Peter Dawkins:
Welcome to the Industries In Motion Podcast from RBC Capital Markets where we take the time to explore what's new and what's next in today's fast moving markets to help you stay ahead of the curve. My name's Peter Dawkins and I'm the product manager here in London, UK. And I'm very excited for today's podcast because we're joined by members of our global banks team from the US, Europe, and Canada. And we're here to discuss their outlook for 2024. From the US, we'll be joined by Gerard Cassidy and John Arfstrom. From Europe, we will be joined by Anke Reingen and Benjamin Toms. And then finally, our Canadian banks research team is represented by Darko Mihelic.
Please listen to the end of this podcast for important disclosures. Why don't we kick it off with the US? Gerard, 2023 was clearly a extremely eventful year for the US banking industry. We saw the collapse of three large banks. We saw the introduction of the Basel III endgame proposal. The rising rate cycle and credit quality and resiliency was also in focus. With all of those major themes, what is your outlook for the banking sector in 2024?
Gerard Cassidy:
Thank you, Peter. Our outlook is quite positive. We think that the Federal Reserve has reached the terminal rate for Fed funds, and we also believe that the US economy will have a soft landing in 2024. The combination of those factors are very positive for the banks, and we think it's very similar to what we saw in 1995. If this proves to play out as we think it will, the upside for bank stocks is still quite meaningful, even though they've come off their October lows quite successfully. One of the expectations we have for 2024 is credit normalizing, credit costs will be higher. However, we think they'll be very manageable. And as the economy starts to improve in the middle to second half of '24, we think credit costs bills actually could come down. The big swing factor for revenue will be net interest revenue. We're looking for an inflection point.
Obviously there's been pressure on net interest revenue in the second half of 2023, but we see the inflection point coming because of that terminal rate and Fed funds being reached sometime between the end of the fourth quarter of '23 and the second quarter of '24. One of the big unknowns this year is going to be that what will the final proposal be for the Basel III regulations? We do think they're going to be watered down from what we saw in the initial proposals, and we'll get to see more of that very soon when the banks give their comments in the month of January. Once we do see the final proposal for the Basel regulations, we do expect banks to accelerate the share repurchases in the second half of the year. We also think that dividends will be increased throughout the year. And then lastly, we think the valuations for the group are attractive. We see the profitability rising with higher ROEs, but we do recognize that the industry's profitability permanently will be reduced because of the new Basel regulations, but we also think that the stocks are attractively priced at these levels.
Peter Dawkins:
Thanks, Gerard. It's clear that you're quite bullish on the banks for 2024, but taking the other side of the conversation, what are some of the risks on the horizon for banks that you might be worried about?
Gerard Cassidy:
There's always risks, of course, and the risks on the horizon for 2024 really center around the inflation. If inflation is not under control, though it appears it is, which is why we're confident that the Fed has reached the terminal rate for Fed funds. But should the inflation re-emerge, surge higher in 2024, forcing the Federal Reserve to not cut interest rates but actually increase interest rates to combat inflation, that would be a major risk for the banks because what that likely would lead to is a much harder landing for the economy, which would then in turn mean higher credit costs greater than anyone's expecting.
And so the credit normalization trends that we're seeing would actually spill over into the deterioration category, which would be certainly painful for the banks. In this scenario, the hard landing of recession would probably start to materialize, and again, bank stocks in a real recession don't do very well and that would make them suffer. That's the biggest risk is inflation coming back, forcing the Fed to have to raise rates. Another risk, of course, is credit specifically in the office market that it spreads further away wider reach than just office. There's some concern about the multifamily market, not too worried about that just yet, but it's really the office market. It's really interest rates going higher and credit being worse. But overall, we think those risks are quite small and that's why we're so bullish.
Peter Dawkins:
Thank, Gerard.
Gerard Cassidy:
Thank you, Peter.
Peter Dawkins:
If we switch gears now to Europe, Anke, 2023 was generally a good year for European bank shares as we saw interest rates at levels that we had not seen for quite some time. Against this backdrop of share price performance in 2023, what's your outlook for the European banks in 2024?
Anke Reingen:
Thank you, Peter. Higher interest rates are unlikely to provide support to bank share prices in '24 as they did in '23. We think '24 will be more about rewriting rather than earnings. If we start with earnings, there will still be some benefits from higher rates coming through from the bank's longer-dated investment portfolios, but this benefit should partially be offset by higher funding costs and higher deposit betas as interest rates are unlikely to come down as fast as in the US. Economic wealth is expected to remain relatively low, supporting only slow growth in loans. Higher wages are expected to support economic growth, but as a result, the banks need to continue to focus on cost control.
