Are U.S. Banks Poised To Outperform?

| About: SPDR S&P (KRE)

Summary

The U.S. banking sector has soared in the post election period with talk of tax cuts, deregulation and infrastructural spending. Markets have sketched out anticipatory new highs.

Yields have soared and prices weakened in the wake as the election has spurred a seismic shift from bonds to equities. Inflation expectations lag current yield gains.

The dollar continues to strengthen as dollar-based assets act as a magnet for global capital flows as the yen, the pound and the euro sketch out new lows.

With expectations for stronger economic growth through a combination of higher levels of government spending, tax cuts and a push back on regulation, investors have sent leading U.S. benchmarks to new market highs last week. The last time the Dow Jones Industrial Averages, the S&P 500 and the Russell 2000 all simultaneously sketched out new market highs was on the last market close of the year in 1999. The reflation of the U.S. economy in wake of the Mr. Trump's surprise Electoral College victory has drawn funds into dollar-based assets like a magnet as the yen, the euro and the pound eke out new year-to-date lows against the high-flying dollar. The interest rate sensitive yield on the 2-year Treasury note has surged from 0.78% to 1.115% through Friday's market close-its highest post since the spring of 2010, while the yield on the 10-year Treasury note jumped just over 50 basis points over the same period. As if rendering commentary on the growing divergence between the rising economic fortunes of the U.S. with those of ever sclerotic Europe and Japan, the yield spread between the U.S. 10-year and that of either 10-year German Bund or the Japanese benchmark note at Friday's market close is at its widest level in a generation as borrowing costs the world over and U.S. equity shares surge almost in syncopated time.

Has the long anticipated breakout from below trend economic growth-at least in the U.S.-finally begun? Is it time to chant the last rites of the three-decade old bull-run in bonds as the reflation of the economy sets off a seismic shift from fixed income to equities? Is it time to cleverly steer an investment course between the seemingly offsetting Scylla of reduced global growth brought about by U.S. protectionism and plummeting world trade volumes and the Charybdis of tax cuts, deregulation and infrastructural spending? Investors are clearly celebrating the second part of this contradictory sentence and jumping at the possible economic vim that could be created-as expectations tilt decidedly to the upside. Congress and the Federal Reserve could prove to be decisive impediments to such a debt-fueled economic boom.

Figure 1: Selected Ratios and Growth Measures

East West Bancorp, Inc. (EWBC)

Signature Bank (SBNY)

PacWest Bancorp (PACW)

Commerce Bancshares, Inc. (CBSH)

S&P BMI Financials Index

Market Cap (NYSE:B)

6.73

7.51

6.05

5.53

P/E

16.74

20.68

17.93

21.79

14.57

Price/Book

2.36

2.31

2.68

2.32

1.23

Yield %

1.68

3.85

1.55

2.35

YOY EPS Growth %

5.85

5.99

-3.87

4.13

ROE %

12.80

12.07

8.24

11.01

9.04

LT Debt/Equity

5.66

7.20

21.62

NPL through 2nd Quarter

0.84%

0.57%

0.02%

1.42%

Click to enlarge

Source: Schwab Research, Ned Davis Research and FDIC data.

Let's shift gears and turn to one of those sectors of the economy that is experiencing a feast or famine moment as the current economic cycle unfolds. At present, investors clearly view banking issues large and small in the former category as Mr. Trump's agenda slowly takes on a bit more form-an agenda that still is astonishingly sparse in substantive policy detail. Small and regional bank shares have spiked since Mr. Trump's upset electoral victory in the U.S. presidential elections, captured by the PowerShares KBW Regional Banking Portfolio ETF (NYSEARCA:KBWR) which was up just over 11% through the market close on election night. Since the U.S. election, KBWR is up almost 20%. The ETF's four principal holdings include California-based East-West Bancorp, New York-based Signature Bank, Oregon-based PacWest Bancorp and Minnesota-based Commerce Bancshares, portrayed in Figure 1, above. EWBC is up almost 18% through Friday's market close-with all of that gain coming since the election. Signature Bank started the year at a share price of $145.68, experiencing a choppy year through an election eve close of $123.78, almost a 15% loss for the period. Since the election, Signature Bancorp has soared just over 23% to Friday's market close of $150.21. PacWest Bank logged a 1.57% return through election eve only to soar 21.33% through Friday's market close. Commerce Bank was the strongest performer through the first Tuesday in November, logging an above trend 19.77% gain over the period. Its post-election surge came to 16.21%.

