we automate, as we put more capital work and labor and we need to make that shift be even more dramatic to be honest and, I think, as Ron describes, we feel good about some of the investments we've made in some of the automation, but I don't think we've sufficiently adjusted the stack of labor that we have against it, but our business is actually becoming more fixed than variable over time.
And I think that means two things. I think that means from an expense program and programmatic standpoint, we need to find ways to take out step level, kind of step function expenses off of -- out of our expense base, so as we automate we need to take labor out, as we work with vendors, we need to find ways to adjust downwards, as we get larger and they get larger and we force the scale benefits to accrue to both parties. So that's part of what we just need to do because of the nature of how this business has evolved, relative to where it was as a highly manual, highly variable business, 10, 20, 30 years ago.
I think the second perspective that we've developed as a senior team here is because it's more fixed than variable, we actually need to find ways that in good times, we create more margin expansion and more leverage because in truth, while we have an ability to take some step wise and step function reductions in the expenses, in difficult times, it's hard to adjust the level that we would like, given that revenues could move as much as they are moving up or down.
And so I think our historic belief that we should run with operating leverage of maybe a point in good times, I think that's not really something that makes sense as we step back and think about how this business has been operated, it may have made sense in the past, but that's something that we need to change. And so we first need to work through this particular market environment, but that gives you at least some context as to how we're thinking about this going forward as well.
Mike I want to add to Eric's last point there because I think part of the challenge that we're facing now is that in the past, the costs have been too variable, as the business has grown and it's not that there were people have been through it, we had these distributed operations and we just weren't achieving scale benefits as rapidly as we should have, as we could have been. With the work that's been done over the last year, not just Beacon, but this consolidation of our operations into this global delivery group and the creation and running of these hubs, that is the goal is to achieve much better scale benefits and as a consequence, we should be able to deliver what Eric's talking about in terms of in good times, actually more operating leverage than we have in the past.
And then just a quick follow up. You guys mentioned some of the pricing challenges across most of the asset servicing or asset management industry versus CNF, but when you think about some of the other products, services that you're offering, where are you seeing the areas where you're not seeing maybe the same level of pressure, there's more maybe growth opportunity that you can allocate resources to?
Mike, it’s Eric. I think the answer to your question really is around the product stack that we offer. If you think about it, custody for example is the most commoditized of our products. Then there's accounting, then there's funded administration, the prospectus creation, then there is middle office, where I think we've actually gotten to be better about how we and smarter about how we price and operate that business. So as you move up the product stack, I think we see and actually more recently with some of the new SEC reporting requirements and so forth, we've seen more pricing power and I think in fact in terms of something like CRD or software, there's actually effectively inflation escalators in contracts because of the nature of that business and of that industry.
So part of this is kind of where you are in the stack, which actually I think encourages us to continue to pivot and make sure that when we're offering custody, we also do accounting. When we do accounting, we also do administration and so on and so forth. And so that's maybe a little bit of flavor as to where you have strength. I think the other places we have found that where we have clients that are moving in different directions, de-leveraging or what have you and as their books adjust downwards, we have gone back and said, look, we need to adjust pricing accordingly and in particular, in the hedge fund space, that's been an important part of the back and forth.
And then lastly I’d tell you the other place that we're working through as pricing is not only as we have price discussions we asked for more wallet and more share of wallet in a much more rigorous and disciplined manner and controlled manner, we've – Ron and I have put in place with some of our most senior folks, very rigorous processes there, but we've also had very active discussions about being paid for in different ways, being paid for with more deposits left with us than with some of the other players and that's been another area where I think we've found some ability to be paid appropriately for the service we provide.
Your next question comes from the line of Jim Mitchell with Buckingham Research.
Maybe just a follow up on Eric on your outlook on NII and NIM, if the Fed were to stop, I mean, historically State Street has seen leverage once the Fed stops, as assets reprice and deposit betas typically or deposit repricing has stopped pretty quickly, because you have high deposit betas during rate hikes and then you stop, sounds like, you didn't, I guess, reinforce that view. So has something changed or should we -- how do you think about Fed deposit pricing once the Fed stops and given where your securities portfolio yield is, it’s still well below 2%, 2-year Treasury, should we expect your securities yield to grind a little higher over -- once the Fed stops, so just thoughts on NIM.
