17 November 2019

BAC: Banks Are Losing Their Advantage

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Financial stocks, as a group, have been struggling for many months now. While the broader S&P 500 made a new high in August and September of this year, bank stocks, as a group, did not and remained below their January 2018 peak.

For years, banks were the beneficiary of cheap funding and an artificially steep yield curve. Recently, that has changed.

Bank stocks have been struggling with an increased cost of funding, a flattening yield curve, shrinking assets, and reduced deposits. It is not all bad news as bank stocks had an enormous rally from 2016-2018 on less regulation and lower taxes.

Bank of America (BAC), for example, saw its stock price rise roughly 200% from 2016-2018. Bank stocks, in general, had a one-time repricing due to lower regulation and tax cuts that now have to be "comped" against in 2019. It is becoming increasingly likely that most financial companies will not be able to post strong growth rates against inflated 2018 numbers.

BAC is now essentially in a bear market with shares falling 19.5% from the March high closing level.

There was nothing specifically wrong with Bank of America's reported financial results but they do, in fact, suffer from the same negative trends that are plaguing the financial sector.

First, the reflex of most analysts is to assume that rising interest rates are good for all bank stocks. This is not true.

A steepening yield curve is good for banks but if short-term rates rise and the cost of funding increases, that could be a negative.

In the nine months ended September 30th, BAC posted a 15% year over year increase in total interest income. Rising rates allowed BAC to increase their interest revenue.

On the other hand, however, BAC posted a 48% increase in their interest expense.

Interest expense rising faster than interest income is not good, on the margin.

While, in nominal dollars, interest income is rising faster than interest expense, this is not likely to be the case in 2019.

Most analysts are not forecasting a compression in net interest income although that is likely to materialize in 2019 as short-term interest rates continue to rise, deposits shrink from Quantitative Tightening (QT) and long-term interest rates remain somewhat capped.

Furthermore, BAC only posted a revenue increase of 2% year over year. While net income increased more than that, BAC is not an exception to the banking sector trends which shows attempts at cost cutting to profitability. Reducing operating efficiency is, of course, a positive but cost-cutting to prosperity is not going to yield the same results in terms of share price gains as previous years.

BAC posted a 3% decline in non-interest expense.

A lower tax rate (19% compared to 31%) and reduced expenses was the theme across all bank earnings and BAC was no different.

As net interest income starts to slow more rapidly in 2019, the decline in bank shares will be more than justified.

In the Q3 presentation, BAC claims that the bank is positioned for net interest income to continue to rise given a parallel shift in the yield curve. BAC sees an increase of almost $3B or roughly $750M per quarter in net interest income if the yield curve has a parallel move 100 basis points higher. That assumes the Federal Reserve increases interest rates four more times and the 30-year yield moves up to 4.3% in the next 12 months.

Over the past eight quarters, a parallel shift in the yield curve is not exactly what has happened. Short-term rates have risen rather materially while long-term rates have only drifted higher.

Below is a chart of the quarterly average interest rate for the Federal Funds rate, the 3-month Treasury rate, the 2-year Treasury rate, and the 30-year Treasury rate.

Short-term rates have been moving higher while long-term rates are barely up in the last eight quarters.

When short-term rates move up faster than long-term rates, a flattening yield curve is a result.

Many will say that the yield curve is not at a "dangerous" level yet but that is just an opinion. Rates of change matter. The yield curve is either getting steeper or flatter and a flatter yield curve is less beneficial for banks on the margin.

Due to Quantitative Tightening, the Federal Reserve is draining excess reserves from the banking system. Roughly $1 trillion in excess reserves have been removed from depository institutions.

Again, some may say the nominal level of reserves is still "plentiful" but the rate of change is one of less liquidity and lower reserves.

It cannot be the case that increasing reserves to $2 trillion was a net benefit to the banks but cutting reserves in half is indifferent.

Liquidity is getting tight and funding costs are rising. This is, on the margin, hurting bank earnings and BAC is a great example of that.

On top of rising interest costs, a flattening yield curve and tightening liquidity, the housing market is on shaky ground. Bank CEOs have had to address the problems in the mortgage market.

BAC CEO, Brian Moynihan, admitted to CNBC that the mortgage origination business was slowing from $13 billion last year to $10.5 billion this year. While no crisis or immediate danger appears on the radar screen at the moment, a slowing housing market is adding just another reason why bank stocks, and BAC, are losing the edge they had over the past few years.

Cheap funding is over and banks are finding it more difficult to post accelerating rates of growth without one-off benefits like tax cuts.

Industry trends show that the results out of BAC are not an outlier. Total bank credit reported by the Federal Reserve shows the growth in bank loans and securities is also decelerating.

Bank credit growth is down from 8% to just above 3% in year over year terms.

Real estate loan growth has also fallen roughly 60% to 3.2% year over year.

This data is aggregated by the Federal Reserve and representative of all commercial banks.

Summary 

I want to make it clear that there is nothing systemically wrong with banks today as there was a decade ago and no crisis is imminent. Banks, however, are facing massive headwinds moving into 2019 and the results out of BAC and the rest of the industry show that to be the case.

Banks are going to face a higher cost of capital, a flatter yield curve and a continued drain on excess reserves given the stated path of the Federal Reserve from actions including rate increases and QT.

BAC showed that interest expense is rising significantly faster than interest income. The nominal dollar change is still allowing net interest income growth to be positive but that may change in 2019 as short-term rates continue to rise and the cost of funding continues to increase.

There was a massive run in bank stocks and BAC over the past two years. The headwinds today may indicate that bank stocks simply ran too far, valuations got too extended and now new challenges are on the horizon.

Banks are now repricing to face these new issues that are challenging the industry as a whole.

Bank stocks and BAC may be due for a rally given how sharp the declines have been but over the next 12 months, the group is likely to continue to underperform.

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