Conviction In The US Banking Sector Remains High

Market Views And Insights | September 25, 2017

Investors had high hopes for the US banking sector when they started 2017. Nine months into the year, while the fundamentals have been strong and are improving, the stocks have underwhelmed. The portfolio management team responsible for our Bank Opportunities and Financial Industries strategies believes that the underlying fundamentals of the sector are being overlooked by short-term factors, and the investment case for the sector is compelling – especially for regional banks.

Backdrop

After initially rallying post the US Presidential Election last Fall, the US Banking sector, specifically US regional banks, has significantly lagged the overall market in 2017. Year-to-date through August, the S&P 500 Index has returned +11.9% versus -3.9% for the S&P Composite 1500 Regional Banks Index.1 While their stock performance has disappointed collectively, we believe the fundamentals continue to strengthen and strongly support the sector overall. We have been discussing four themes for several years that have led to our positive long-term outlook:

 

  • Potential for improving earnings, as a result of continued loan growth and higher short-term rates,
  • Benign credit environment resulting in low credit-related costs,
  • Continued M&A driven by a focus on improving efficiencies, and
  • Valuations that remain attractive compared to historical levels.

 

Additionally, after the US election, we pointed to a number of potential catalysts that independently could benefit the US banking sector, including higher interest rates/steeper yield curve, improved economic growth, lower corporate tax rates, and less regulation. Although we cautioned there was a low probability every catalyst would take place, the potential created a very positive backdrop for US banks.

While the four long-term themes highlighted above remain intact, uncertainty in Washington has caused investors to worry that some of these post-election potential benefits may not materialize. As a result, the sector’s stock prices have stalled, with banks’ performance well behind that of the overall market. Notwithstanding the daily headlines that have created angst among investors, underlying fundamentals have improved this year – we have seen solid earnings and tangible book value growth, as well as higher returns on assets and equity. We believe the dislocation between company fundamentals and stock performance has created a very attractive opportunity for investors today.

Interest Rates

Although the Federal Reserve has raised interest rates three time since December 2016, the US Treasury 10-Year yield has declined over 30 basis points (bps) from 2.45% at the end of 2016 to 2.12% at the end of August.1 In our view, the backup in long rates is certainly disappointing and has also factored into the weak sentiment of bank stocks; however, bank earnings are much more dependent on the short end of the interest rate curve versus the long end.

Due to the composition of bank balance sheets today, less than 15% of bank assets are priced off the 10-year portion of the curve.2 Moreover, despite the decline in the 10-year rate, bank earnings in the first half of 2017 benefited from the December and March rate hikes with the sector’s net interest margin increasing by 6 bps over the first two quarters.3 Furthermore, we expect net interest margins to trend higher as the effect of the June interest rate hike is captured in second half earnings.

The improvement in net interest margins, coupled with continued loan growth and tight expense controls has led to strong EPS (earnings per share) growth for the sector. In fact, 2Q17 operating EPS for the median bank grew 12.5% from the prior year quarter.4 We believe we will see similar year-over-year EPS growth in the second half of 2017 as the sector continues to benefit from the Fed’s more recent rate hikes.

Loan Growth

Investors have not received the swift implementation of pro-growth policies that they had expected following the election. Nonetheless, the US economy has been on a modest upswing for an extended period of time. This has supported steady loan growth in the banking industry. Recently, 2Q17 GDP growth came in at 3.0%, rebounding from the 1.2% level reported for the first quarter.1 We expect economic activity to remain solid in the second half of the year. This perspective is supported by our frequent conversations with management teams of regional banks across the country who indicate that their middle market and small business customers remain confident about the US economy and are, in fact, expanding their businesses.

The market has been concerned about slower loan growth in 2017 based on industry data reported by the Federal Reserve. For the first two quarters of the year Federal Reserve composite data showed industry loan growth year-over-year of 4.1% and 3.6%, respectively.5 While we agree this is sluggish, we note that except for home equity loans, all loan categories continue to grow. Home equity loans, which represent a small percentage of total loans, have been in decline since the financial crisis. We view this positively as it suggests consumers are not repeating the mistakes of the past and using their home as an ATM in order to finance their lifestyles.

