There are several reasons for optimism. The fundamental set-up heading into 1Q bank earnings season is generally pretty encouraging, for a number of reasons.
- First, we think banks will report further improvement in asset quality, which will lead to lighter-than-expected provisions and for many, outright reserve release. This continues a very recent trend which started for some banks in 3Q20 and then extended to just about the entire sector in 4Q. From my days as a research analyst, I know that the tendency among the analyst community (myself included!) at the beginning of a trend is not to over-extrapolate based on a small sample size. This holds true even if the consensus thinking is that the trend is likely to continue. In other words, my sense is that analysts have yet to fully incorporate the likelihood of sharp credit improvement into their forward modeling. With that in mind, while improved credit in 1Q isn’t really a surprise to most, the end result is likely to be an earnings tailwind that persists through the rest of this year at least, above and beyond what is currently projected.
- Second, the bulk of PPP forgiveness income from the early rounds of the program should flow through bank income statements in the first half of the year, providing an income boost and temporarily masking the impact of still-low interest rates on bank net interest margins. The next round of PPP, now well underway, should ensure a continuous stream of “bonus” income for the balance of this year.
- Third, capital return is likely to return to the forefront of the discussion. Anecdotally, our sense is that with authorizations resumed or newly in place, banks have been active in repurchasing their stock, a message that is likely to be well-received by investors
- Finally, while net interest margins ex-PPP are likely to have been under pressure in 1Q, the sharp rise in market interest rates and increased steepness in the yield curve is likely to yield more optimistic commentary about the road ahead. This is particularly true for banks that have the loan demand that will enable them to convert excess liquidity into “rocket fuel” to drive future earnings.
All that said, quarterly reports and call commentary are likely to evidence some upcoming challenges as well. Our sense is that loan growth has been weaker than expected so far year-to-date, leading some larger banks in recent weeks to “update” their prior guidance. Slower than expected loan growth for most banks in 1Q isn’t completely unexpected given the still-raging pandemic for a good portion of the first quarter. Therefore, forward commentary will be key as investors look for signs that loan demand is starting to return in sync with what is expected to be strong economic growth in the back half of the year.
With longer-term interest rates on the rise, it may seem obvious that mortgage banking will slow meaningfully at some point. However, our impression is that 1Q results are still likely to be at the very upper end of what we typically tend to see during the seasonally slower 1Q. Perhaps a somewhat surprising development this quarter is the likelihood that most banks will be challenged to show strong growth in tangible book value. This will be due to the mark-to-market adjustment of the available-for-sale investment portfolio which runs through “other comprehensive income” and reflects the sharp rise in market interest rates over the course of the first quarter.
So what does it all mean for the stocks? A good question! In the very near-term, it’s certainly possible that the stocks have moved perhaps a little too far, too fast, and that some consolidation of recent gains is in order. While we’ve certainly had an optimistic view, the upward trajectory for just about the entire quarter has nevertheless been breathtaking, creating some heightened risk that disappointing 1Q results and earnings call commentary could perhaps drive a sharp retraction.
Still, I think it’s important not to miss the forest for the trees. The virus seems to be subsiding with the mass roll-out of the vaccines and the economic outlook is vastly improved. The flood of liquidity seems to have forestalled or perhaps even eliminated the possibility of a severe credit cycle for banks. The interest rate environment is as accommodative as it’s been in several years and we continue to believe we’re on the verge of one of the great M&A waves of the past few decades.
The argument from those that are perhaps less optimistic on the longer-term outlook for the stocks seems to center on the notion that since bank stock prices have mostly regained their pre-pandemic levels, the bulk of the gains has been realized. Our pushback is that while we, like everyone else, look back fondly to “normal” life in December 2019, the operating environment for banks was downright terrible! An inverted yield curve, an easing campaign that was already underway from the Fed, the widespread belief that the economy was on the precipice of a downturn, and the decade-long hangover from the Great Recession that drove soured sentiment on bank stocks from investors were but a few of the many factors contributing to low absolute bank stock valuation levels relative to history. So given that backdrop, why exactly are pre-pandemic bank stock valuation levels considered by some to be a constraint on bank stock valuations today?
Bottom line, we’re still optimistic, and are looking back instead to valuation levels from mid-2018 as perhaps an indication of where we might be headed next.
Joe Fenech is the Managing Principal of SMBT Consulting, LLC, which provides consulting services to banks. The article represents the views and beliefs of Mr. Fenech and does not purport to be complete. The information in this article is provided to you as of the dates indicated and the data and facts presented herein may change. You should not rely on this article as the basis upon which to make an investment decision; this article is not intended to provide, and should not be relied upon for, tax, legal, accounting or investment advice. Mr. Fenech is also the Chief Investment Officer and Managing Member of GenOpp Capital Management LLC, an investment adviser that maintains exempt reporting status in the State of Indiana. Affiliates of SMBT Consulting, LLC may recommend to such affiliates’ clients the purchase or sale of securities of companies discussed in articles published by SMBT Consulting, LLC.
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