Banks
Deutsche Bank's woes highlight a much wider malaise within European banks: under-capitalisation and under-profitability. We explain why getting the banks right is crucial to a successful investment strategy in equity, bond and currency markets.
U.S. bank stocks have been joined at the hip with the expected 12-month change in the Fed funds rate since 2014, based on the notion that a rate hike will boost net interest margins. However, even if the Fed hikes rates, that may do little to help bank profits. The lesson from the dismal performance of Japanese bank stocks in their era of extraordinarily low interest rates is that outperformance has only occurred within the context of a steepening yield curve. We place low odds on a steepening in the U.S. yield curve if the Fed raises interest rates, given the softening in leading economic and employment indicators, not to mention the anchoring of U.S. long-term Treasurys by the shortage of global government bonds. Instead, an end to the long-term U.S. bank share underperformance phase requires broad-based economic reacceleration that drives an upturn in credit growth, stabilization in deteriorating credit quality and steeper yield curve. Until then, stay underweight and please see yesterday's Special Report on bank stocks for more details.
Since 2014, market expectations of the Fed funds rate has been the primary driver of banks stock performance. Investors' heightened focus about the positive role of interest rate hikes on bank profitability has some merit because when interest rates are near the zero lower bound, net interest margins are unduly suppressed. However, a breakout in bank stocks requires much more than a hawkish Fed outlook: without a significant pick-up in top-line growth, there is no impetus for bank stocks to sustain rallies.
This week's <i>Special Report</i> looks at the three controversial predictions that I made at this year's <i>BCA New York Investment Conference</i>.
Following a temporary reprieve, banks are about to run into a brick wall. The latest Bank For International Settlements (BIS) Quarterly Review[1] made for grim reading on the global loan growth front: the global credit impulse continues to nosedive reflecting capital constraints and deleveraging. Weak demand for and limited availability of credit is a serious constraint to banking sector profitability. The bottom panel of the chart shows that the BIS global credit impulse indicator has been an excellent leading indicator of relative bank profitability, and the current message is bearish. Higher interest rates are unlikely to solve this problem, as appears to be the hope based on the short-term positive correlation between interest rates and bank stock relative performance. Bottom Line: Every bank rally has proved self-limiting year-to-date and at least a retest of the July relative performance lows is looming. Stay underweight the S&P banks index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX-JPM, WFC, BAC, C, USB, PNC, BBT, STI, MTB, FITB, KEY, CFG, CMA, HBAN, ZION, RF, PBCT. [1] http://www.bis.org/publ/qtrpdf/r_qt1609.htm
The latest FDIC Quarterly Banking Profile showed that bank earnings' improvement remains lackluster. What caught our attention from the release was the persistent widening in the C&I non-current loan rate, coupled with rising C&I charge-offs. C&I loans now comprise the largest category of bank credit and the recent credit quality deterioration is unnerving, despite the low starting point (C&I non-current rate shown inverted, top panel). There are high odds that the credit cycle has turned for the worse given deteriorating corporate balance sheets. Moreover, the latest reading from the labor market conditions index - the Fed's preferred labor market indicator - is signaling that total non-performing loans will soon hook back up (middle panel). This message is also corroborated by the quickly flattening yield curve, which has historically been an excellent leading indicator of the credit cycle (yield curve shown inverted, third panel). Bottom line: Shy away from the banking sector. The ticker symbols for the stocks in this index are: BLBG: S5BANKX-JPM, WFC, BAC, C, USB, PNC, BBT, STI, MTB, FITB, KEY, CFG, CMA, HBAN, ZION, RF, PBCT.
Shift to a small vs. large cap bias as a stealth way to play the overall equity market overshoot. The oversold bounce in banks is not worth chasing, and buy dips in medical equipment stocks.
The euro area's NPL problem is unlikely to be solved quickly, constraining bank profitability and the capacity to lend. There are three important repercussions for investors.
The strong July employment report may tempt investors to lean into bank stock relative performance weakness, under the assumption that signs of solid domestic growth will finally alter the interest rate structure in a positive fashion. However, before acting too quickly, it is important to keep in mind that the bulk of the deflation impacting the U.S. is being transmitted through a strong U.S. dollar, which acts as an overall corporate profit drag. Thus, to the extent that the currency continues to appreciate (shown inverted and advanced, top panel), it will be difficult for inflation expectations to recover from depressed levels and/or the long end of the yield curve to rise. Bank stocks and inflation expectations have been tightly linked since the financial crisis. In addition, the employment report revealed that banks are slowly adding headcount, even though overall financial hours worked are plunging. The implication is dwindling productivity gains, which will ensure that the group remains a value trap. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5BANKX-JPM, WFC, BAC, C, USB, PNC, BBT, STI, MTB, FITB, KEY, CMA, HBAN, ZION, RF, PBCT.
Typically when the Fed has begun to lift interest rates, overall credit growth is expanding at a rapid clip because banks have been increasingly lax in doling out credit. Consequently, any deterioration in credit quality can be offset by an expansion in assets. This cycle, according to the latest Fed Senior Loan Officer Survey, banks are tightening lending standards even before the Fed has raised interest rates by much, because there has already been an upturn in non-performing loans. While a more discerning banking sector is a plus for bank balance sheet health over a full cycle, the downside is that overall credit growth is likely to cool. The implication of slower loan growth is that the profit drag from increased reserving may be more pronounced than in past cycles, particularly given razor thin net interest margins and an historically low loan loss coverage ratio. Despite the perception of good value, banks are likely to continue underperforming the broad market. The ticker symbols for the stocks in this index are: BLBG: S5BANKX-JPM, WFC, BAC, C, USB, PNC, BBT, STI, MTB, FITB, KEY, CFG, RF, CMA, HBAN, ZION, PBCT.