Small and mid-cap banks, a core competency of our investment team, have experienced loan growth that has dramatically outpaced the industry as a whole. For example, in 2Q17, loans grew 4.3% from the prior quarter and 13.3% from the prior year for small and mid-cap banks.6 The smaller banks have consistently outgrown the biggest banks by increasing their market share of total loans, and we expect this trend to continue.

Regulation

While implementing large scale regulatory reform through Congress may be difficult in the near term – a viewpoint we’ve held even post election – many beneficial changes to the industry can be achieved without Congressional approval. In June, the US Treasury Department released a paper that highlighted regulatory reforms to “make regulation efficient, effective, and appropriately tailored”.7 The report detailed 97 recommendations of changes to the regulatory landscape to improve the banking system. Of these 97 recommendations, only about 1/3 would need Congressional approval and the remaining 2/3 could be implemented by one or more of the regulatory agencies. We have already seen some changes that are positive for the industry including a widely expected delay in the implementation of the Department of Labor’s Fiduciary Standard8 and what has been perceived by the banking industry as a more streamlined approval process for proposed mergers. As can be seen in the table below, many of the leaders of the various financial regulatory agencies have already changed and more are expected to within the next few years. We believe as new leadership takes over, the regulators will begin to act on the Treasury’s recommendations.

Consolidation

Industry consolidation has been a long-term investment theme that has benefitted US bank stocks for three decades and should continue to do so for the foreseeable future. In our view, the US banking industry is still ripe for consolidation today with over 5,700 banks in the United States. Over the past five years, we have seen on average approximately 250 mergers per year within the sector. Year to date, there have been 1,697 announced deals putting the industry on track for another year of consolidation near 250.9 We expect this pace of consolidation to ontinue as banks seek efficiency through scale, hich disseminates increased compliance and echnology costs across a wider asset base, and xcess capacity comes out of the system.

Valuation

Even after the strong performance of the sector in late 2016, in our view, banks remain attractively valued. Currently, anks are trading at approximately 1.4x book value well below their long term average of 1.8x. Moreover, valuations today re only slightly above levels observed in 2014, when the operating environment was materially worse. During that period, he Fed Funds Rate was close to zero, causing net interest margins to compress and the regulatory environment showed ittle signs of stabilizing. Today, net interest margins are improving, and the regulatory environment has stabilized with the rajectory of new rule making beginning to move in the banks’ favor.

We believe increased earnings power, supported by higher net interest margins, loan growth, operating leverage and ossibily some regulatory tailwinds, can continue to drive valuations back toward more normalized levels. Irrespective f this, we believe the industry should continue to compound book value as the sector is generating a return on equity pproaching 10%.

Conclusion

The US banking industry is experiencing improving fundamentals driven by higher short-term interest rates, solid loan growth and a stable credit environment supported by a growing US economy. Industry consolidation is continuing at asteady pace with no sign of a slowdown in activity. We believe these trends coupled with attractive valuations provide a compelling opportunity for long-term investors.

Finally, sentiment for US bank stocks has worsened due to the ongoing turmoil in Washington. We believe stock prices do not reflect the improved fundamentals of the sector, and they no longer reflect many of the potential regulatory, tax or economic improvements that were anticipated immediately following last November’s election. If sentiment shifts and if any of the potential outcomes were to happen, it could provide additional benefits to the sector.

1 Bloomberg, as of August 31, 2017.
2 Bank of America Merrill Lynch, June 7, 2017.
3 FDIC Statistics as of June 30, 2017.
4 Keefe, Bruyette & Woods: 2Q 2017 Bank Earnings Wrap-Up, August 8, 2017.
5 Federal Reserve, as of June 30, 2017.
6 Keefe, Bruyette & Woods: Quarterly Loan Growth Trends, August 25, 2017.
7 US Department of the Treasury, A Financial System That Creates Economic Opportunities, Banks and Credit Unions, June 2017.
8 Reuters: Labor Department Delays Fiduciary Rule Implementation Date, August 9, 2017.
9 SNL Financial, June 30, 2017.

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