The recent plunge in interest rates should benefit Corporate America. Most obviously, companies across all sectors should enjoy lower funding costs and, in some cases, better access to credit as rates go down. Lower interest rates should also cause the dollar to fall relative to other currencies, improving US companies’ competitiveness relative to their foreign counterparts. And lower interest rates generally cause stock prices to rise for a couple of reasons. Stocks with high dividend yields garner more attention as investors requiring income flee the bond market in search of better yields. At the same time, falling rates can boost valuations for higher-growth stocks – including the massive tech stocks that have been a critical component to the current bull market – that are not expected to generate meaningful earnings and cash flow until several years out in the future. The logic is that as interest rates drop, investors are forgoing less income in order to invest in higher-growth companies that pay modest or no dividends.
But bank management teams, for the most part, are not celebrating. As interest rates have dropped, so have the yields on many of the loans sitting on bank balance sheets. Banks with a greater focus on business customers are more at risk because many business loans carry variable rates. But certain consumer loans carry variable rates as well. And, needless to say, the rates banks are able to charge on any new loans have also dropped as interest rates have come down. Yes, there is some potential offset in the form of lower rates paid on deposits. However, most banks are “asset sensitive” to varying degrees, which means that the yields on their assets, or loans, adjust more quickly than the rates they need to pay their depositors. The net effect is pressure on Net Interest Margins, or “NIMs”, as interest rates fall. Because net interest income is the bread and butter of any bank’s business model, the rapid drop in interest rates over the past several months is going to sting.
There is a chance that the drop in interest rates, and corresponding drop in bank NIMs, could be happening at a critical time. The amounts that banks have been losing on bad loans, which are called “credit losses” in bank parlance, have been running at very low levels for several years. Given the fact that unemployment is at 3.7% (and therefore has nowhere to go but up) and business debt has risen at a very rapid clip (even in the face of large corporate tax cuts), there is a risk that any further deterioration in the economy could cause bank credit losses to rise meaningfully. And if higher credit losses begin to materialize at the same time that NIMs are contracting, the effect on bank earnings could be quite meaningful. This would be a worst-case scenario of which any bank investor must be aware.
There are some offsets to the NIM compression that the banks are experiencing. First, some banks do hedge against the possibility of falling interest rates by buying derivatives like swaps. Also, the large bond portfolios held on bank balance sheets have appreciated as rates have dropped, creating the opportunity to book some gains through the sale of those assets. (However, the proceeds of those bond sales would have to be reinvested, likely at lower rates.) Some banks are using funds they had on deposit at the Fed to reinvest in higher-yielding loans and securities. And lower interest rates should also boost the number of mortgages that banks originate, creating origination fee income, larger servicing portfolios, and the opportunity for gains on the sale of those new mortgages.
It is also true that falling interest rates are not an unambiguous negative for banks. One of the most common arguments for owning bank stocks right now is that their capital returns (to shareholders) are large and growing. Since the Financial Crisis, banks have built fortress balance sheets, with high levels of capital and liquidity. Now that we are further removed from the crisis, regulators (and investors) have become more comfortable that we are unlikely to experience a replay of that debacle. As a result, bank management teams are now returning a greater percentage of their quarterly earnings to shareholders in the form of share buybacks and dividend increases. In some cases banks are returning 100% or more of their quarterly earnings. Rising capital returns against the backdrop of falling interest rates is a pretty compelling investment case. But to be sure, bank management teams would rather not have to contend with rapidly falling interest rates.
So far, the jury on the banks is still out. Bank stocks have actually done pretty well thus far in the earnings season despite the ongoing NIM compression. My view is that the strength is more reflective of compelling valuations (in comparison to an expensive market) and rapidly rising capital returns rather than any improvement in fundamental earnings outlook. Going forward, bank investors are hopeful that Fed rate cuts will eventually lead to a steepening in the yield curve as investors become more comfortable that the Fed is able to forestall a recession through rate cuts. This would be a best-case scenario: loan demand would improve, NIMs would start to widen out again, and big increases in credit losses would be avoided, at least for the time being. The reality is that we will get something in between the best- and worst-case scenarios, but bank investors should be aware of the gathering risks and stay nimble.
For our client portfolios, we are slightly underweight financials (the weighting in the S&P 500 is currently about 13%) and are concentrated in the highest-quality names. We own JP Morgan for its best-in-class management and its business diversification. We own BB&T for its conservative underwriting profile and the potential for large expense synergies as the SunTrust acquisition is integrated. We own PNC for its outstanding execution, including expansion into new markets; investments in digital initiatives, successful cross-selling of fee-based products, and its presence in niche lending markets and products that are less competitive. And finally, we own Goldman Sachs as the world’s premier investment bank trading at a very undemanding valuation.