Bank Stocks - Losing Luster or Getting Attractive?
As if a gloomy start to 2016 for global markets was not enough, many investors are puzzled to see sectors with the strongest earnings estimates failing to buck the trend. The financial sector, in particular, is seemingly trapped in the broadly negative sentiment stemming from global equity weakness.
Banking sector under performance, in our view, contradicts fundamentals: Zacks estimates that Financial Sector earnings will reach +10.1% in Q4 2015, compared to the same period last year. Additionally, the sector has posted solidly positive growth numbers in the previous three quarters, which makes it apparent that there could be a disconnect between fundamentals and market performance. The sector looks oversold.
That could mean solid opportunities for investors looking forward. Anytime a sector feels the pain of a broader correction – such that strong fundamentals are overshadowed by global uncertainties – it could create opportunistic mis-pricing. Below, we take a look at three factors that are worrying the markets about the banking industry, which we see as overblown:
Too Much Exposure to the Energy Sector
With crude oil prices crossing the $30 threshold, investors are increasingly high-strung about financial institutions’ exposure to the Energy sector. News reports regarding the Energy sector’s rising bond credit-spreads and questionable loans have exacerbated investor skepticism about how much exposure banks have in their loan portfolios. With many U.S. shale oil drillers going out of production and a growing number of retrenched projects, concern over defaults and their impact on banks is looming large. These fears seem linked to the weakness in banking stocks.
However, a closer look reveals that Energy loans represent a small percentage of the banking sector’s loan and investment portfolio. To be sure, small regional banks in drilling areas may have a rough road ahead, if they’re not already nearing bankruptcy. But, a macro look at the banking sector shows that the biggest players not only have modest exposure but have also been recapitalizing in recent weeks. This activity is to account for potential losses while also intensifying their scrutiny on energy companies’ balance sheets. Remember too that nearly all of these loans are asset-backed, so the banks have property to seize if a company defaults.
The untold story is that lower oil prices can benefit other sectors that banks cater to, like housing and transportation, and that lower oil should ultimately help more sectors than it hurts. As such, we see it as overly pessimistic to assume that the banking industry is due for big trouble ahead. Instead of getting spooked by falling stock prices, investors should keep in mind sturdy fundamentals and see lower prices as opportunities, not indicators of trouble ahead. It could make sense to keep an eye out for currently undervalued banking stocks with strong earnings estimates.
Emerging Markets Financial Concerns
Global investors seem increasingly skeptical about the state of Emerging Markets and their presence on U.S. financial institutions’ balance sheets. Furthermore, interest rate hikes expected by the Fed this year coupled with a strengthening dollar could weigh heavily on the dollar-denominated debts of the emerging world. A stronger dollar coupled with slowing growth rates in Emerging Markets, particularly China, creates serious doubts about the serviceability of the debts. These are real concerns, but investors may mistakenly over-estimate the magnitude of bank exposure and may underestimate the ability of Emerging Markets to pay. On balance, Emerging Markets countries are holding more foreign reserves than ever before, and the most severe issues are likely limited to commodities exporters – risks which banks can hedge.
Moreover, banks across the globe have reduced exposure to Emerging Markets: international banking statistics released by the Bank for International Settlements (BIS) indicate cross-border lending to Emerging Market economies fell by $142 billion over Q3 2015, mainly due to reduced lending to China. Total cross-border claims on China have declined sharply by -17% annually as of September 2015. American financial institutions, in particular, are taking strong measures to mitigate their exposure to risky Asian markets. For instance, in Q4 2015, Bank of America reduced exposure to China and Hong Kong by $877 million and $2.196 billion respectively from the previous quarter. In fact, U.S. dollar-denominated lending to China has been contracting for quite a while now – the share of U.S. dollar denominated cross-border claims on China has declined from 54% in 2008 to 39% in 2014.
Also worth considering is that banks are retrenching costs of operation – something that’s reflected in recent earnings reports. Bank of America reported net income of $15.9 billion for 2015, which is well over 200% more than they reported in 2014 ($4.8 billion), largely due to lower legal and regulatory fees. Citigroup and Bank of America have reduced headcounts in 2015 by 4% and 4.6% respectively, and JPMorgan has slashed its number of branches by 3.4%. These active measures by financial institutions to counter adverse global conditions should bolster earnings prospects which, in turn, should bolster fundamentals of the banking sector.
The Problems with a Flattening Yield Curve
Another concern playing in some investors’ minds is the implication of a flatter yield curve. With the Fed commencing the rate hike cycle in December, and no signs of rising yields on long-term Treasuries as yet, many are justifiably expecting a flattening yield curve. Volatility in equities and commodities don’t help, as a flight to quality (U.S. Treasuries) keeps downward pressure on long-term rates. With inflation expectations very modest in the year ahead, it seems unlikely that investors will require higher yields on the longer end of the curve.
Higher short term rates and unchanged or modestly moving longer rates could mean a flatter yield curve, which is not ideal for banks. A steep yield curve means banks can borrow money at short-term rates, loan it out at much higher long-term rates and pocket the spread. More profits mean more loans, which is great for the economy. But, a flat yield curve implies that margins are squeezed (there is less of a spread for banks to pocket) and it dis-incentivizes loan activity (a negative for the economy). The anticipation of a flatter yield curve has arguably led some to sell-off their banking stocks.
But, these fears seem a bit far-fetched at this point. The Fed has indicated they will only very gradually raise the fed funds rate this year, and it seems unlikely that longer term rates will fall so severely as to truly flatten the yield curve. The yield curve will be something to watch, perhaps in the years ahead, but this year will almost certainly remain upward sloping – which is good for banks and the economy. It is possible traders are over-shooting their expectations for lending activity in 2016.
Bottom Line for Investors
While it is difficult to put your fears to rest amidst the global turmoil, it is nevertheless wise to stay focused on fundamentals reflected in earnings estimates and revisions. Unfortunately, there’s entrenched apprehension about the banking sector’s credibility in uncertain times; with memories of the last financial meltdown still fresh, many tend to develop an aversion to all financial firms even before carefully assessing their respective potential over time. We think a more constructive focus on strong earnings performance coupled with several banks’ efforts at mitigating risks and improving profit margins should guide investment decisions. A company’s fundamentals should ultimately determine an investor’s gains over time, and right now bank stock prices could be disconnected from fundamentals – meaning potential for opportunities.
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