2023-11-21 05:59:21 ET
Summary
- Despite all the doomsday pessimism surrounding the regional banking crisis when it peaked in March 2023, the SPDR S&P Regional Banking ETF has outperformed the broader S&P 500 Index.
- Since we initiated our "Strong Buy" rating on KRE, the fund has gained by 19.9% versus 9.9% on the SPX.
- Given a 2- to 3-year investment horizon and a forward P/E multiple of just 8.3x, we still see substantial upside potential for KRE.
- Overall, we think regional banks are in a challenging but generally benign environment that should improve over time. We maintain our bullish view on regional banks and reiterate our "Strong Buy" rating on KRE.
Despite all the doomsday pessimism surrounding the regional banking crisis when it peaked in March 2023, the SPDR S&P Regional Banking ETF (KRE) has outperformed the broader S&P 500 Index ( SPX ) by a substantial margin. Since we initiated our "Strong Buy" rating on KRE in an article titled "KRE: Too Much Fear, Too Cheap To Ignore" on 5 May, the fund has gained by 19.9%, not including dividends. In comparison, the SPX has gained by just 9.9% over the same period, and 18.4% year-to-date.
By any measure, the recent bank failures were not small compared to the Global Financial Crisis ((GFC)) of 2008-2009. As the accompanying chart shows, if we compare the combined total assets of the three regional banks that failed this year, they were just as large compared to the combined bank failures during the GFC after adjusting for inflation.
What made the aftermath of the recent failures much more manageable compared to the GFC was that there was no contagion of losses across the broader banking sector. We share the view that this was mainly because the risks were idiosyncratic rather than systemic in nature. The stock market, however, was overwhelmed by fear of another GFC at the time and regional bank stocks were heavily discounted. Environments in which investing gets uncomfortable, however, also present opportunities for disciplined value investors to be rewarded with alpha.
Indeed, if we were told to select a reliable factor for generating equity returns over time, it would be fear. Many studies have shown that outsized returns tend to be preceded by periods of economic uncertainty and fearful sentiment. The fear factor is really just another disguise of the value factor given that fear is usually what causes quality companies to be priced at deep discounts. Perhaps without the fear factor, it is just more challenging to find deep-value investment opportunities.
So What Is In Store For KRE In 2024?
Now that our bullish view on KRE is doing well, it may be tempting to take profit and lock in those hard-earned gains. However, we prefer to take a longer-term approach to investing. And given a 2 to 3-year investment horizon, we still see attractive gains on KRE to justify maintaining our "Strong Buy" rating for now.
Not only is the U.S. economy unfolding in a manner that is closely in line with our disinflation and soft-landing view (with the potential for a mild recession), but we are also witnessing a normalisation in investor sentiment. Sentiment indices such as the CNN Fear and Greed Index have been swinging between extreme levels of fear and greed since last year, but there has been a general stabilization in sentiment in recent weeks as the U.S. economy as well as corporate earnings continue to exceed expectations.
Similarly, the University of Michigan Consumer Sentiment Index is recovering meaningfully from the historic lows recorded in June.
Although higher interest rates have resulted in an increase in provisions for non-performing loans as well as higher funding costs, the challenging economic environment has not significantly undermined the performance of regional banks. This is in part due to increased regulatory scrutiny and oversight of risk-taking across regional banks. The irony here is that the more regulators scrutinise these banks, the more conservative and lower in risk they become. This partly explains why KRE is no longer priced at "crisis" levels. Because there really is little evidence to suggest that recent bank runs would be contagious or that any banking crisis may be on the cards.
The Worst Is Over And Mostly Priced In
Despite the resilience of regional banks in the months following the wave of regional bank failures, rating agencies have nonetheless downgraded several banks.
Moody's downgraded 10 banks including Commerce Bancshares ( CBSH ), BOK Financial ( BOKF ), M&T Bank ( MTB ), Old National Bancorp ( ONB ), Prosperity Bancshares ( PB ), Amarillo National Bank, Webster Financial ( WBS ), Fulton Financial ( FULT ), Pinnacle Financial and Associated Bank ( PNFP ). Additionally, six other banks have been placed under review including BNY Mellon ( BK ), Northern Trust ( NTRS ), State Street ( STT ), Cullen/Frost Bankers ( CFR ), Truist Financial ( TFC ) and U.S. Bancorp ( USB ).
S&P Global also downgraded ratings for The Associated Banc-Corp ( ASB ), Comerica Inc. ( CMA ), KeyCorp ( KEY ), UMB Financial Corp ( UMBF ), and Valley National Bancorp ( VLY ). Adding River City Bank ( RCBC ) and S&T Bancorp ( STBA ) to negative watch.
We believe that the worst has already been priced into the stock prices for many of these banks and that investing in KRE would achieve the diversification needed to manage idiosyncratic risks. More importantly, we view this as an attractive opportunity for valuations to catch up to the broader market as sentiment recovers. This is likely to continue in the coming months and should accelerate when the Federal Reserve eventually embark on monetary normalisation.
At a forward P/E multiple of just 8.3x, we still see substantial upside potential for KRE in 2024.
The Real Risk To Watch Is In Commercial Real Estate
The main risk to our bullish outlook on KRE is likely to come from regional banks' concentrated exposure to commercial real estate loans . According to data compiled by Bloomberg, regional banks have substantially increased their exposure to commercial real estate loans in recent years.
Admittedly, the outlook for commercial real estate remains uncertain as many companies and employees remain reluctant to return to their offices. We also suspect that as companies and employees grow ever more accustomed to the partial work-from-home policy, it is more likely that such policies will remain permanent.
Having said that, we also believe that as time passes without the commercial real estate sector escalating into a blown crisis, regional banks will be able to better manage and reduce their risk exposure to the sector. There is growing optimism that having survived the deposit flight earlier this year, regional banks are now in a great position to roll some of their maturing loan book into higher-yielding assets. With larger lenders facing increased scrutiny and higher capital requirements by regulators, we are also witnessing a surge in private credit growth. We see this surge in private credit as another factor that will help alleviate stress in commercial real estate.
In terms of monetary policy, we maintain our view that the U.S economy will continue to cool in H1 2024 with a small chance of a mild recession should the Federal Reserve hold its policy rate beyond June 2024. Market consensus is expecting the Federal Reserve to begin cutting rates in June 2024. This is generally in line with our view, although we do see the chance for an early rate cut in March.
Overall, we think regional banks are in a challenging but generally benign environment that should improve over time. We maintain our bullish view on regional banks and reiterate our "Strong Buy" rating on KRE.
For further details see:
KRE: Fear Is Profitable