It’s been a challenging year for bank stocks, to say the least, as the COVID-19 pandemic began to take hold early on. The chart below shows a recovery from the March lows, but not at the pace of the market’s leading sectors.
However, the prospect of a divided government and multiple positives on the vaccine front has injected a much-needed dose of confidence into the sector. To put this in reference, the day that Pfizer announced better-than-expected vaccine results, the smaller-cap bank index had its best day ever at +13.3%. Larger banks were up 13.5%, though not the largest up day, given the volatility surrounding the index during the Great Financial Crisis (“GFC”).
While the current recession is certainly different from the GFC in many ways, from our perspective, it appears that with the recent improvement in economic data that the current recession will end up being shorter, and less severe, than the GFC. In turn, we see investor interest in the sector accelerating given waning credit concern, the prospect of further yield curve steepening, a resumption of activity in COVID-impacted sectors (hotels/restaurants/leisure, etc.) fueling rising loan demand, increasing capital distribution, and a pickup in M&A into next year.
On top of our Yield + Growth framework, we like to look at M&A deals in certain economic industries, with banks being one of them. Anecdotally, this can be a signal of tops or bottoms of specific sectors or industries, as spectacularly expensive deals can sometimes signal irrational exuberance (given some of our Cincinnati roots, look at Fifth Third Bank acquiring FL-based banks around 5.0x Tangible Book Value) or a potential bottom in an industry. It’s in this spirt that PNC’s purchase of BBVA’s U.S. banking operations last week caught our attention.
To be clear, we don’t think that this deal is signaling irrational exuberance, and it’s not the “bottom” in banks (that was in March and again in late September). But given that we are more constructive on value sectors broadly, the PNC/BBVA deal did catch our attention and we think the outlook for banks is turning more constructive because of the aforementioned reasons.
First, it’s hard to deny the value in the banking space. Valuations will be more closely called into question moving forward given the move off the March lows although we note the P/B multiple for larger banks (even when accounting for the recent rebound) is down ~25% from the beginning of the recession while smaller banks are down ~12% (vs. +9% for the S&P 500) as of 11/10/20.
On a forward P/E basis, regional banks (KRE) are trading around 12.1x 2021 expected EPS, while diversified banks (think larger, money center banks) are trading even cheaper at around 10.9X 2021 EPS. For reference, the S&P 500 is trading around 21x 2021 earnings. If that 9-11x multiple spread between banks and the S&P 500 isn’t a record, we think it has to be close. Banks look even cheaper from a Price : Tangible Book(P/TBV) perspective, as they continue to trade below book value for large, diversified banks and right at book value for regional banks.
But as we have said many times with regards to value sectors, being cheap is not, by itself, a reason to buy (read our value trap piece here). Sometimes sectors are cheap for a reason, and that was the case with banks earlier this summer. But there has now been a positive catalyst that improves the outlook for banks: The yield curve.
Specifically, the 10s-2s spread has recently rallied to multi-month highs at 0.78%, well above the 0.30% level we started 2020, and the 0.11% panic low in March. And the trend is currently decidedly higher, with a clear yet gradual (and hopefully sustainable) uptrend in place.
Source: Bloomberg, 10-2 Spread
This matters to banks because the 10s-2s spread is a loose proxy for banks’ net interest margins (“NIM”) which is essentially their profit on loans they make. A declining 10s-2s spread is a headwind on banks’ profitability, and that’s been the case for awhile now. But in part due to slowly rising inflation expectations and thanks to the Fed’s promise to keep rates at 0% for years to come, we believe the yield curve is steepening, which means better margins for banks going forward.
But in order to boost earnings, banks need more than just improved margins on loans—they need to make more loans, and that’s why loan demand is an important metric to watch going forward. Recent earnings commentary revealed bank loan growth has been mediocre, but that came amidst still negative macroeconomic measures of loan growth.
Specifically, Commercial and Industrial (C&I) loans measured by the Fed are still down sharply from pre-COVID levels and haven’t really rebounded much. C&I loans are still about $300 billion below the pre-COVID peak. Additionally, Consumer Credit (which includes auto loans, credit card balances, etc.) is still down materially on a YTD basis.
Clearly, banks aren’t without risks. If stimulus doesn’t materialize, that will be a headwind on Treasury yields and the yield curve, not to mention loan growth. Additionally, the Fed could alter QE to focus on buying longer-dated Treasuries, effectively putting a headwind on the rise in the 10-year yield and bank net interest margins (there’s been rumblings about this for a few weeks and we believe it could happen at the December meeting).
So, the outlook on banks has improved, but is still mixed. Ideally, we’d want to see not only the yield curve steepening (NIM rising for banks) but also a rebound in loan growth (better margins on more revenue). We’re firm believers that growth is part of value, and study from both angles to find opportunity.
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