Yes. Let me tackle it from a couple of different directions. I think if the Fed stops now, there are a couple ways that we will get some incremental growth in NII. First, just get the fourth quarter run rate over the earlier quarters will create a full year back to ‘19 relative to ’18, that's the first piece. The second piece, as you described is that the investment portfolio tractor continues to work upwards and that's worth, we continue to have investment coupons higher than those that are falling off, it’s a little more complicated for our book, because we operate not only in the US geography, but also the international geography, but there is more there. I think third, there is a continued mixing of the portfolio.
We've historically run with a very large kind of a barbell portfolio of credit and treasuries. I think you've seen in some of the changes that we made, the first quarter of ‘18 and then the fourth quarter of ’18, you've seen we've shifted into more of agency MBS portfolio that gives us some pickup relative to treasuries and then we've also shifted in the foreign sovereigns, it's -- you can see it directly, but out of some of the sovereign versus some of the supers and also and the other types of global government agencies. So we think there is some amount of grind up work.
And then I think, the final one, which in some ways is most connected to the business is how do we continue engaging with our clients on cash and how do we actually find ways to create better solutions for them on cash, right. And I think that's where, it's not only their cash position, but it’s their needs for repo, whether it's direct repo or FIC repo, it’s their money market sweeps and so forth. And so each one of those is a very engaged conversation, to the extent that we can drive some amount of volume growth, we feel like backing follow the bottom line and that will just, we can just report on as we see developments.
And on the deposit pricing point, do the prices go up still despite no rate hikes?
No. I think you get a little bit of the tail end of December, flowing through the first quarter, but you get some relative stability in deposit pricing I think. I think on a direct basis, I think the question is how much competition is there out there in a flat rate environment, I think what happens is what happens to the competition for deposits in the banking system and while we don't directly compete, there is always some spillover effect and so if we get a situation where lending grows relatively quickly for a time period, back to the 5%, 6%, 7%, 8% range and banks need to fund that lending with deposits and there's more deposit competition, then you can see pricing, then you can see pricing go in the favor of clients and against the favor of the banks. I don't think we see that at this point, but we're always watching carefully.
And then as a follow up question, just on your revenue, fee revenue forecast, can you just for our modeling purposes, help us understand what market levels you're kind of assuming, I see that in the footnote, you talk about 5% growth from December levels, obviously, right now, we’re up 6% to 8% in the US, depending on which index. What are you assuming in your first and second quarters to give us that kind of fee guidance?
At this point, what we've done is, we've started off of the December 31st step off with that for the US and for the international markets as well. I'm a little cautious on a particular quarter, so just that's why I gave some guidance on total fees for 1Q. Because the way our pricing works is some of it's geared to the, literally, the month end. Some of it's geared to daily averages, sometimes it's a 2 point average and so there is a mix and so it was not helpful that you get that December 31st print.
And I think the other part that's going on here is flows and client activity matter, right. I think in my remarks, I describes that flows, because the natural course of business on flows and remember we get because of the size of our business in the US and in EMEA for asset managers, we get about a third of the inflows that you see in the industry, we get that in our books and records, right, in our custodial counts. But those kinds of flows and then the client activity or that transactional activity is material. That's historically been worth 2 percentage points of growth over the course of annually, right. And right now, we're not seeing much of that at all and so that's another reason why we are quite cautious on the first quarter and we've added a little bit of wording around that as well.
The next question comes from the line of Brian Kleinhanzl with KBW.
A quick question on the market sensitivity that you gave, you mentioned that a 5% uplift is 25 million in servicing fees. So I mean, if you put that relative to what the 2018 revenues are, it's about 1% revenue uptick for the 5% uplift in the markets. So last quarter when you gave that, it was 10% and it gives you a 3% increase, so a 30% pull through rate. This quarter, now, it's down to a 20% pull through rate. So when you finish all these renegotiations that you have ongoing, how does the market sensitivity look when all said and done, I mean, do you expect it to be another step down for market sensitivity from here?
