As valuations have become compelling, is now the time for investors to add bank exposure to portfolios?
July 20, 2023
Managing Director, Head of Investment StrategyRBC Europe Limited
Banks have historically performed well when interest rates rise. When they do rise, banks are quick to pass on interest rate increases to borrowers, but slow to pass them on to depositors. Thus, their net interest margins tend to increase.
In fact, in late June, UK Chancellor of the Exchequer Jeremy Hunt met with bank bosses to discuss how reluctant the banks had been to pass on higher returns to savers. Britain’s four largest banks were then offering rates of less than 1.35 percent on easy access accounts, where close to two-thirds of household deposits are held, at a time the Bank of England (BoE) had raised the bank rate to 4.5 percent, according to the Treasury Select Committee.
With the delay between raising borrowing costs and deposit rates, banks’ profitability can improve, as long as the lending cycle remains benign and loan loss provisions restrained. This can lead to bank stocks outperforming.
However, it has not been the case this year, of course, due to the failure of three U.S. regional banks, and the collapse of Credit Suisse in Europe which all rattled the sector. U.S. bank stocks have underperformed the broader market year to date. European banks have barely outperformed, while UK banks, widely perceived as having avoided these issues, have held up better, largely thanks to international banks performing well as banks catering solely to the domestic market struggled.
The chart shows the performance of four regional Bank indexes relative to their broad domestic market, all rebased to 100 for ease of comparison. They all performed very poorly in March after the U.S. regional banking crisis erupted. U.S. and Canadian banks haven’t clawed back all the lost relative performance, though in the case of the U.S., it is partly because the S&P 500 Tech sector has performed so well, lifting the overall market. European banks sold off due to the Credit Suisse collapse, recovered, and have now performed slightly better than the broad European market. UK banks, seen as isolated from the banking crisis issue, performed better and outperformed the FTSE All-Share Index.
Source – RBC Wealth Management, Bloomberg; data through 7/17/23
The ongoing U.S. earnings season is providing a useful temperature check for the sector. Gerard Cassidy, RBC Capital Markets, LLC’s head of U.S. bank equity strategy, expects a subdued earnings season overall. He cautions that due to the regional bank crisis, the traditional expansion in net interest margin at this point in the cycle may not have materialised as banks had to pass on interest rate increases to depositors more swiftly than usual to avoid deposit flight. While the largest banks have mostly avoided this squeeze, the jury is still out on the smaller and regional competitors.
Cassidy expects credit quality to remain strong for now, with the exception of the commercial real estate sector. But with credit losses still at unsustainably low levels, he anticipates loan loss provisions to start to increase from Q2 2023 compared to prior periods as banks start to build up their loan loss reserves. Most banks still factor in a mild recession in their outlooks.
As for the strength of the banking sector’s capital base, the results of the Dodd-Frank Act Stress Test show that the capital positions of the largest U.S. banks would remain strong even in a severely stressed scenario. This enables most of the large banks to afford compelling dividend payouts.
Lori Calvasina, RBC Capital Markets, LLC’s head of U.S. equity strategy, recently upgraded Financials to Overweight from Market Weight. Valuations are not demanding, in her view, with the top 20 bank stocks trading at 1.0x book value, on average, and 8.2x 2023 estimated EPS. She also thinks the sector can serve a cyclical function in portfolios as it tends to outperform when ISM manufacturing data is rising. If confidence in a 2024 economic recovery gathers steam, she believes that banks could benefit.
The risk of adding banks to portfolios now is that if a recession materialises, as the reliable leading indicators we follow suggest , the sector would struggle to outperform the broader market. The recent pro-cyclical stock market run suggests a benign economic environment is being discounted, leaving banks vulnerable, in our view, if a darker economic scenario prevails.
Canadian banks’ valuations, at 1.3x book value, are nearing the stressed levels reached during the global financial crisis of 2008. This reflects slowing loan growth, higher deposit costs and loan losses, while the regulatory environment is increasingly unfriendly. A potential peak in loan losses, as well as opportunities linked to immigration could unlock the sector’s low valuations, though we think the state of the economy remains the key short-term concern.
In the UK, the BoE also performed a stress test recently to assess the resilience of the sector’s capital position. The results indicated that the major UK banks would be resilient to an economic scenario more severe than the 2007–08 global financial crisis, an outcome substantially worse than that currently expected by the BoE and consensus.
Therefore, we do not foresee changes to forthcoming share buybacks or dividends for the group. UK bank valuations are not demanding with the sector trading at 6x this year’s earnings and 0.7x price to book value. Nevertheless, we believe renewed positive economic momentum is likely needed for UK bank shares to re-rate materially higher.
Unlike their U.S. counterparts, European banks have continued to enjoy earnings upgrades throughout this year, reflecting the benefit of higher interest rates on their net interest margin. European bank valuations are similar to those in the UK, but we would remain selective and focus on banks of the highest quality given the current subdued economic environment.
We expect the ongoing Q2 corporate earnings season to give clues as to how the banking sector is navigating the current tricky economic environment. The sector in the U.S., Canada, UK, and Europe is well capitalised, and valuations are undemanding. In the short term, however, given the recent rally in the sector, which was particularly strong in the U.S. and Europe, we believe bank stocks would be vulnerable should a deep economic slowdown materialise and loan losses increase sharply.
With contributions from Thomas McGarrity, CFA and Sunny Singh, CFA.
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