Summary
- 2022 represented a challenging year for the regional banks where their price performance didn’t offer a respite vs. the bear market hitting the major indices.
- The current wall of worry hanging over the banks will be resolved in 2023.
- Bank earnings are poised to accelerate as net interest income and net interest margin benefit from the most aggressive Fed-rate hiking cycle in modern history.
- 2022 represented a challenging year for the regional banks, where their price performance didn’t offer a respite vs. the bear market hitting the major indices (KBW Bank Index -24% vs. S&P 500 Index -19% and Nasdaq -33% in 2022).
- Primary reasons for underperformance in 2022 are ephemeral and likely won’t carry over into 2023. These reasons include AOCI headwinds due to higher rates environment, P/E multiple compression due to recession fears, elimination of M&A premium due to more stringent regulatory review of large bank mergers and evaporation of traditional drivers of fee income.
- Current dividend yield is attractive at 4% for the sector while also providing modest capital appreciation potential.
- Bank NII and NIM benefiting from the most aggressive Fed-rate hiking cycle in modern history.
- Current wall of worry hanging over the banks is the direction of credit costs and that NIM has peaked due to both funding pressures and potential for falling rates in mid-late 2023.
- Top regional bank picks for 2023 include CFG, PNC & MTB.
The broader markets in 2022 generated the worst returns since 2008, as the uptick in inflation forced the Fed to hike the federal funds rate by 425 bps since its March 16 th meeting. This along with the Fed’s transition to quantitative tightening and Jackson Hole rhetoric about a willingness to cause “some pain” has caused the market to sell-off as it awaits future Fed guidance on when the rate hikes will cease or if/when the Fed will pivot. While a rapid ascent in rates is detrimental to risk assets due to investors’ pricing in a higher cost of capital, higher rates are a boon for banks as their net interest margin ((NIM)) and net interest income ((NII)) increase given the ability to earn more on interest rate sensitive assets (e.g., loans, securities and excess reserve balances). Despite the underperformance in 2022, we are convinced that the regional banks are poised to outperform in 2022 and should prove to be a desirable asset class in what will likely be a volatile year for the economy and broader markets.
For the purposes of this report, we define the regional banks as a depository institution with assets between $100 - $600 Billion). While we are also constructive on the Big 4 Banks (JPMorgan, Bank of America, Citigroup, Wells Fargo), the additional complexity associated with their more stringent and evolving regulatory capital requirements and the associated regulatory risk leaves us on the sidelines for now.
The universe of regional banks is as shown in the table below:
S&P Capital IQ; Author Calculations.
Current State of the Banking Sector
The past year has presented a quandary for bank investors. While current conditions have been mostly favorable, with higher levels of NII and solid credit quality, the fear of what may occur if the economy enters a recession in 2023 has caused bank investors to stay on the sidelines for the time being. Early in the year, bank stocks jumped out to a +11% return in mid-January but then pulled back sharply (see below chart) as the war in Ukraine escalated and the Fed’s transitory inflation call fell apart and it became clear that the Fed would have to turn hawkish.
The current fundamentals of the regional banks appear solid, as demonstrated by:
- Clean credit quality with low levels of non-performing assets (NPAs) and net charge-offs (NCOs) for the regional banks (see below);
Author calculations. Author calculations.
- Robust reserve coverage that is positioned to be able to accommodate much higher levels of unemployment and stress in the economy. Anecdotally, many of the bank CEO’s have stated at industry conferences that they are reserved for 5% unemployment and 0% GDP growth;
- Modest, but consistent, loan growth, as Fed H8 data shows loan balances up 1.9% QoQ and 12% YoY;
- Higher levels of NIM due to higher rates (see below chart depicting the Fed Funds rate alongside the 2- and 10-Year Treasury yields) and bank asset sensitivity;
Bloomberg Author calculations.
- Solid capital generation evidenced by high double-digit return on tangible common equity ((ROTCE));
The primary issue dragging down bank stock prices has been the massive revaluation lower of fixed income securities holdings due to the spike in interest rates across the yield curve. Banks have most of their bond holdings designated as available-for-sale, which pursuant to FASB ASC 320 results in unrealized gains/losses flowing through AOCI, net of taxes. This has resulted in the following:
- Bank tangible book values ((TBV)) have taken a substantial hit, as AOCI is a component of shareholders’ equity. On average, regional banks saw AOCI decline by $6.3 billion (or $12.82 per share) thus far in 2022.
- Although regional banks have generated high returns on capital which is accretive to TBV, it has been more than overshadowed by the drastic decline in TBV precipitated by negative AOCI marks.
- As Price/TBV is a primary valuation metric used to value banks, the hit to TBV as a result of AOCI has been magnified as the average regional bank trades at 2.0x TBV. As shown in the below chart, the average regional bank saw its share price drop by 31% solely as a result of a lower TBV.
For further details see:
Bank The Dividend Yield And Look For Incremental Upside In Regional Banks In 2023