The shift in the interest-rate environment from a position of expected future rate hikes to future rate cuts has brought about an unambiguous sentiment change in the outlook for bank stocks.
We believe there’s a misimpression that the U.S. banking sector is likely to see revenue shrink as a result of declining rates and compression in banks’ net interest margins (NIMs)—a key financial metric that measures the difference between the interest income that a bank generates from lending and the amount of interest paid to depositors, relative to the amount of the bank’s interest-earning assets. While higher rates would have been an incremental positive for bank profits, bank fundamentals remain strong, in our view, and we expect the industry to post mid- to high-single-digit earnings growth in 2019 and 2020. Despite higher earnings per share growth versus the broad market as measured by the S&P 500 Index, the banking sector trades at a meaningful discount to its historical multiple, as well as a relative multiple to the broader market.1
The close relationship between bank profits and interest rates
From 2009 to 2015, the federal funds rate was near zero, and banks had little incentive to hedge future movements in rates. Therefore, the overall industry shifted balance sheets to an asset-sensitive position; that is, a bank’s assets benefited more from rising rates than the bank’s liabilities did. Since 2015, bank profits have been lifted by the U.S. Federal Reserve’s (Fed's) shift away from its zero interest-rate policy. While the industry remains asset sensitive, the recent shift in monetary policy has given banks an incentive to hedge balance sheets, and many have begun to reduce this sensitivity by adding on interest-rate hedges. Moreover, after increasing deposit rates in a rising-rate environment, banks now have the ability to cut deposit rates. Both decisions will help protect banks’ NIMs and the outlook for bank stocks, reducing the negative impact from rate cuts.
Taking a long-term view of U.S. banks’ industrywide average NIM versus the federal funds rate, it’s clear that the average expanded and the industry benefited after the Fed raised rates in 2015 to end its extended zero interest-rate policy. Also noteworthy is that the industry’s NIM has been largely uncorrelated to the movement in the federal funds rate over the longer term, as banks have generally sought to manage to a more asset-neutral position, as has been the case recently.
Given the Fed’s shift in monetary policy, it’s worthwhile to explore how declining rates have historically affected the industry’s net interest income. (A key measure of revenue growth for banks, net interest income is a bank’s interest income received on assets minus interest expense paid on its liabilities.)
History shows there's been a nonlinear relationship between the industry’s net interest income and its average NIM; in fact, U.S. banks consistently grew net interest income in the 1990s and early 2000s despite the headwinds of declining NIMs.2 This was also a period of strong returns for investors in the banking industry; the S&P Composite 1500 Banks Index returned 19.3% annualized from March 1994 to March 2001, a period when the industrywide NIM declined 115 basis points.3
Rather than focus exclusively on how the federal funds rate and NIMs will affect U.S. bank revenue, we believe that analyzing the impact on revenue growth requires evaluating the strong correlation between net interest income and growth in total loans. The only instance since 1985 in which net interest income declined was the period that followed the 2007/2008 financial crisis, when corporations and consumers alike delevered and total loans declined.2 This trend continued until 2011, as borrowers and banks finally began investing again after maintaining a conservative approach post-crisis. The relationship between both measures persisted and, as total loans increased, net interest income began to grow again. The compounding of loans on banks’ balance sheets provides a very predictable and stable revenue source, which has historically been a key factor in valuing bank stocks, in our view.
We don't foresee any near-term scenarios that would be equivalent in magnitude to the 2007/2008 financial crisis. Historically, severe recessions that restrict growth in total loans and net interest income have been extremely rare, as the only such occurrence in the last 100 years came during the Great Depression, when the industry’s net interest income declined over a sustained period.2
We believe the Fed’s monetary policy of cutting rates amid an already-strong economy is likely to extend the current expansion, further supporting loan growth. Industry loan growth has been solid more recently, averaging 5% year-over-year growth the past few years.2 We view this as healthy growth, given today’s economic environment, and believe it's sustainable as the economy continues to expand.
A key metric to watch: net interest income
Of course, an environment with rising NIMs is more attractive than one with declining NIMs; however, we believe investors should shift their focus toward net interest income, an important revenue growth driver for U.S. banks. We see many positive catalysts supporting the outlook for bank stocks: solid loan growth with a stable credit environment, a focus on controlling expenses and creating operating leverage, and a continuation of sound capital management, including share buybacks and dividends.
Taking these factors into consideration, we see an industry that should continue to generate mid- to high-single-digit earnings per share growth in 2019 and 2020. The industry still benefits from a structural tailwind, given the long-term trend of consolidation, as merger-and-acquisition activity continues to broadly benefit bank investors, in our view. Overall, U.S. bank stocks offer a compelling investment opportunity, considering their sound fundamentals and current discounted valuations, compared with their own history and relative to the overall market.
Heightened stock market volatility may persist given today’s geopolitical environment and global macro concerns, but as investors in U.S. banks, we believe it’s always important to focus on the domestic economy, as it drives both loan growth and credit expense. In our view, the U.S. expansion is likely to continue, providing a tailwind for the U.S. banking sector over the next few years.
For more on the case for U.S. regional banks, click here.
1 SNL Financial, FactSet, August 2019. 2 U.S. Federal Reserve Bank of St. Louis, August 2019. 3 Manulife Investment Management, August 2019.