As valuations have become compelling, is now the time for investors to add bank exposure to portfolios?
July 20, 2023
Frédérique Carrier 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.
This publication has been issued by Royal Bank of Canada on behalf of certain RBC ® companies that form part of the international network of RBC Wealth Management. You should carefully read any risk warnings or regulatory disclosures in this publication or in any other literature accompanying this publication or transmitted to you by Royal Bank of Canada, its affiliates or subsidiaries.
The information contained in this report has been compiled by Royal Bank of Canada and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgments as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S. and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, any securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice.
This material is prepared for general circulation to clients, including clients who are affiliates of Royal Bank of Canada, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Royal Bank of Canada nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Royal Bank of Canada.
Clients of United Kingdom companies may be entitled to compensation from the UK Financial Services Compensation Scheme if any of these entities cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £85,000. The Channel Island subsidiaries are not covered by the UK Financial Services Compensation Scheme; the offices of Royal Bank of Canada (Channel Islands) Limited in Guernsey and Jersey are covered by the respective compensation schemes in these jurisdictions for deposit taking business only.