RBC Capital Markets’ Head of US Bank Equity Strategy Gerard Cassidy has been covering the industry for nearly three decades and he’s never seen a banking cycle like the last 18 months. Banks put aside billions of dollars for loan loss provisions, expecting a credit cycle that never happened because of the actions of the Federal Reserve and the Federal Government in supporting the economy.
“It's going to be interesting because the recovery in earnings, kicking off in 2021, had been driven by what we've referred to as loan loss reserve releases. The industry set aside billions of dollars to handle the expected credit losses from the recession in 2020 – and didn't need to use them. So now they're putting them back into earnings.. But we all know the earnings releases are almost one-time in nature. And they're going to fade away as we enter into 2022,” says Cassidy
Nevertheless, Cassidy is optimistic about bank stocks going forward based on two core fundamentals – a steepening yield curve and loan growth.
Short-term interest rates and steepening curve
“Market interest rates are very important to the profitability of the banking industry. It's the cost of their raw material, which is cash. And when you take a look at the current rate environment, the rates are very low, and banks are less profitable in a lower rate environment with a flatter yield curves. Therefore, a steepening curve would add to their profitability,” he explains.
As the Federal Reserve comes into the market every month, buying up billions in securities, this quantitive easing policy is creating an excess, even an artificial, demand, pushing rates down. But this monetary policy won’t last forever. Indeed, most forecasters are predicting that the Fed will start to taper from late 2021 or into 2022, scaling purchases back until they reach zero.
“The expectation is that when the tapering ends, or during the tapering period, long term interest rates will start to rise. Should this take place, that will help benefit the bank's net interest margin, which is equivalent to a gross profit margin for an industrial company. So as the net interest margin rises due to a steepening curve, that will increase the revenue growth for the banks,” Cassidy explains.
"Interest rates are very low, and banks are less profitable in a lower rate environment with a flatter yield curves. Therefore, a steepening curve would add to their profitability"
Gerard Cassidy, Large Cap Bank Analyst and Head of US Bank Equity Strategy at RBC Capital Markets
Is loan growth on the horizon?
“That’s the number one question investors are asking us about the future of banking,” says Cassidy, “because loan growth has not been positive, it's actually been negative. But when you look back at past cycles, this loan issue that we're seeing today is not unusual. And it takes some time for borrowers to start borrowing, again, whether it's corporates or individuals.
“We anticipate as the economy grows through the end of ’22, supply chain issues are ironed out and capital expenditures pick up, the banks will benefit. Not only from the consumer loan growth we're already seeing, but they're going to benefit from commercial loan growth over the next 12 to 18 months.”
In this environment of steepening yield curves and loan growth, the banking industry as a whole will do well. Universal banks will benefit from consumer and commercial loan growth, although they will be battling very robust capital markets. Regional banks will perhaps do even better, particularly in areas of the US that are experiencing real growth in the Southwest and Eastern parts of the country.
What are the risks to this bullish outlook?
The largest risk for banks is that inflation becomes persistent and starts to accelerate, forcing the Fed to move rates more quickly.
“If the Fed has to be more aggressive, and doesn't raise rates in a very methodical fashion of 25 basis points every meeting, but they move at a 50 or 75 basis point increase, or they raise rates intra-meeting, which happened back in the 1970s and 80s, that would be problematic for the banks. So the one big risk we see on the horizon is that inflation gets out of control. It's not the base forecast. But that is the risk forecast,” says Cassidy.
A delayed recessionary reaction would also be an issue, likely pushing the industry into the credit cycle it managed to avoid through the pandemic. But so far, Cassidy sees these risks as relatively unlikely. Instead, the industry in the coming months will be facing the challenge of accelerating digitization, assessing potential M&A activity and keeping one eye on the current administration’s banking regulations.
