Vito Sperduto
Hello and welcome to Strategic Alternatives, where we uncover new ways to raise capital, drive growth and create value in an ever changing world, with insights and outlooks from the RBC Capital Markets team. I'm Vito Sperduto, Head of RBC Capital Markets U.S., Today we have a very special guest, Gerard Cassidy, who's a managing director here at RBC Capital Markets and is Co- Head of Global financials research Large Cap U.S. bank analyst. Gerard has a great background. Has been in the business for almost 37 years, primarily as a bank equity research analyst, and has certainly been acknowledged by institutional investor as the top analyst in his space over a long number of years. So Gerard, welcome to the podcast, and really looking forward to having a good conversation at an opportune time of the year here.
Gerard Cassidy
Thank you, Vito, for the kind introduction. I'm real pleased to join you today.
Vito Sperduto
Well, Gerard, why don't we start with the macro picture? Certainly, the landscapes evolved with the Fed Chairman statement that the time has come for interest rate cuts, which obviously was music to a lot of people's ears. Certainly you and I both follow our US economist Michael Reed and his views on potential rate cuts, Michael's been squarely in the camp of a 25 basis point cut coming in September, up until recently, where last week, he published a note that talked about a 50 basis point cut, gaining in probability now based on some of the recent numbers that we've seen, so that'd be interesting to hear about. At the same time, we've had a very significant shift from a political perspective, with Harris replacing Biden at the top of the Democratic ticket, and some of the forecasts currently point to a Harris win in terms of the November election. So it'd be really good to get your view in terms of the impact of these items on your client base.
Gerard Cassidy
Sure. Vito, it's interesting. Powell's commentary about interest rate cuts - very important for the banks. Equally as important was his pivot in December of ‘23 that was when investors really got to see that the Federal Reserve was maybe going to change their monetary policy from one of tightening to easing, and now we're closer to that day finally, that the Fed, it seems likely they're going to cut in September, based upon what they're going to print for the August payroll numbers. So the payroll numbers and the job numbers and unemployment rate will be very important to the Fed's decision this month when they look at interest rates. And the reason this is so important for the banks is that when you think about it, cash is the raw material for a bank, and so the cost of that cash has obviously gone up from a zero to 25 basis point Fed funds rate before the spring of 2022 to where it is today, at around five and a half to five and three quarters, percent. So the banks have been preparing for the likelihood that the Fed was going to cut interest rates. Vito, you might remember, at the beginning of the year, the futures market thought the Fed funds rate was going to be cut six or seven times that has moved around the now. Today, in September, there's a call for maybe up to four fed fund rate cuts between now and the end of the year. We see it's all going to be, obviously, data dependent. But the important part of this is this is positive for the banks, a steepening of the yield curve, or less inverted yield curve is positive for the banks based on the historical relationship that the bank stocks have had with the steepening of the curve. And second and just as important is that when rates start to fall at the front end of the curve, the banks will eventually start lowering their funding costs pretty aggressively. However, the earning asset yields of most banks, believe it or not, will still go higher, because as the cash flows come off the balance sheet from assets that were purchased back in 2020, 2021, at rates of less than 1% or above 1% they'll be reinvested. Even if rates are down 100 basis points, you're still going to pick up spreads of two or 300 basis points. So we're quite positive on the banks in this environment, because the Fed is going to generate, again, lower short term rates. The other interesting comparison is the last time we've had a soft landing in our careers is back in 1995 And when you look closely at the numbers like we have done, what you find is that the bank stocks in 95 are up 55% best sector in the S&P and we've been writing about this, Vito, for over 18 months now, about the comparisons to 1995 and if we're right investors will do quite well in owning the bank stocks over the next 12 to 18 months. Now it's interesting. You brought up the election, because it is a new twist obviously with Harris now being the nominee, rather than Biden, and it'll be interesting to see how that plays out. Should Harris win, we see a continuation of the policies that this current administration has had on the banking industry, which have been somewhat onerous, whereas if Trump was to be reelected and came back into office, we think there'll be a lighter touch on the regulation side, not as light as what he showed in the 2016 period when he was elected, but still, it would be a more favorable environment for the banks in a Trump administration versus the Harris administration.