Brian, it's Eric. I think we gave relatively consistent guidance, so the historical guidance that we’ve given in our -- is around 10% change in equity markets is worth about 3 percentage points. So on a base of $5 billion of servicing fees, right, that's about $150 million. I think what I said earlier today in my prepared remarks is that 5 percentage points, about 10 is worth about 25 a quarter, but you lose part of that first quarter, so you get a little more than 75, you get call it 85 to 90. So you're kind of within the range of that 10% and 3%, which would give you $150 million. The other part of that is you get a little bit of sensitivity on management fees that you also have to work through, so we can go through that with the offline, but just trying to give kind of some ranges there, so that you could do a little bit of estimation.
Maybe the general assumption is it should be moving lower, as you're trying to fix -- move to more fixed pricing in the asset servicing business.
Well, I think -- just to clarify, what's happened in -- on the cost structure is the cost structure has become more fixed and less variable. That's on the cost side. On the pricing side, I don't think we have really seen shifts at pricing and pricing structures at this point. I mean, at this point, we still have pricing, which has asset levels as the basis, we have some pricing that is around transactional fees and we have some pricing that's fixed, but there's still some real variability baked into our pricing and we don't see that pricing structure as having changed in new contracts that we're negotiating now relative to those that we've had it, it’s for the level pricing has been adjusted downward and what we're trying to do in several different ways is put controls around our internal processes on how those are negotiated, what we get for them, not only in terms of servicing fees and markets and the FX and security lending and deposits, but also who's engaged at what level of seniority in those discussions, because those are in some ways the most important discussions that we should be having at the most senior levels in our counterparties.
And I just want to clarify one thing on that fee guidance, as you had mentioned. I mean, you were talking about AUM and AUC, right, before you gave the guidance, but I mean you were talking about total fee revenues being down 3% to 4% in the first quarter from fourth quarter, correct?
Yeah. That's correct and that just includes all of our fee categories. Correct.
Your next question comes from the line of Mike Mayo with Wells Fargo Securities.
Hey, Ron. I hear what you're saying, you have a new expense program, merger synergies with Charles River, you're increasing intensity, but here's my question. What assurance can you give that savings will be sustainable and what is your new pretax margin target and before answering, here's what’s in my head. State Street said that it achieved all savings from business ops and IT transformation and almost all the savings from Project Beacon and had a target at the start of the decade to improve the pretax margin from 29% in 2010 to 33%. But over this 8 year period, State Street, not only missed its own pretax margin target, but the pretax margin declined from 29% in 2010 to 28% last year.
So while the pretax margin got worse over 8 years, State Street took victory laps on earnings calls, from press releases and its proxy and Ron, I know this is predates you, but still this is a question to what extent is the board looking after shareholder interests, to what extent would State Street apply clawbacks to the prior CEO's pay. Jay, a Grade A person, you've always treated me well, you guys have given me access, but at some point, don't you have to look at the business and say, well, actually, the targets were not met, but again the question is, what assurance can you give that the new potential savings are sustainable? Thank you.
Mike, I'm not going to spend too much time on what happened in the past, but what happened over that decade in terms of regulatory costs and things like that that may or may not have been in the forecasts or presented, but let me talk about going forward and the assurances here. One, there's been a lot of work done and I keep coming back to Beacon, I keep coming back to what we're doing in terms of consolidated operations that we have not realized the full promise from. We need to accelerate that, but this is not something that we're just thinking about, this is actually work that's underway, has been completed and we need to make sure that we realize the benefits from that.
