How are investors weighing up rate cuts and U.S. election uncertainty?
Vito Sperduto: Our U.S. economist Michael Reed published a note recently that talked about a 50 basis point cut in September gaining in probability based on some of the recent numbers that we've seen. 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. How are investors weighing up these impacts to the banks?
Gerard Cassidy: The banks have been preparing for the likelihood of this rate cut. A less inverted yield curve has historically been favorable for financial institutions. Just as important is that when rates start to fall at the front end of the curve, banks will eventually start lowering their funding costs pretty aggressively. Earning asset yields on most banks should still go higher as banks start to reinvest assets they purchased in 2020 and 2021.
The political landscape does add some complexity. With Kamala Harris emerging as the Democratic frontrunner, there's potential for policy continuity from the current administration, which could maintain regulatory pressures on banks. While a Trump victory might lead to a more favorable regulatory environment, we don’t expect him to be as lenient if re-elected to a second term.
How has sector performance and sentiment evolved over the year?
Vito Sperduto: During our March Global Financial Institutions Conference, credit quality and New York Community Bank’s recapitalization were key concerns. Back then, bank executives cautiously optimistic that credit trends and net interest margins would get better.
Gerard Cassidy: The credit picture has improved, though concerns remain in commercial real estate, particularly office spaces. Although, arguably, banks today show minimal exposure to these risks compared to what we saw in 1990. The sentiment has shifted, and bank stocks have performed strongly year-to-date. Investors are now more interested in revenue growth for 2025 and 2026, with expectations for expanding margins and net interest income in line with earlier optimism. This positive trend is likely to continue as we approach our next conference in March 2025.
Are we likely to see increased M&A activity in the financial sector?
Vito Sperduto: Scotiabank's recent acquisition of a stake in KeyCorp was a notable August development. Could this move signal a shift towards further consolidation in the sector?
Gerard Cassidy: Consolidation has been a recurring theme in the banking industry, moving in waves. We’ve been in a trough, especially regarding large bank M&A. We anticipate that as the Federal Reserve adjusts rates, it will boost confidence among bankers and drive more M&A activity, as higher rates have previously led to undervalued acquisitions due to mark-to-market adjustments.
The Scotiabank stake in KeyCorp, while surprising, benefited KeyCorp investors with a premium of nearly 20%. This move could signal a broader strategy, reminiscent of TD's approach twenty years ago, where initial stakes eventually led to full acquisitions. While Scotiabank has not indicated plans to acquire KeyCorp outright, such a strategy is not unprecedented.
What regulatory milestones should investors watch for in the coming months?
Gerard Cassidy: The Basel III end game will impose new capital standards on large banks and require them to account for unrealized bond losses in their regulatory capital. This is expected to improve the regulatory environment, making M&A processes more efficient.
As it stands, regulatory delays, particularly from the FDIC, have extended deal closures. However, there’s pressure for faster approvals, which could vary depending on the administration. A Trump re-election might accelerate M&A activity, while a Harris administration could lead to longer approval times. Overall, increased M&A activity is anticipated as banks seek scale and efficiency.
Vito Sperduto: 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. As banks diversify into fintech and other areas, adapting the review process to modern business models will be crucial going forward.
How can banks continue to improve profitability?
Gerard Cassidy: Enhancing collaboration is a key strategy for improving profitability and leveraging existing resources effectively. While the term "collaboration" may seem overused, it remains a powerful tool. This approach is the long hanging fruit for banks because it’s not as if you have to go out and buy another company or create a new product set. It’s already here. It just comes down to leading front the top and conveying areas of synergy to the folks on the frontline.
Are financial institutions driving AI adoption?
Vito Sperduto: Given the difficulty of acquiring the skills to leverage large data sets what I’ve seen is that many businesses are now discussing AI, even if their practical investments lag.
Gerard Cassidy: AI promises to be a game changer in the long term. While we've seen early successes with customer service bots and other AI applications but the impact to the bottom line remains challenging to measure. Banks, including RBC, invest heavily in AI, but the true benefits are often seen in automating repetitive tasks. We should temper expectations and recognize that while AI will drive significant changes over the next 10-15 years, its immediate impact is still evolving.
What does the investment landscape look for the financial services sector now?
Gerard Cassidy: Investment interest in bank stocks is rising as tech stocks face potential slowdowns. With the Fed expected to cut rates and a modest economic growth outlook, banks are well-positioned for strong performance. A soft landing with real GDP growth around 2% supports this positive outlook. Banks are likely to benefit from increased capital returns, including dividends and share repurchases, enhancing their appeal to investors. While risks remain, the current indicators are favorable for bank stocks.
