After outperforming the S&P 500 by as much as 6% earlier in the year, bank stocks are now underperforming the market for the year. The KBW Bank Index, which consists of 24 money-center and large regional banks, was down more than 5% for the year as of Tuesday’s close compared to a decrease of 2.7% for the S&P 500. A negative reception to earnings reports last night and this morning from the likes of JP Morgan, Wells Fargo, and PNC Financial suggests that the selling could continue. What’s going on? What has changed since July that has caused nearly 10 percentage points of underperformance for the bank stocks relative to the market, and what will lift them out of the doldrums?
The problem is that the banks are currently in a race against the clock. For years, bank earnings have benefited from the release of reserves that had been previously set aside for loan losses. This was possible because banks had been far too pessimistic in forecasting loan losses during the financial crisis. The dire loan-loss predictions never materialized, and so banks were permitted to reduce their loss reserves to reflect the improved environment. This juiced earnings for several years. However, following several years of taking such action, reserves for credit losses have now been reduced to unsustainably low levels to reflect the continuation of an unsustainably benign credit environment. In other words, credit costs are now troughing and will likely head higher in the coming quarters and years as the credit cycle turns. Guess what? This means no more earnings from the reduction of loan loss reserves. In fact, some banks have already started to bolster reserve levels due, in part, to credit issues that have already started to develop in the energy sector. So, although we don’t expect a huge spike in non-performing loans (notwithstanding the problems in the energy sector) anytime soon, the inability of the banks to continue dropping reserves to the bottom line will be a meaningful drag on earnings growth in the quarters to come.
Now, it shouldn’t come as a surprise that credit costs are currently unsustainably low and will head higher. The real surprise (to some, but not us!) is that the expected offset to higher credit costs, higher interest rates, has effectively been pushed further out into the future. The Federal Reserve had been expected to raise rates by now. However, the process of normalizing monetary policy has been delayed due to: 1) inflation rates that remain too low; 2) weak economic growth outside the US; 3) a strong dollar and its effect on exports and inflation; and 4) fears about financial turmoil that could result from the Fed moving too quickly. The result of the Fed’s decision to punt is that longer-term interest rates have come down and the yield curve has flattened. This is bad news for banks because they generate a large portion of their revenue from net interest income. It is true that better loan growth in recent quarters has been offsetting some of the effects of continued lower interest rates. However, some are starting to fear that a softening in recent economic data could be the prelude to a deceleration in loan growth in the quarters to come. The jury is still out on that.
So, in the race against the clock, the clock appears to be winning right now. Credit costs will likely rise before they can be offset by higher spread income. This results in a poor earnings outlook for banks that engage in spread lending activity. To be sure, banks are doing what they can to offset the pressures on earnings. Many have cut operating expenses, to include payrolls, to better match the revenue outlook. Many are seeing lower litigation/regulatory costs as well as lower costs to service mortgages. Others are buying back stock to the extent that the regulators will allow. However, just like reserve releases, these are not sustainable sources of income growth for the banks. The only thing that will get the growth outlook back on track (and stock prices up) are the following:
- The most obvious development would be better economic growth. Faster growth would lead to better loan origination volumes, higher home prices, improved housing turnover (mortgage origination fees), continued low credit losses, improved consumer spending (credit card interchange fees), more investment banking (underwriting, M&A) and asset management fees, improved trading activity, higher interest rates and a steeper yield curve.
- Banks would also benefit tremendously from higher interest rates and a steeper yield curve, both of which would coincide with better economic growth. Under this scenario, banks would finally be able to earn higher margins for the loans they originate and hold on balance sheet. Moreover, if rates were to rise materially, banks would be more inclined to increase the supply of credit rather than parking huge amounts of money at the Fed. An improved supply of credit would increase the pace of economic growth. Can you see the virtuous cycle developing?
- More regulatory clarity would also serve to improve the supply of credit and increase liquidity and confidence in the capital markets.
A final note on bank regulation. We have argued that by raising capital and liquidity requirements and further restricting bank activities, the Fed has effectively provided an (albeit arbitrary) optimal size for banks to target. Too small and banks don’t gain the efficiencies associated with scale. Too big and the Fed imposes onerous capital surcharges and additional oversight on enterprises it deems “Systemically Important Financial Institutions” or SIFI’s. We think it is a good thing that banks have been “de-risked”. From an investor’s perspective, we think that lower prospective bank returns (ROE’s) could be offset by higher stock valuations (price-to-earnings multiples) that reflect a lower risk of financial distress. However, we remain troubled by the arbitrary nature of the Fed’s guidance. Are there unforeseen consequences to the Fed’s actions? Has the Fed overreached in favor of safety to the detriment of credit availability and capital markets liquidity? We don’t have the answer to these questions but we think they are issues the Fed should address. I think the Fed has repeatedly proven that it makes no sense to have blind faith in their policies.
We should note that low bank valuations (relative to both historical levels and future earnings growth potential) should limit the downside in bank stocks from today’s levels. In addition, there is no way to effectively predict where interest rates will go over the next few years (although many have tried). For this reason, it may make sense to maintain some exposure to the highest-quality bank stocks and earn the dividend while we await a better operating backdrop.