Two, as we were talking about earlier, the business, as revenues have come on in this firm, costs have gone up almost at the same rate. We have not gotten sufficient scale advantages, because of the work that's been done and frankly because of the way we're going to manage the business going forward, we will capture more scale benefits. Three, the board is very involved in this. We've worked with them on our new performance management and accountability system and there's a very, very close tie, more so than ever between pay and performance. And so we've got incentives aligned across the firm, so I am confident that we will deliver on what we've said here and we need to do that because we understand that firstly, just to be in a position, to be able to service the business that we see coming down the road, we have to achieve all this. Secondly, we recognize that while there are certain things we can control, there's a lot of things we can’t such as markets, such as client flows and things like that, so therefore that's why we need to redouble the efforts around there. So in those periods, like a 2018, that we don't see that same kind of fall off.
And just a follow up, again, from covering State Street for a while and again this predates you, a lot of comments about the success of these prior programs, when business ops and IT transformation was first launched, it talked about improving scale and you think you'd see the scale benefits in the pretax margin, so with your more fresh view, do you say what should investors think about State Street for the past decade, given the success of these programs, but then the bottom line not really changing as much, what's your more fresh perspective?
I point to two things. One is that I don't think that anybody at the beginning of the last decade anticipated the significance of regulatory cost increase and just what that would be. Second, we have been slow to achieve scale. We have not achieved as much scale at the pace that we should have and that's where we've got laser focused right now.
The next question comes from the line of Gerard Cassidy with RBC.
Can you share with us, when you look at your fee revenue for this quarter, let's call it 2.3 billion, you gave us some color on the servicing fee sensitivity to the markets, but out of the total 2.3 billion, how much is at equity related. Ron mentioned that you've got a disproportionate amount of equity customers in your client base, so what would be a good estimate of that number being tied to equity type customers?
Gerard, I’m trying to think if we have a quantitative estimate in our disclosure on that. We do disclose the mix of some of the ACAs in our supplement, the mix of equities in for our asset management business and then obviously our sec lending is a heavy equity based underlying business. So I do think that we have higher equity exposure than kind of the servicing industry in aggregate. I don't know that I have an excellent estimate, because remember even when we custody for funds that are multiple asset funds, there is a wide range. If you do turn to page 9 in our financial supplement, you will see that there is one thought of our $31.6 trillion of assets under custody and we described 18 billion of those being equity based.
So I think that's a good indication on the custodial side and then on the asset management side, we also do the equity cut on page 10. So, it's significant, it's in the -- you can see it's in the 55, 60, 60-ish percentage range and so we are somewhat dependent on equity markets. I think that's why, in good times, we need -- we're going to be able to benefit from that, but we also need to make sure that we are heavily – that we are always careful on expenses and create that scalable cost base, so that we don't actually add too many costs in good time, so that we can navigate through. But it is certainly part of our business model.
And then to follow up, I think Ron, you touched on the pricing headwinds historically or maybe Eric you brought it up that 1.5% to 2% was something that was common, but it looked like in 2018, it bumped up to 4%, you're looking for something similar in 2019. What's driving that? Is that competitors are just being much more aggressive and they're willing to price products at maybe, leaving a loss as just the way of getting the business and maybe cross selling other products, but what do you think has driven it up to doubling what it used to be?
Gerard, I think it's what we said earlier, the amount I heard these clients are on is quite high. So typical asset manager, whether you're large, medium or small. So there's just inordinate pressure coming from the client base with the number one. Number two, this assumption, particularly when you're pricing an asset management client, that there'll be both market and fees that will over time actually make what looks like an entry level price, that takes an entry level price and may look like it's too thin, kind of make it fall over time as flows and market help out.
When that assumption goes away, it just lays bare that the price that you had as an initial price on a sustained basis in fact isn't sustainable. So at least for us, can't speak for the obviously rest of the industry, it has caused us to be much more careful about how we think about this. That in addition to getting more term, so that pricing can change overnight, looking at what other products and as Eric talked about earlier, the product stack as you move up from custody becomes -- it tends to be less, it's not price insensitive, but less and less price sensitive or less and less commodity like, if you will. And looking hard at deposits and then as importantly, making sure that we try and get another part of the wallet or some consolidation out of it and in most cases, we're getting some or all of those kinds of things.
The next question comes from the line of Steven Chubak with Wolfe Research.