Vito Sperduto
That's really informative. And we're certainly seeing a lot of the banks hit some pretty significant levels in the markets right now, and they've been very strong performers, so which we were all obviously following closely. But as we think about sort of performance and sentiment more generally, you know, I know you and I spend a lot of time each year at our global financial institutions conference, largest conference in the industry. I think we had record attendance, both in terms of investors and clients, this past year again. But back then, you know, I think credit quality was a big focus. And you know, certainly investors were watching and looking at the New York community bank recapitalization that was announced at the time of the conference. We're approximately six months past that when we're recording this today. How are you seeing it? How are folks reacting? What's changed over that time period?
Gerard Cassidy
When you look at the picture today versus six months ago, so the credit picture has actually improved. There was a concern back in the spring, of course, of commercial real estate, office commercial real estate, that is still a real issue. But I think what the market has figured out Vito is that the banks have minimal exposure and how New York community was idiosyncratic with its excess exposure, especially in the New York rent controlled apartment market. But what's interesting is that the banks are being able to take their charges in their commercial real estate portfolios, and once again, it's just not as dramatic or as severe as what we saw in 1990. So the narrative and the sentiment has shifted from what's going on with credit quality to now net interest income and net interest margin. And as you pointed out the bank executives were more optimistic, I think, on net interest income, than investors. And sure enough, investors have come around, because the bank stocks since the spring have done very well and are now today, year to date, in performance, are doing better than the S&P by about 400 basis points. And so what we're suggesting and what we're hearing from investors, it's now, and you know, when you talk to them today, not too many questions on credit, even though credit's always a focus point, it's more about, how are they going to grow revenues in 2025, how are they going to grow revenues in 2026, will loan growth come back? And will these margins expand? And once again, if today is similar to history, I would suggest the margins are going to expand. You're going to see net interest income growth similar to what the executives were saying at our conference. And I think you're going to hear more of that in March of ‘25 when we hold our conference again.
Vito Sperduto
I'm always interested to hear the tone of our clients as I'm meeting with them, and how they're thinking about it. And you know, they certainly are… There certainly is an acknowledgement that there's likely going to be a wave of consolidation looming, and especially in the US, which is the most developed banking market in the world, right? We certainly saw in August where Scotiabank bought a stake in KeyCorp, and that was an interesting transaction to watch. But I think as we look at it, you know, there's certainly, I'm always trying to figure out, what are the catalysts going to be for these clients as they think about it? Is there an overhang from the election? Are they waiting for the rate cuts to take hold and get a better view as to what that's going to look like going forward? Would love to understand your view on what this upcoming cycle might look like from an M&A perspective.
Gerard Cassidy
So consolidation has been a theme that has been ongoing for decades. Now, it's not linear. It moves in waves, and we're currently in a trough. There's been especially amongst the bigger bank acquisitions and mergers, and we expect that once the Fed starts to move on rates that will give more bankers confidence that we're not heading into a recession and that there's not going to be very big marks to the to the securities and asset portfolios, because that's been the challenge since 2022, Vito. It's all about the marks to the balance sheet. And so when rates have moved up and you have fixed rate assets, obviously, on your on your balance sheet, they're worth less. And therefore, in an acquire or they mark everything to market when they make the acquisition, and it depletes capital, which means it will lead to a lower acquisition price. And in banks, as we like to call it, banks are sold. They're not bought. Now it's interesting we published about three weeks ago, our M&A model, we have a model that we have sent out to clients that allows them to do all their own M&A analysis, very straightforward as hundreds of banks in the database, where you could combine, let's say, a PNC and a KeyCorp or a Huntington Bank shares in the First Horizon, and you can make your own assumptions. You could take on you know, the premium you should think would be appropriate. So the consolidation of the industry is going to continue. Now. Are we going to end up with a banking system where we'll have five banks like we have in Canada? No. But we will end up with a more polarized barbell approach, where the top 10 banks will probably control 75-80% of the banking assets in the next 10 or 15 years, and then you'll still have 1000s of community banks. You bring up another interesting point about this Scotiabank investment in KeyCorp. It was a surprise. None of us were expecting that news, and it was very beneficial to KeyCorp investors, because they paid almost a 20% premium for that stake, which is around 14 to 15%, assuming they receive the regulatory approval to do it, we expect them to. We've never seen the Fed turn down an opportunity to bring more capital into the U.S. banking system. And so we thought that was interesting. Some are wondering if it's a stakeout where Scotiabank someday could eventually buy the entire bank being in KeyCorp, that's the way, believe it or not, TD came into the United States about 20 years ago. They took a stakeout position in a bank called Bank North, which eventually led to the acquisition of the entire company. And that strategy has been used before. We'll see if that plays out here, Scotia has not suggested they're going to do that, and KeyCorp certainly is not willing to sell out at this time we don't believe. But the consolidation of the industry we expect to accelerate as rates fall, the interest rate marks become less of an obstacle, and then we get a clearer picture on the regulatory front when Basel III end game finally comes out. So once we get that, you can get lower interest rates. I think the market is very fertile for more bank mergers and acquisitions. And we are certainly expecting that. And institutional investor clients are expecting it as well.
