An unsteady ride for U.S. banking sector stocks is unlikely to smooth as the threat of a recession and a protracted period of ultralow interest rates impinges on valuations and lending models, experts say.
“The combination of the Fed saying that there will be slower economic growth and higher unemployment in the future spooked bank investors, who are always looking out for the next recession,” Eric Compton, banking-sector equity analyst at Morningstar told MarketWatch.
Last Wednesday, the Federal Reserve cut its projections for economic growth, while lowering the number of rate increases it expects to zero from two. The S&P 500 index SPX, +0.72% has fallen 0.5% since that time, but financial services stocks, as measured by the Financial Select Sector SPDR fund XLF, +1.19% and the SPDR S&P Bank ETF KBE, +2.30% have taken the news much more severely, falling 4.4% and 6.6%, respectively, over the past week.
Month-to-date, financials have fallen 3.7%, worst of all S&P 500 sectors, while the S&P 500 has advanced 1.2%. Meanwhile, the Invesco KBW Bank ETF KBWB, +1.72% considered the best proxy for large-cap banks, is down 7.5%.
Year-to-date, the S&P 500 has risen 12.4%, while the Financial Select Sector SPDR fund has lagged behind, climbing 7.2% and the SPDR S&P Bank ETF has advanced 10.6%.
Read: Why stock market investors should worry about a bearish divergence in financials
As stock-market investors have adjusted to the Federal Reserve’s abrupt decision to halt rate increases, with policy makers signaling expectations for no rate increases in 2019, amid diminished expectations for economic growth, bank stocks have taken it in on the chin, and investors shouldn’t expect a reversal of this trend, analysts tell MarketWatch.
The banking sector has been hurt by a flattening, and even inverting, yield curve, describing conditions where short-term interest rates sit at or above long-term rates, a dynamic in the government-debt market that can be a precursor to an impending recession, as it indicates investors believe that growth will be weak.
Read: The yield curve inverted — here are 5 things investors need to know
“A flattening yield curve isn’t good for banks, but that alone wouldn’t crush them,” Compton said, adding that the inversion of the yield curve, and the recession fears it reflects, probably accounted for much of the recent selloff. A recession would hit bank stocks hard and likely do so before they hurt other cyclical equities, Compton said.
Banks typically borrow money on a short-term basis and lend on a long-term basis at higher rates. A flat yield curve squeezes bank’s profit margins for such activities, while an inverted curve can be even more problematic.
Some boons from lower rates
That said, lower interest rates aren’t entirely bad news for lenders, according to Stephen Biggar, director of financial services research at Argus Research. “There’s an element of built-in hedging going on with banks and rates,” he said. “As yields come down, it stimulates loan growth and it makes their portfolios of bonds worth more.” Bond prices rise as yields fall.
There’s evidence that lower rates have stimulated more borrowing, at least in the residential mortgage market. New issuance of 30-year fixed rate loans rose 18.7% in February, compared with the month-ago period, while rising 0.6% year-over-year, according to the Mortgage Banker’s Association. Meanwhile, mortgage prepayment activity increased by 11% in February from January’s 18-year low, “suggesting an increase in refinance activity driven by the recent decline in 30-year interest rates,” according to mortgage data firm Black Knight Inc.
A rise in mortgage-loan issuance could help banks, Scott Siefers, principle of equity research at Sandler O’Neill told MarketWatch. However, that issuance may not be enough to offset other headwinds facing the sector. He estimated that revenues from mortgage-related activities can contribute between 5% to 15% of a typical bank’s revenue stream, and so a modest recovery in the mortgage underwriting and loan servicing businesses would be insufficient to blunt the effect of a flattening yield curve on financial institution’s profit margins from other types of loans.
“If you take a step back, the bull case for financials since the 2016 election was that interest rates were headed higher, tax reform, regulatory relief, and an improving macroeconomic picture,” Siefers said. “All of these stories are pretty much over,” he added, noting that the effects of tax reform and regulatory relief have been realized, while global growth is slowing along with plans for central-bank rate increases.
That doesn’t mean there isn’t room to selectively invest in banks, as analysts say several names have become oversold in the wake of the Fed’s decision.
Morningstar’s Compton points to Citigroup C, +1.48% as one bank that is undervalued, as he is bullish on the firm’s plans to cut $2.8 billion in costs over the next two years. Both Compton and Sandler’s Siefers also named KeyCorp KEY, +2.73% as a regional bank that has been oversold over the past six months, arguing that the firm’s 2016 acquisition of First Niagra Bank is only now delivering benefits, by improving scale and strength in the regional banks of New York market.
Providing critical information for the U.S. trading day. Subscribe to MarketWatch's free Need to Know newsletter. Sign up here.