On the positive side, higher levels of employment should mean that there are less concerns on asset quality. The more volatile part is investment banking. In the past, once the interest rate path was clearer and volatility came down, investment banking activity picked up. Given the rate outlook for '24 this year might provide a better backdrop for investment banking than '23 was. This takes us to 2024 being more of a story of re-rating of European banks. Return expectations are higher than in the past, as rates are much higher than in the last years. Capital distributions will support returns and lead to attractive yields, yet the bank sector is trading on lower valuations than in the past. What we need to see for re-rating is a more constructive economic outlook and GDP upgrades.
Peter Dawkins:
Thanks very much, Anke. Ben, if we look at UK versus EU banks, ultimately the UK banks underperformed their EU counterparts in 2023. Do you expect any change in that dynamic in 2024?
Benjamin Toms:
Thanks Peter. From a macroeconomic perspective, the UK will likely experience limited growth in 2024. Unemployment should remain low due to a tight labour market and house prices should start to stabilize following recent modest declines. Inflation has fallen significantly in recent months and should continue to trend downwards although it's harder yards from here. The Bank of England base rate, which is just over 5%, is currently expected to fall just under 4% by year-end. Although we're cautious on large UK banks going into full year '23 results with the potential in our view for downgrades to NIM and costs. We think that in general, the macroeconomic environment will be supportive of high UK bank valuations as we go through the rest of 2024. In our view, a small fall in base rate would take interest rates into a sweet spot of two to 4%.
In this range, UK banks can generate a decent spread between what they charge for a mortgage and what they pay for a deposit without having to worry about worsening asset quality. Top line momentum should be provided from structural hedge re-pricing and falling inflation should help cost to control. The largest risk to our thesis is that there is increased competition on both sides of the balance sheets driven by low mortgage volumes and repayment of TFSME funding leading to banks passing lower rates to mortgage customers without being able to equally pass them on to deposit holders leading to margin squeeze. We have a preference for the specialty lenders for the first part of the year where we expect that falling rates and an improving outlook for house prices should lead to a recovery in buy-to-let volumes. A potential softening of Basel 3.1 capital regulation could also provide a catalyst in May. Approval of IRB modelling is unlikely to come in 2024, but should provide a medium term boost to capital.
Peter Dawkins:
Thanks very much, Ben. And continuing along with the theme of mortgages, I want to shift gears to Canada because Darko has written extensively on this subject over the past couple of months and years. And so Darko, could you maybe add your view on the Canadian mortgage market and what your outlook is for it in 2024?
Darko Mihelic:
Our report highlighted that the 2025 and 2026 renewal years were big for the Canadian banks. And if interest rates stayed elevated, this large cohort of borrowers were facing high double-digit increases in mortgage payments. Now, the interest rate expectations have changed materially since we wrote that report. And there's now a sense of relief that by the time 2025 and 2026 rolls around, the payment shock will be significantly lower than what we'd originally calculated and therefore more manageable. On top of that, there's been more evidence that continues to come in on mortgage borrowers that have already renewed and faced payment shock and delinquency levels are still below pre-pandemic levels. This is suggesting that consumers are adapting to the new reality by cutting back on discretionary spending and LTVs remain elevated so far. I would suggest that for now, think of it as a concern that is still there in the background, but fading for the Canadian banks.
Peter Dawkins:
Thanks, Darko. And if we can go beyond mortgages here and think more broadly about the Canadian banking market, what's your outlook for the industry overall in 2024?
Darko Mihelic:
We're essentially expecting a soft landing with credit losses normalizing rather than spiking. While loan growth will be more modest than in the past, net interest margins should be stable and expense control has been a strong focus into 2024. Given this outlook, we believe we could see mid-single digit earnings per share growth in 2024. And this is in contrast to earnings per share declines in 2023. In addition to better EPS growth, we believe the regulator has ended this push for higher capital ratios. We suspect that share issuance and this is happening through discounted drip programs, can stop and eventually lead to share buybacks as long as a hard landing is avoided. We have indeed become a little more constructive on the stocks, but we would caution that economic risks are still high. And if interest rates fall dramatically, that's probably accompanied by significant capital market volatility. We are constructive on the names, but the risk is still present, so we're not excessively bullish on the group for now.
Peter Dawkins:
And with that, we'll now wrap the podcast. I just want to take a moment to thank Gerard, John, Anke, Ben and Darko for taking the time to meet with us today. I think it's really fascinating to be able to bring together the analysts from the different regions, hear about their 2024 outlooks, and really be thinking about what 2024 might have in store. Thank you very much for dialling in and listening. And as always, we really appreciate your viewership and your listenership, and if you ever do have any feedback or questions, please do not hesitate to reach out to any one of your RBC counterparts.
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