Bank stocks are extending a significant rally as quarterly earnings reports continue to come across the tape. This is welcome news for investors who saw bank stocks endure a correction from early March to late June – a period during which the KBW Bank Index dropped about 11%. The index, which contains 24 of the largest US banks, has now rallied about 4.5% from its low on June 27th. Will the bounce continue? What interpretations, if any, came be made from the trading action in this highly influential sector, which is tied with Health Care for the second-largest sector in the S&P 500?
The correction in bank stocks earlier this year has been widely attributed to a flattening in the yield curve, which we discussed in last week’s Market Commentary. We said that a convergence between short- and long-term interest rates could signal that economic growth is slowing. And situations in which the yield curve becomes inverted (short-term rates are higher than long-term rates) have historically been very good predictors of recessions. While we are not there yet, the difference between the yield on the 2-year Treasury and the 10-year Treasury has shrunk to just 0.25%. Naturally, investors are wondering whether the curve will invert, ushering in the next recession.
As a highly cyclical industry, banks are particularly susceptible to a deceleration in economic growth or a recession. During these periods, loan losses rise, demand for loans begins to dry up, and client activity slows. And because banks are inherently highly leveraged, their earnings tend to go down a lot more than some of the less cyclical industry sectors. So when traders see the bank stocks enter correction territory, it is quite justified to be worried about the economy. Fortunately, we think some of the fears of an imminent economic contraction have been alleviated by bank management commentary. Consider this excerpt from Jamie Dimon:
“Yeah. So just real quickly, I mean Marianne said it, we’ve had almost 9 to 10 years of growth at 2%. Averaging 20% over the 10 years, it really should have been closer to 40%. There’s a lot of evidence that there’s slack in the system and it’s been finally people going back to workforce. The consumer balance sheet is in good shape. Capital expenditures are going up. Household formation is going up. Homebuilding is in short supply. The banking system is very, very healthy compared to the past. Consumer confidence and business confidence are very high, albeit off their highs, probably because of some of the noise in trade. So if you’re looking for potholes out there, there are not a lot of things out there. And growth is accelerating.” – Jamie Dimon, CEO of JP Morgan
There is also a widely held perception that a flatter yield curve is bad for banks because most banks tend to pay interest on deposits based on short-term interest rates while earning interest on the loans they make based on fixed, longer-term interest rates. While there is some validity to this notion (particularly for smaller community banks), it doesn’t capture the nuances of the current market environment. The first point would be that many banks are heavily weighted toward loans that earn variable rates of interest. The interest rates on many commercial loans, for instance, are tied to LIBOR or the prime rate – both of which fluctuate based on short-term rates. Of course, we also need to consider the other side of the balance sheet – interest paid on deposits. Fortunately, the news is good here as well. In general, banks are not having to increase the rates they pay on deposits in lockstep with Fed interest rate increases. Banks track a metric called a “deposit beta”, which measures how much their deposit rates go up relative to increases in short-term interest rates. And while most banks are having to increase rates on commercial deposits much more than consumer deposits, overall cumulative deposit betas are still pretty low (well below 50%) at most banks. This means that deposit costs are not going up nearly as fast as Fed interest-rate hikes.
The notion that banks are going to suddenly get blindsided by rising interest rates after having many years to prepare for this moment is a bit misguided. Most banks are firmly “asset-sensitive” at this point, which means they will benefit as the Fed continues to increase rates. Obviously, conditions will get more difficult for banks if the yield curve inverts for a significant period of time. But for now, it appears banks are managing just fine.
“…fundamentally what you’re seeing in terms of the flattening is pretty typical of a tightening cycle. And as long as it’s accompanied with solid to strong economic growth, it doesn’t concern us at this point. And in fact, as we’ve been pointing out, we are still levered towards front-end rates from a profitability perspective and we do expect the curve to steepen over time.” -Marianne Lake, CFO of JP Morgan
On balance, we do attribute some of the rebound in bank stocks to solid 2Q results. However, the bigger driver, in my opinion, is the management commentary concerning both the economic backdrop and interest rates. Specifically, we are hearing bullish commentary about economic growth (at least in the short term), which portends better loan growth, rising interest rates, continued low credit costs and increasing business activity. Obviously, a lot of this optimism is based on the tax-cut legislation and spending bill, each of which act as stimulus on growth over the short term. (For our part, we think the economic acceleration we are seeing this year may be fleeting). And as for the flattening yield curve, management teams are not, at this point, flagging it as a serious risk. Could any this change? Of course, and possibly very quickly. But over the short-term, investors have gained some confidence.
So what are bank management teams worried about if not a recession or the yield curve? So far the two biggest concerns we have heard are increased competition and trade. We are hearing that there are pockets of irrational pricing in areas like commercial real estate (CRE), residential mortgage and auto loans. The competition is causing some banks to pull back from these areas rather than loosen underwriting standards. With regard to trade, it seems like it’s more of a threat at this point.
“So, we’re not necessarily tightening credit; we’re just not loosening credit to chase, and that means that all else equal, we win less deals in competition which is why total growth fell down. But that’s most apparent in CRE where we – coming out of the crisis, we had quite strong growth and it’s tapered off over time as that market, in our view, has gotten overheated.” – Bill Demchak, CEO of PNC Financial
“So I would say so far where we are is that trade is firmly part of the risk narrative. So it’s definitely as Jamie has said on the psyche of people, but it is not at this point causing them to change the strategic actions and decisions that they’re making, but clearly part of the conversation. And as currently outlined, it’s more of that than it is a real impact to sort of the global macroeconomic outlook. But that isn’t to say that uncertainty can’t ultimately lead to more challenges or slower growth but because confidence is a really important part of not just the business investment cycle, but also the financial market stability. So, at this point, it’s more of a risk narrative than it is an actual driver, but it is important that that uncertainty is taken off the table.” – Marianne Lake, CFO of JP Morgan
“And notwithstanding all of the daily news trade, it doesn’t seem to be showing up in the sales pipeline or loan demand, or even in dialogue with clients. There’s obviously a handful who are impacted maybe more than that, but as a practical matter when we look at our pipeline it doesn’t seem to be playing into it at this point.” – Bill Demchak, CEO of PNC Financial
I would be remiss not to mention the importance of “capital returns” to the recent rally in bank stocks. In general, banks passed more stringent annual stress tests and were allowed by the Fed to meaningfully increase their dividends and share buybacks (in some cases to over 100% of earnings). Many bank stocks are now yielding in excess of the 10-year Treasury bond. Together with hefty buyback authorizations, we think the capital returns act as solid support for bank stocks over the near term. Perhaps more importantly, though, the increased capital returns signal a new era of less stringent regulatory oversight.
With 3%-4% GDP growth expected for the second quarter, it seems like the near-term path of least resistance for bank stocks is a continued recovery from the early year correction.