So I wanted to ask a follow-up question on capital return. Last year, in CCAR, you were about 50 basis points short of that stress tier 1 leverage target. Your capital ratios are flat year on year. Eric, you gave a lot of really helpful color, talking about the actions you've taken to improve your CCAR standing. What I'm wondering is if the Fed stress test assumptions are similar to last year, what gives you that confidence that you can achieve an 80% payout target. Is that – should we view that more as a medium term target or do you think you can get there in the upcoming tests?
It's Eric. We're optimistic about this upcoming task where there's no certainty on it. So, but we're optimistic. I think we're optimistic for two reasons that we have under control and then there's one that we don't, right. The two that we do have are under our control are number one, the shape of the investment portfolio and if you remember, we made adjustments in the first quarter of last year, where we saw the results and how those played through in to CCAR, so we had a good understanding of the kind of the change this and then results in that and then we made some more adjustments to the fourth quarter of this year based on some of those learnings and the other six data points we've had over the last year.
The second one is because of the way we've now better understood the counterparty stress test that the Fed runs, right, we've actively intervened in terms of how we actually structure and limit our counterparty exposures across our businesses, whether that's in FX, whether that’s in securities lending and so we've made very conscious choices, some of which have impacted revenue and you've seen that in particular in sec lending to actually adjust our exposure levels. Now, we're trying to transact with our best clients as much as we used to before, but in some cases, we've had to be more calibrated. So we have literally, if we -- if you go down to the trading floor and the risk management team, they’ve literally had new parameters that they've installed that we've been operating at since late summer and early fall.
So both of those give us some confidence that we can -- that we should be able to do better this year. The obvious unknown is the test itself, right, there's the macroeconomic shock, what's in that. There is global market trading bookshop, which has the counterparty piece to it. And then it's everything else in the test, including assumptions for balance sheet growth and so forth. And on those areas, we don't have any new information obviously won't until we see some of that in late this month or early next month and then we see the test come through in June.
Got it. And just one more follow up for me on capital optimization efforts, you continue to have a significant amount of preferred in your capital stack, certainly well in excess of many of your peers. I was hoping you could speak to your capacity or appetite to maybe redeem some of those preferreds and how we could possibly think about the timing of redemptions and the associated savings?
Yeah. I think the way I would describe the capital stack is the capital stack is proportioned relative to how the current rules are written and implemented through CCAR, where the leverage ratios matter and so there's obviously an importance of having press in the stack. If that were to change, we'd obviously reconsider and so that would give us an opportunity to call or to adjust the alternative tier 1 component, which is the press. I do think though as we go into CCAR, our first priority is to return capital to our common equity holders, right. We're quite conscious of the -- of some of our dealer activity in our issuances this past year and we feel like the first priority is to get capital back to our common equity holders, as we go through the CCAR process this year.
And just one quick follow up relating to that common equity remark, just given the Fed’s willingness to greenlight payouts, north of 100%, the fact that they've clearly indicated that they're to have this binary pass fail outcome, given the context that you're having all the changes that you've made to reposition yourself ahead of CCAR, would you actually look in the near term and maybe exceed that 80% in order to more aggressively mitigate the dilution impact from CRD?
We have said that we'd like to and we're optimistic that we can do better than 80%, so that's exactly the intention and intention and hope that we have and I'll just be clear that there is some of both that's necessary for that, but that is what we'd like to be able to deliver this year and we believe we've made some of the adjustments necessary at our end of the -- that are under our own control to effectuate that. So we're -- we'd like to be able to deliver on that, that would be our intention, given what we've -- how we're proceeding.
Your next question comes from the line of Geoffrey Elliott with Autonomous.
On the fee income guide, just to be clear first of all, the 3% to 4% down points to about 2.2 billion and then annualizing that, we kind of get to an annual run rate of about 8.8, if that was sustained, is that right?
