Bank stocks have been lagging behind the broader market. Despite record profits, benefits from the tax cut and strong balance sheets, U.S. bank stocks have underperformed the S&P 500 Index by 15% on average since the beginning of 2018. Although interest rates have been falling recently, they were rising for most of 2018, which should have helped bank stocks. So, why are bank stocks lagging? Below, I outline three telling indicators.
First, I attribute a significant portion of the underperformance to recession fears. The current period of economic expansion will be the longest in recent history if it lasts into the summer. How long can the U.S. economy defy gravity when growth in Europe and China is slowing significantly? According to the Federal Reserve Bank of Cleveland, the probability of a recession in one year is 32.7%, the highest reading since 2008, and investors haven’t forgotten what happened to bank stocks during the last recession.
Second, it is important to consider the shape of the interest rate curve. Conventional wisdom says banks borrow short-term loans to finance lending long-term loans. Therefore, the wider the gap between the long-term interest rate and the short-term interest rate, the bigger the interest rate margin banks can earn. But the gap has been shrinking. On March 15, 2019, the three-month LIBOR rate (a proxy for short-term interest rates) grew higher than the 10-year swap rate (a proxy for long-term interest rates) and has stayed above that level since then. The resulting shape of the interest rate curve has historically been a precursor to recession.
The third factor is the potential disruption caused by technology. These days, banks are becoming less attractive to talent. Fintech companies are increasingly stealing business from banks because bright, young minds don’t want to work for financial institutions that are considered antiquated and could be replaced. Online lending has already become a major player in the mortgage space. We have all witnessed Amazon’s disruption of the retail sector. Could some entity play a similar role in the banking industry?
If there is any consolation to U.S. banks, their European peers have fared even worse. Although Europe’s economic growth has been slowing, European banks have a greater regulatory burden. European markets are fragmented, and therefore at a disadvantage since each country has its own regulations. Still, many blame the banks themselves. Compared to U.S. banks, European banks lack scale and cost-cutting measures. According to the European Banking Authority, their most recent average return on equity (ROE) was a miserable 6.5%. U.S. banks’ average ROE is greater than 10%. These qualities are certainly not rewarded by investors.
Key Takeaway
Since the beginning of 2018, U.S. and European bank stocks have underperformed. U.S. banks are fundamentally strong – their underperformance reflects worries about the future. On the other hand, European banks have some real issues to fix before they can win back investors’ confidence. Personally, I have a more optimistic view of U.S. banks than their current valuation. They are much better prepared for a recession than they were before the 2008 financial crisis. The banking industry is tightly regulated and has a much higher barrier to entry than retail. I prefer banks that maintain diversified portfolios, conduct business honestly and proactively embrace new technologies.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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