2U.S. 2019 Banking Outlook
Inversion of yield curve is a good predictor….. The 10-2 year Treasury yield (2s10s) spread is currently at its lowest level since June 2007. A yield curve inversion does not cause a recession but it has been an uncanny leading indicator to a recession. Of the last 9 recessions post-WWII, yield inversion has predicted 7. Historically, the time lag between a yield curve inversion and recessions have been highly variable. As seen from Figure 4, it was 13 months for the 1990 U.S. recession, 8 months for the dot-com crash in 2000 and 16 months for the Global financial crisis (GFC). On average, recession begins 15 months after a yield curve inversion. Given that the yield curve has not yet inverted, it is unlikely that a recession will occur next year.
…..but unlikely for next year. Short-term interest rates are mainly affected by the Federal policy rates, while the long-term interest rates are a factor of market supply and demand of U.S. Treasuries. We believe the current flattening of the yield curve has peaked. The Fed is rolling US$500bn off its balance sheet. This will remove a major captive buyer for Treasuries. On supply, the larger fiscal deficit due to the tax reforms would cause increased issuance of U.S. Treasuries. Moreover, Figure 7 shows that the yield spread between U.S. Treasuries and other major reserve currencies (German, Japanese and Swiss) has widened over the years and at a 18-year high. This central bank intervention has been a major foreign demand driver for U.S. Treasuries. It is worth noting that there is inconclusive data to suggest that the inversion of the yield curve will lead to a downward spiral for the performance of banks. As shown in Figure 5, the correlation between the yield spread and performance of large-cap banks is low. Share prices of banks continue to soar in periods of declining yield spread.
Deposit costs will rise at a faster rate, but would be offset by faster loan repricing and low demand for deposits. Back in early 2016, depositors were paid zero interest rates on their deposits and they hardly switch banks. However, depositors are becoming increasingly rate sensitive as they digest the 9 consecutive interest rate hikes. They are more likely to switch their deposits into higher yield products. As seen in Figure 1, the increase in 30-day commercial paper (30DCP) rate is twice as much as that in the previous interest rate hike. Average cost of deposits for large banks have increased 9 percentage points since 1Q 2017. According to the 2018 U.S. Bank Market Report by Standard & Poor’s, banks are passing about 25% of the increase in Federal funds rate to depositors, compared with less than 5% in early 2016. However, banks have accumulated huge amount of deposits after the 2008 GFC. The loan-to-deposit ratio for large-cap banks remains low at 63%, while the industry standard for loan-to-deposit ratio of banks is approximately 80-90%. Coupled with the recent tax reforms, there is less demand for deposits as banks have excess capital to make new loans. Therefore, deposit rates are scheduled for a catch-up, but the repricing gap is unlikely to narrow with loans being repriced in months and deposits repriced in years.
Auto and mortgage loans to pick up, while capital spending of small business will drive C&I loan growth. As the 10-year Treasury yield is closely linked to both the mortgage and auto loan rates, moderate rise in Treasury yields next year will translate to higher finance rates and reduced affordability for new car and homeowners. However, macroeconomic factors such as low unemployment, rising real wages and rising consumer sentiment will likely drive mortgage and loan origination growth in 2019. In terms of C&I loans, small businesses will drive C&I loan growth as they remain upbeat about the economy. According to the NFIB Business Optimism Index, small businesses’ outlook for expansion in 2019 is up 7.4% YoY while the percentage of small businesses with future capital expenditure plans is up 11.5% YoY.
Overall asset quality remains healthy. Following the Dodd-Frank Act signed in 2010, asset quality for banks has improved steadily. Non-performing loans ratio has been steadily declined from 7.5% in 2010 to 1.58% in Q3 2018, while charge-off rates is stable at a low level. It is likely that the U.S. banks will continue to pull back from risky loans next year amidst
clouded market outlook. In fact, banks have been tightening credit loans. According to the New York Fed’s Survey of Consumer Expectations Credit Access Survey, the proportion of respondents who had an account shut down by a lender was the highest since the survey was launched in 2013. In October, 7.2% of surveyed consumers reported having an account involuntarily shut down in the previous 12 months, up from 5.7% last year and 4.2% in 2016. Rejection rates for credit cards are 21.2%, well above the October 2017 figure of 15.7%.
Banking sector is currently undervalued and cheap compared to other sectors. Both the Price-to-earnings (P/E) and Price-to-Book (P/B) Ratio for the US banking sector is currently
below its one standard deviation and the lowest since 2013 and 2016 respectively. It currently has the lowest P/E and P/B ratio of all sectors. The P/E ratio and P/B ratio of financials are currently one of the lowest besides industrials and materials, despite having a respectable EPS for 2018. Therefore, we believe that the US banking sector is presently oversold and is expected to trend higher in the upcoming year.
We are calling OVERWEIGHT on the U.S. Banking Sector and including it as one of 2019 sectors to focus. The flattening yield curve is one of the main reason for the recent sell-off of US bank equities. However, we believe that the market correction will be short-lived as the downward yield curve trend reverses next year. Funding costs, moderate loan growth, and favourable asset quality will contribute to a steady EPS growth for US banks. As banks return to health from the recent fall, massive capital return plans approved by regulators should provide comfort to investors. Valuations are attractive and currently at their 25-year lows.
Some of the ETFs with exposure to the US banks include: Invesco KBW Bank ETF, First Trust Nasdaq Bank ETF, Direxion Daily Financial Bull 3X Shares and ProShares Ultra Financials.
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Edmund covers the US Market Strategy. He was previously a risk transformation consultant in the Big Four.
He graduated with a Bachelor of Accountancy (Honours) with a major in Finance from the National University of Singapore.