Vito Sperduto
Yeah, look, you make some excellent points there. I do think the tone from bank management teams has still been that scale and consolidation are a critical part of the thesis going forward. So that's not going to change. It's interesting, you brought up the regulatory item. Gerard, you know, I spend a lot of time in a lot of other industry sectors, and I'm always focused on what the Department of Justice, from an antitrust perspective, and the FTC are doing in terms of their review. Obviously, here it's more about the Fed in terms of the ultimate regulator or the OCC but what about the regulatory picture? You know, what are the key milestones? I mean, you mentioned the Basel III end game, but would love to delve into that a little more
Gerard Cassidy
Sure, the Basel III end game will set new capital standards for our largest banks, it takes an approach to measuring risk weighted assets, setting aside more capital for higher risk businesses such as trading capital markets in general. What we're going to see is that what we call category three banks. Those are the banks between essentially 100B and 250 billion in size, and those banks are going to be required now to move their unrealized bond losses, not only through gap capital, also through regulatory capital, which they're not required to do today, once we get the clear path there, I think the regulatory environment starts to improve, because one of the challenges for the banks, it always, generally takes six to nine months for deals to close. But there's been a real problem, particularly with the FDIC, in slowing that process down. And it's been taking 12 to sometimes 18 months for deals to close. And I think now that it's been a focus point by not only industry executives, but also politicians, to have the regulators start moving in the direction of, let's start moving on these deals when they're announced. I think you'll get a buy in from the Federal Reserve, as well as the FDIC Controller of the Currency, which are the three main bank regulators, but also Department of Justice, they get involved from a competitive standpoint, in the deposit area, that's the key area, the deposit concentration risks, and what happens is, when there's over concentration, what after the deal is announced, the set the merged banks oftentimes will spin out. Should the Department of Justice require it, they'll spin out the deposits and the branches that need to be sold off to a competitor to complete the deal. So we think the regulatory environment, especially if there's a change in the administration and Trump is reelected, we think it will be a much more supportive to allowing deals to go through, and it doesn't mean they won't go through under a Harris administration, but they just may take a little longer. So we're encouraged with the with the signs we're seeing out of Washington that following Basel III end game, we're going to see more activity in bank M&A because you touched on a moment ago, it's economies of scale. It was really needed for banks, particularly when you're over 50 billion in assets, that's where the economies of scale really kick in, and that's where we think you're gonna see a lot of activity,
Vito Sperduto
I would say that, you know, in any M&A transaction that time to close, from the time of announcement or signing is so critical, and what we've seen in recent years is that it has expanded. I think there is a noticeable effort on the part of the regulators to try to contract that, I do think that when we think about a regulatory review of any transaction, it does need to get updated for the modern day realities of the businesses that our clients are operating in. And so in some cases, deposit concentration, branch concentration? Yes, those are simple formulas that we can look at. But I do think one of the things that's become more difficult is that so many of our clients are getting into diverse businesses where it's not just simply a depository game. There are, you know, different technologies that they're looking at, whether it's FinTech applications that they're using with their clients, or different businesses that they're more focused on, especially as they're thinking about growth going forward. And then it becomes a little bit of a different calculus in terms of how you think about that from a combined perspective if you're looking at M&A.
