US economy

Can things get worse for banks?

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Are the bad times almost over for US banks?

Ha ha just kidding, they are definitely not over. But one related question is a bit more plausible: Are the worst times over for bank stocks, strictly compared to the rest of the US stock market?

Analysts at Bank of America say that could be true, at least for the short term. Peaking interest rates could be a “clearing event” for the financial sector, they write in a note this week.

Whoops, make that a “mini clearing event”. Can’t get too confident or spicy with the takes. From BofA, with our emphasis:

Peak rates could serve as mini clearing event

While we are careful to not get carried away, peak interest rates do have potential to serve as a mini clearing event for bank stocks. Most pressure points this cycle — margin squeeze due to rising deposit costs, TBV hit due to MTM losses on bonds, CRE repricing, credit losses due to hard landing — stem from risks due to higher for longer interest rates. Lower rates = reduced likelihood of tail risk events = higher valuation multiples for bank stocks that are trading near 80yr lows vs. S&P.

We wouldn’t call ourselves bulls, but at first glance 80-year lows versus the S&P 500 seems big.

Or it would be, if the analysts were talking about valuations. They aren’t. Instead they choose to compare absolute prices, which don’t really tell us much. The banking sector’s market capitalisation is a smaller proportion of the S&P 500 than it was 80 years ago, but that’s because they went through 1) a sharp deleveraging in 2008-09, following 2) a wave of mergers in the 80s-90s when regulators relaxed rules about banking across state lines. And the Savings & Loan crisis.

Here’s that chart, if you find absolute price comparisons compelling:

But even if you don’t, it’s still pretty easy to see that banks are trading cheap relative to recent history.

The SPDR Banks Select Industry ETF is trading around 8 times next year’s earnings forecasts, while the S&P 500 is trading at 18 times. That’s a much wider difference in multiple (10) than the long-term average of 5.7.

Messy? Sure. But a little more valuation-focused, we’d hope.

Anyway! Now that we’ve established some cheapness, we can dig more into the meat of BofA’s argument.

As we’ve covered, banks been paying higher funding costs and seeing losses on their bond portfolios as interest rates rise across the US yield curve. (On the funding side, banks have had to pay up to hang on to customers’ deposits as people shift cash into money-market funds for the higher yields.)

So if rates were to stop rising — both short-term Fed policy rates and long-term bond yields — funding will still be relatively pricey compared to history, but it won’t be getting worse. And their bond-portfolio losses won’t get any worse either.

If rates fall (both short and long) their bond marks will improve and they’ll see marginally less pressure on funding costs:

NII pressures easing, but QT could play spoilsport

2022 the year of asset repricing (positive for margins), 2023 the year of deposits repricing (negative for margins), 2024 could be a grind given the potential for asset yields to mitigate deposit repricing risk. Messaging from bank mgmt teams suggests moderating margin pressures, but $100bn/month in QT could play spoilsport. Not unrealistic that certain banks could see QoQ NII growth next year, especially if loan demand re-emerges.

Remember when folks were sceptical of the idea that QT increases banks’ costs for holding onto liquidity/deposits? Not your friendly neighbourhood bloggers at Alphaville.

Anyway, there are plenty of caveats here, as the analysts highlight:

Things could always go south

A resurgence in inflation (= significantly higher interest rates) has the potential to more than reverse any stock bounce. Plus, credit cycle on the come (only the severity is up for debate) as the lagged effects of higher rates catch-up with businesses/consumers. Our base case view remains that a credit cycle is likely to be closer to the early 2000s (earnings event) vs 2008/09 (capital event). Our forecast assumes net charge offs nearly doubling to 40bp in 2024 vs 23bp in 2023 on avg.; credit provisioning costs +20% YoY.

So . . . more inflation could bring more Fed rate increases and kill the whole idea. Losses from loans and credit extended to businesses and consumers could also make it a tough road for banks, given rising corporate defaults and delinquencies on credit cards.

But if you want to give it a try anyway, the team some ideas:

Pick your spots and add exposure

We believe investors should selectively add exposure, especially if two conditions hold, peak interest rates behind and no 2024 US recession (= BofA Global Research macro view). Stocks we highlight: Wells Fargo, US Bancorp, Goldman Sachs, Morgan Stanley, Fifth Third, Keycorp, BNY Mellon, Northern Trust, Western Alliance, East West.

Also, the two conditions needed for this upbeat outlook are iffy: the US needs to dodge a 2024 recession and the Fed to stop raising rates despite the continued growth.

That scenario seems rather . . . optimistic, at best. While it’s possible for the US economy to keep growing without excess inflation, Fed officials now seem thoroughly spooked about price stability. So continued growth might itself become a reason for higher rates, in the Fed’s view.

And what if there is a recession? It’s true that banks won’t look great, given their role as middlemen for the whole dang economy.

But because they’re the middlemen for the whole dang economy, the biggest global banks will surely look a bit better than companies that aren’t Too Big To Fail. Like maybe — just a guess — small-to-mid-sized banks with outsized exposure to commercial real estate?


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