Financial stocks have performed extremely well over the past year. The entire index is up roughly 70% in the past 12 months as COVID related fears have subsided. However, the financials have been giving back some of these huge gains in the past month or so. So what’s going on? The answer, in our view, is the recent pull-back in long-term interest rates and the flattening of the yield curve.
Banks generally make a large chunk of their money by taking deposits, paying low variable rates on those deposits, and investing the proceeds in loans that are more closely tied to longer-term interest rates. As longer-term interest rates have dropped in recent months, the outlook for interest income has deteriorated.
Is this short term move in long-term rates a sign that the global economy is set to slow due to concerns about the new delta variant? Is it a sign that inflation concerns were overblown? Unfortunately, no one knows.
To better understand bank stocks today, let’s revisit the Great Financial Crisis (GFC) for a moment. Though the banks benefited from fiscal and monetary support during the COVID crisis, this crisis was quite different from the GFC.
In response to the GFC, the federal government decided to lend its full support to banks and other financial companies. The government’s initiatives were designed to protect US consumers and businesses from the effects of the housing bust and associated collapse seem in the financial system. But in doing so, they also extended a lifeline to financial companies (and others sectors hit hard by the crisis, like the auto manufacturers). The government dramatically increased spending, reduced taxes, and stepped in to buy (or guarantee) massive amounts of bad debt from banks and other investors. The government’s actions prevented big investment losses on unsecured bank bonds, mortgage-backed securities, commercial paper, and other debt instruments, as well as a tangled web of derivatives that multiplied total exposures many times over. And, of course, the government’s action also reduced the losses sustained by investors in bank stocks.
The government’s assistance during the GFC did not come for free. Banks were forced to recapitalize (issue more stock, diluting existing shareholders) and agree to some onerous terms in exchange for the government’s support. The higher capital requirements imposed in the wake of the GFC continue to affect bank returns on equity (ROEs), which drive valuations for bank stocks. These actions were painful but did set the stage for recovery, leaving the U.S. banks in significantly better shape than their European counterparts.
While there may be some similarities between the government’s support for banking sector after the GFC and its response to the pandemic, there are critical differences. First, bank balance sheets were in excellent shape going into the COVID crisis. Second, the COVID crisis was in no way caused by reckless behavior on the part of banks. The appropriateness of the most recent bailout, compared to the GFC bailout, is far easier to defend. In fact, it could be argued that banks had been too cautious in underwriting new loans after the GFC, thereby inhibiting better rates of economic growth in the years leading up to COVID’s arrival. I would argue that this time the government and its agencies have acted well within their mandates to protect U.S. citizens and the U.S. financial system.
The following chart shows the delivery mechanisms through which the federal government has assisted the banking sector over the past 15 months or so. At the cost of a temporary restriction on stock buybacks and dividend increases, the government protected banks from incurring a wave of consumer and business loan defaults which otherwise may have eaten through earnings and loan loss reserves and into capital. True, the banks were forced to make huge additions to their loan loss reserves, which heavily affected earnings for a couple of quarters. But those reserves are now being dropped to the bottom line as unemployment recedes and the economy is opening up. As a result, bank profitability has been restored, capital returns are increasing, and the stocks have soared. The KBW Bank Index is 5% higher than it was at the end of 2019, prior to the arrival of COVID. Bank bonds are also materially higher, driven by the Fed’s initiatives to suppress interest rates and promote tight credit spreads.
Though banks have been beneficiaries of COVID-related government support initiatives, other sectors have clearly benefitted as well. In fact, the U.S. corporations in the S&P 500 are expected to post $189.59 in EPS in 2021, which would be a record high and some 18% above the prior record in 2019. Large U.S. companies are benefitting not only from the economic rebound and COVID-related stimulus, but also from market share gains taken from foreign competitors and, in many cases, smaller U.S. competitors.
So what do we think about the banks today? The economic outlook is always uncertain. However, we do know that the high quality financials that we own for clients are a bit cheaper than they were a month ago. We continue to believe that the risk/reward in these stocks remains attractive for long-term investors. The balance sheets are excellent, dividend yields are well-above average, ROEs are low- to mid-teens, and valuations are undemanding vs. the overall market. Bank stocks typically benefit from a recovering economy and a steeper yield curve. Despite the market action in rates over the past few months, this positive scenario could still play out over the next few years. If the economic recovery stumbles, we want to own banks with rock solid balance sheets that can endure another tough period and come out stronger on the other side.