Yes, it's Eric. That's right. I mean, that's where we're trying to start with where we are today and we're trying to adjust for the markets, the flows, the limited amount of client transaction activity and then you have the lumpiness from trading, from 4Q to 1Q, right. So, we always want to be careful and appropriately conservative there. And then there's just the 606 effects of Charles River. So we’ve tried to factor all that in to our estimates.
And then we've said that, that's a good run rate for several quarters, we'd like that to be just a quarter or two, not very long, but we're trying to be careful here and to be honest, we're trying to be careful about revenues, because we think if we're doing that, then we're going to be even more effective and adroit in interventions on expenses and we think that's what we should demand of ourselves and what you would all expect of us.
I think the scenarios on revenue though are very wide to be honest, because there is a range of different market assumptions, flow assumptions and underlying transaction activity. We just have some -- we just have a little more visibility into the first quarter, including the usual adjustments on market flows, macroeconomics and a little bit of pricing, which tends to be a little deeper in the first quarter than the out quarters, just the way the calendar works and so we're just trying to factor that in, but off of that base, I think there's a range of scenarios and we'd obviously like to see more positive ones and if we see those, we've got to set a conference schedule set up in February and March and in May, we'll certainly update for changes.
It sounds like in the sort of market assumptions that you're showing on slide 16, that could be a run rate that sticks around for a couple of quarters. Is that fair? I just want to make sure that we're understanding it right.
Yeah. That could be the case and that's what we're calibrating our expense we’re up to.
Next question comes from the line of [indiscernible] with Morgan Stanley, I’m sorry, JP Morgan.
Hi. This is Vivek. Thanks. A couple of questions for you folks. Firstly, Eric, on CRD, the operating margin obviously in Q4, because of FAS 606 is a little bit inflated, what, on a full year basis, what would you guide us to as a sort of a more normalized operating margin, before you put in any cost savings or anything else?
Vivek, I think we disclosed back in July an operating margin for that business at around 50% on the old ASC basis. I think the way the current year adjusts a bit, you might get for going from 605 to 606, just given the pattern of how -- what they've, how they've done the accounting historically versus now, you get a small uptick in margin from there. I think then the modeling becomes -- has probably two facets going in. One is the investments that we're making in the business and then the revenue ramp up, relative to those investments and that will tend to trend the margin rate down a bit, as we, in the early year, to building the business.
Okay. All right, because while you cautioned us on not annualizing the revenues, I’m presuming the costs we can analyze, if we have modeling out CRD separately, right? Yeah. Okay. Different question. You called out in your NIM, one-time benefits from hedging activities, can you quantify that and is how much of that in the fourth quarter?
Yeah. In the fourth quarter, it was about $6 million roughly and a little bit comes from some of the dislocation being swap markets, we've taken our swap positions down over the year as you know, but there's always some dislocations towards the, obviously over the holiday season in particular towards the end of the quarter. So we saw a little bit of that. And it was a positive dislocation, because of how the currencies between euro and some of the -- and yen actually played through, so that was a positive.
And then on long term debt, you get a little bit of this mark to market adjustment in the underlying accounting as you got rates and credit spreads move a little bit, so about 6 bucks and it will just, which won't reappear in the first quarter.
Can I sneak in another one, which as you combined an accounting with FX and brokerage, I know a lot of -- part of brokerage used to have electronic FX trading, the rest of it, things like transition management, have they just diminished to a smaller base or has something else changed?
No. I think what we're trying to do is literally simplify the disclosure and if we did something that took helpful materials away, we can certainly revisit, but we had a line that was historically called total trading services, which is both our direct foreign exchange trading plus our, what I'll call, electronic foreign exchange venues. Those were in what was called brokerage and then some of the other kind of fun connect, like our money market, electronic venue, a little bit of transition management and a few other smaller items like portfolio solutions. So we've just, I think, relabeled that total FX trading services, just to give it the kind of the description that's appropriate. I think within that, I'm just scanning through, about 80% percent of those revenues are foreign exchange related, the rest tend to be a little bit of the money market or portfolio solutions type activity.
And there are no further questions at this time. This concludes today's call and we thank you for your participation. You may now disconnect.
Thank you.