Vito Sperduto
Well, look, it would not be a podcast or any other form of media if we didn't talk about artificial intelligence. We've got a team at Borealis of researchers that are constantly working on new applications to produce more efficiencies in our business. It seems that there's a requirement now for businesses to talk about these types of offerings quite a bit, as we're doing just now, even if they haven't managed to invest in it in practical ways. But maybe, what's your impression?
Gerard Cassidy
Artificial Intelligence, to us, is going to be a game changer over the long run. There has been some early successes, particularly amongst the large banks, using bots to answer questions from their customers. And the hard part for the banks is in they spend, our bank included, we spend billions and billions of dollars on technology and artificial intelligence and other technological advances, and it's hard for outside investors to really gage whether this is really moving the needle on the bottom line, and the measurements are difficult to determine how successful it is going to be. But specifically, coming back to artificial intelligence, I think you're going to find that the first successors, and it's already showing up, is in more the repetitive processes that banks have, that can be easily done with AI. So I think we have to be careful not to put the cart before the horse. I think over the next 10-15, years, we're going to see incredible changes, not just in the banking community or the investment community, but throughout our economy.
Vito Sperduto
I mean, it's incredibly powerful. I think I use it every day in some facet, and it's, I always find that really rewarding. Well, look, as we finish up, Gerard, I it would be great for you to sum up what is the investor's perspective, and how are they thinking about it?
Gerard Cassidy
It's very interesting. Vito, we see the investment community moving more into the bank stocks, but they are not what I would call fully weighted or overweighted into the banks. When you talk to the portfolio management community, where these portfolio managers have different sectors to choose from, the banking sector has really not been a concentration that we've seen in different parts of the cycle, and so it is now picking up greater interest. And not to cast aspersions on other sectors of the market, like technology, but should we start to see a slowdown in the Magnificent Seven, as they're referred to, those large seven technology companies, you could see a movement more into the value names. And as value becomes more mainstream or more center focused, banks obviously are value investments. Banks are a big part of the value stream, and so we see more generalists coming to the banks, especially if the Fed really does come through and cuts interest rates, as we all expect them to over the next 12 to 18 months, you get a steeper yield curve. Simultaneously with this, we've often heard about the soft landing. Well, we think we're in the soft landing. It's not coming, but it's here. And you look at the real GDP numbers that have come through the first half of the year, as you know, they've been around 2% real growth. The Atlanta Federal Reserve has something called Real GDP. Now this is an indicator that they create every week that shows us where the growth is going in the current quarter. As of last week, that real GDP now number was showing third quarter growth in the United States just over 2% so we're still seeing modest growth, and that's ideal for the banks. If we can see 2% to two and a half percent real GDP growth in 2025 with lower short term rates, credit quality remains resilient. You have the Basel III end game regulations finalized, it's setting up for some very strong opportunities for bank stocks to outperform next year and investors to do well by owning them. Not only that, the banking industry, obviously, is a mature industry. We're in a mature economy here in the United States, the banking industry kicks off every year an enormous amount of excess capital. They generally 20 to 30% of their annual earnings and plow it back into their business for organic growth. But that leaves anywhere from 70 to 80% of earnings to either be used for dividends, which generally are 30 to 40% of earnings in stock repurchases, also for timely acquisitions. So I think what investors will see over the next two to three years is they're going to see steady dividend increases, share repurchases, possibly some acquisitions, but we see positive earnings growth coming through due to the Fed policy and a soft landing continuing or modest economic growth. Now, if somebody is in the hard landing camp thinks we're going to have a recession, then obviously that will change the dynamics for banks. But we're not in that camp. There's no evidence of that happening yet. We certainly hope to see it before it hits the bank stocks. But again, we don't see that at this time.
Vito Sperduto
Well, Gerard, I'm going to be quoting that in terms of the fact that we are in a soft landing. I love that term. Look, I this has been invaluable, and certainly thank you for all the insights.
Gerard Cassidy
You're welcome. Real privilege to be with you. Thank you.
Vito Sperduto
You've been listening to Strategic Alternatives, the RBC Capital Markets podcast. This episode was recorded on September 5, 2024. Listen and subscribe to strategic alternatives on Apple podcasts, Spotify, or wherever you listen to your podcasts. If you enjoyed the podcast, please leave us a review and share the podcast with others. Thank you.