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Good morning. Walmart reports earnings this morning, and Wall Street (and Unhedged) will be keen to hear what the biggest big-box US retailer has to say about consumer demand, especially after somewhat equivocal comments from Target and Home Depot earlier this week. The company has little room for error, as the stock has been on a tear recently. Send us your thoughts on the retail sector: email@example.com and firstname.lastname@example.org.
Banks and the soft landing
Is it finally safe to buy bank stocks? Many pundits, Unhedged included, took yesterday’s inflation report as a strong signal that the interest rate cycle has peaked, and both long and short-term rates could well head down from here. And there is still no recession in sight; a soft landing feels close.
The market concluded that all this was very, very good for banks: the 30 largest US banks by market cap rose by an average of 6 per cent on the news. The riskiest, most beat-up members of the group (KeyCorp, Comerica, Zions, Western Alliance et al) rose the most.
Bank stocks have been under pressure and look cheap, so it makes sense that investors would be looking for an excuse to buy them. The relationship between rates and the profitability and stability of banks is not simple, however. Neither are the reasons for bank stocks’ poor performance. We need to think a bit before diving in.
Start with bank valuations. The banks began to underperform long before rates started to rise sharply last year. Three shocks have hit the sector’s stocks over the past five years, and they have not fully recovered from any of them. When the market dropped sharply at the end of 2018, partly because of concerns about Federal Reserve policy and a slowing economy, banks fell harder than the rest of the market, and did not make up the difference in the years that followed. The gap grew wider in the early-pandemic rout of 2020. Again, as the market recovered, banks didn’t make up the difference. Finally, in March of this year, a few banks that had badly mismanaged their interest rate exposure failed, giving the sector a fright from which it has not rebounded. The sum effect of all this is that bank indices have underperformed the wider market by an epic margin over the past five years:
The result is that the stocks are now historically cheap. The price-to-tangible book ratio of the 30 largest banks has fallen 24 per cent over five years, on a capitalisation-weighted basis; the price/earnings ratio has fallen 35 per cent.
There are three reasons a lower-rate environment might help banks; they are not equally important. Many banks loaded up on long-duration securities when rates were low in order to capture a bit of yield. The jump in long-term interest rates crushed the value of these holdings. Even though these losses mostly do not flow through the income statement, the resulting pressure on balance sheets helped take down a handful of banks in March.
For the banks holding a lot of long-term assets, a fall in rates would surely be a relief. Their asset yields would no longer glaringly trail market rates, and they would have the option of selling their duration exposure without crystallising large losses. But absent a solvency crisis in which a bank is forced to sell bonds from its portfolio, securities losses driven by rising rates are not that big a problem, and lower rates curing those losses is not that big a benefit.
Next comes margins. Lately, rising short-term rates had been passing through to deposit costs, eating into some banks’ profit margins. Higher rates increase asset yields, too, however; assets tend to respond first, and deposits later. Through a cycle what matters is the net effect on the two, and that varies by bank. Here for example is interest income and interest expense, and the sum of the two, net interest income, at Comerica:
Net interest income at Comerica has fallen in recent quarters as deposit costs have caught up with asset yields, but it is still as high as it was pre-pandemic. At other banks the picture looks even better. Here is Bank of America, which has a very low-cost deposit base, allowing it to achieve higher net interest income in the higher-rates world:
The punchline here is that, while for some banks higher interest rates are a threat to margins, this is not true in all banks, or in all parts of the rates cycle.
Now we come to the bit that really matters: credit quality. Higher rates put pressure on the people and businesses banks lend to, both by slowing the economy and by driving up the cost of debt. Some borrowers will default; in a proper recession, a lot of them will. And it is defaults, not balance sheet marks or margins, that gets the banking industry into real trouble.
“For banks, the number one story in a soft landing is credit,” says Gerard Cassidy of RBC Capital Markets. “Credit quality trumps margins and AOCI [securities losses]. If a soft landing happens, all the analysts’ earnings estimates, mine included, are way too low, because we have provisions for loan losses going up meaningfully next year.”
Ebrahim Poonawala of Bank of America makes the comparison to early 1995, when bank stocks were similarly beat up. As the fed funds rate peaked and began to fall, the sector went on to outperform the S&P 500 by 20 percentage points:
The crucial thing for banks, then, is not rates peaking; it is rates stabilising without a recession and a violent end to the credit cycle. “If the job market holds up, the credit cycle will be OK,” Poonawala summarises. If there is not a recession next year, bank stocks are too cheap.
One good read
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