- Banks have excellent fundamentals and low valuations.
- Increased interest rates mean increased spreads and higher profits.
- Complying with Basel guidelines lower the risks of another financial crisis.
Since the great recession investors have been wary of investing in financials as the bankruptcies, bailouts and layoffs left a big mark. This article is going to shed some light on the current banking situation to see if the 2009 debacle was a once in a century happening, or if there are still inherent risks for the US banking sector.
The Banking Sector
The situation in the banking sector is starting to look better, but stocks are still far from their highs reached last summer.
Figure 1: Wells Fargo & Co trailing 12-month stock price. Source: Bloomberg.
Bank stocks have risen since more good news about the economy came out and interest rate increases become imminent. The economic logic suggests that increased interest rates should be beneficial for banking profitability. Increased interest rates directly increase the yield banks receive on their cash, increasing the margin between what they have to pay on customers’ deposits and the yield received on short term notes. Of course, there are other important factors for banks like the quality of assets and liquidity, but the trend in interest rates suggests good times ahead for banks especially as increased interest rates are a consequence of better economic times.
As the great recession spurred a wave of new legislation in order to prevent a similar financial crisis from happening again, the quality of assets should be at an historically high level. One example of that is the “net stable funding ratio” proposed by the Federal Deposit Insurance Corporation (FDIC) where banks will need to have enough cash to last for a year. The good news is that banks will need to increase their cash balances by only 0.5% as they have already prepared to meet the new requirements. This is one of the final steps for US regulators to complete in order to comply with the guidelines set by the Basel Committee in order to lower the risks for a new financial crisis.
So, with high liquidity requirements, low interest rates and potential interest rates increases, banks should have high PE ratios due to their low current earnings and future expected earnings growth coming from interest rate increases, right?
Wrong, the below table shows the fundamentals of the 5 biggest banks in the US by market capitalization.
With the S&P 500 having an average PE ratio of 24.26, the above ratios look like something scary is going to happen to financials, but the reality tells a different story.
igure 3: Wells Fargo’s (NYSE: WFC) earnings sensitivity to interest rate changes. Source: Wells Fargo Financials 2016 Q1 10-Q.
An interest rate decrease would lower WFC’s earnings by 5%, while higher interest rates would have positive repercussions as high as 5%. As banks are prepared for low interest rates, they have switched their portfolios toward assets that are not sensitive to interest rate changes in the short term and therefore the small changes in earnings. But, with higher interest rates banks would be able to increase their profits by adapting their portfolio accordingly, so banking profits would not immediately increase with increased interest rates but slowly in the longer term. By looking at the FED’s targets, the higher rates scenario is more likely than the lower rates scenario.
Figure 4: FED’s interest rate expectations. Source: Federal Reserve.
With interest rates going up to 3% in 2017, banks should benefit from increased spreads and from a better economy.
Risks and Opportunities
By investing in banks there is always the risk of a financial crisis, but on the other hand, the low PE ratios create extra rewards for bank owners. The historical bank failures chart shows how difficult times sooner or later always hit banks but that longer periods of relative stability are not uncommon.
Figure 5: Number of bank failures per year. Source: CalculatedRISK.
The long, peaceful periods between banking crises and the high bank stability provided by new regulations could create a new 40-year stable period like the one enjoyed by investors between 1940 and 1980. With the current low PE ratios and low interest rates, things should only improve for banks.
There is always the opportunity to invest in a banking ETF and by doing so, being exposed to all of the US financial sector. The iShares US financials ETF chart shows how risky it can be to invest in all financials as the bankruptcy of a few affects the whole sector.
Figure 6: Performance comparison of Citi with Wells Fargo in the last 10 years. Source: Yahoo Finance.
Wells Fargo is 50% higher than before the great recession while Citi will probably never recover from its 2009 bailout. The best investing option should be to individually assess each bank and pick the one that presents the best-risk reward opportunity for the investor. If you do not trust your own analysis skills you can always follow Warren Buffet who, through Berkshire Hathaway, owns Wells Fargo, U.S. Bancorp, M&T Bank Corporation, Mastercard Inc., Goldman Sachs, Bank of New York Mellon and American Express.
There are two contrasting conclusions from this article. The first is that banks are undervalued because a PE ratio of 11.58 seems too low for a growing economy and imminent interest rate increases. The second conclusion relates to the fact that if the banks are properly valued, then the low PE ratio indicates a future US slowdown, but then the S&P 500 with its PE ratio of 24.26 is highly overvalued. This discrepancy between valuations of financials and other businesses is pretty strange as one indicates trouble and the other indicates strong economic growth.