(Oct 15): A decade after the global financial crisis, the landscape of the US financial services industry has transformed for the better. Indeed, after the shakeout following the GFC, the existing players have become more efficient and more competitive. The banks are in a better position to help other companies grow and help consumers save and spend.
Healthier banks are not just good for the economy, they are good for investors as well. In fact, US banks are in a sweet spot, where a congruence of favourable cyclical and structural factors makes them a compelling investment.
On the cyclical front, with healthier economic fundamentals, the US Federal Reserve has started the slow and steady process of unwinding its decade-long quantitative-easing programme. The prolonged zero-interest-rate environment is history. From now till June next year, economists see the Fed making scheduled hikes of 25 basis points each quarter. The most recent round of increases was announced on Sept 26.
With higher US rates, some US banks will enjoy higher net interest margins as credit costs, lagging slightly, remain near cycle lows. That aside, additional earnings lift will come from higher levels of borrowings, as both corporates and consumers feel more confident amid the stronger economic environment. Furthermore, US corporate tax rates, cut at the beginning of the year from 35% to 21%, will translate directly into higher earnings. The industry is looking forward to both higher returns on both assets and equity.
The impact of higher interest rates will be felt differently among US banks. Larger banks, with a wider range of products and services such as asset management and investment banking, have a more diversified earnings base.
As small- and mid-cap banks focus more on traditional functions of lending, the effect of variances in interest rates is amplified.
True, interest rates are creeping up. Yet, it is important to see the increase in context: Rates are merely heading back to the norm. The recent years of a low interest rate environment have given companies, especially large corporations, plenty of choices to secure financing. Instead of borrowing from banks, many have relied on the bond markets for long-term funds to refinance or fund expansion.
As a result, the larger banks have yet to see a healthy loan growth despite accelerating economic growth. Yet, smaller banks, with a stronger domestic US focus, are seeing an uptick in loans given to commercial and industrial customers. These companies, in turn, have an additional inducement to borrow: As part of the US tax reforms, companies are allowed to expense some capital investments immediately. The volume of US loan growth, which ranged between 3% and 4% in 2017, is seen to rise more quickly in 2018 (source: Federal Reserve, April 30, 2018; seasonally adjusted monthly data, in US dollars. Total loans and leases in bank credit, domestically chartered commercial banks).
While the tax reforms benefit all US companies, the deregulation of the financial industry is a structural tailwind that benefits US banks even more. For one, the threshold for systemically important financial institutions (SIFIs) has been raised from those with above US$50 billion ($68.8 billion) worth of assets to US$250 billion.
This change, which is part of the widely known Dodd-Frank Wall Street Reform and Consumer Protection Act, is seen to benefit smaller banks more. The practical effect of this revision means banks below this threshold would no longer be subject to onerous annual stress tests. They will be able to reduce their compliance costs and enjoy better earnings.
Thankfully for astute investors, the market has yet to factor in its entirety the combination of all these positive factors. Pegged against historical levels, the valuation of the US banking sector is attractive. In 2014, US banks were trading around 1.5 times book value. That was a period when the industry was grappling with the recent introduction of tighter regulations, as well as a compression of net interest margins.
Currently, the banking industry is trading at about 1.56 times book value compared with a long-term average of 1.82 times book value (source: SNL Bank Index as at Aug 31, 2018. Average since 1992). In short, there is substantial upside to capture.
The US economy is at its healthiest ever in a decade, and US banks are natural beneficiaries.
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