There is little in the selected ratios and measures of Figure 1 (above) that dramatically stands out to justify such a post-election surge. Commerce Bank has the lowest market cap and the highest P/E ratio but also is encumbered with the largest non-performing loan portfolio of the group. The bank sports the second lowest yield and price to book ratio and the third lowest return on equity ratio, though still outpacing that of the S&P benchmark for the sector. Commerce Bank posted the third worst year-over-year earnings-per share growth rank of the four-group survey, outpaced only by the negative post logged by PacWest for the period. That post likely reflects the outsized long-term debt to equity measure through the end of the 2nd quarter. Only Signature Bank pays no dividend. The ratios and measures in Figure 1 are arguably consistent with a banking sector that has endured the past eight years in a low interest rate environment that largely flattened out the yield curve. Return on equity ratios have suffered across the board while price-to-book ratios have withered in the wake of the onslaught as non-performing loan portfolios swelled during the dark years of the financial crisis and investors still look askance at portfolio holdings. The FDIC percentage of non-performing loans outstanding through the end of the 2nd quarter clocked in at 1.49%-a vast improvement on the 5.46% high logged in the 1st quarter of 2010 and well below the long-term average of 1.97% on data from 1984 through the peak of the housing bubble through the 1st quarter of 2006.

There is little doubt that rising interest rates will help small- and mid-sized banks earn more on their loan portfolios as the yield curve steepens and the fact appears not to have been lost on investors since the election. More relief for mid- and regional-sized banks will come from Congress who is likely to raise the threshold for mandatory annual stress testing by the Federal Reserve to $250 billion from the $50 billion threshold that is currently in place. The move will allow banks to return more of their retained earnings to shareholders through enhanced and one-time dividend payouts as well as free up funds for lending to both businesses and households at the local level. (Share buyback programs will become more problematic as the cost of borrowing increases.) Little surprise here: The general thrust of regulatory easing of a Trump-assembled supervisory team is likely is the offing.

Mr. Trump was vociferous in his criticism of the Dodd-Frank Act of 2010 during the campaign. The Obama Administration's approach to rectifying the abuses that emerged from the financial crisis tilted toward the punitive and Dodd-Frank augmented the approach. Mr. Trump's regulatory approach, while again astonishingly short on policy detail, will likely diverge markedly from such a path. The regulatory reach of the Act is far from finished as almost a third of its rules have yet to be written. Yet its current reach into the financial sector is so omnipotent and the billions in compliance costs that have already been spent to meet the dictates that are already in place likely mean that to unravel the Act completely will take years and likely decades to accomplish-if then. Still, the old adage that legislators legislate and bureaucracies carry out those mandates rings true: Rules are only as effective as the agencies mandated to carry out the enforcement of such rules. The president appoints the heads of each of the agencies charged with the implementation of Dodd-Frank-the SEC, the Department of Labor, the Justice Department, the vice-chair of regulation at the Federal Reserve, the entire board of the Financial Stability Oversight Council and the director of the Consumer Financial Protection Bureau. The power of appointment can quickly change the agenda of these bodies-a point not lost on investors. Markets have so far responded favorably.

The bond market has most certainly taken these issues to heart. The bond world is binary by nature as events are judged in either inflationary or deflationary terms. The surprise Trump victory in the Electoral College firmly cemented the event in the inflationary column. Talk of tax cuts and infrastructural spending without offsetting spending cuts-however lacking in policy detail-is possible only by increasing the supply of government debt. Unsurprisingly, Treasury yields have leapt forward since the election as bond markets determine the new level of term premia that is needed to compensate for the increase in risk that investors will have to shoulder to hold government debt. The 10-year term premium had moved above zero for the first time in 10 months, according to data from the Federal Reserve Bank of New York-days after the election results were known. The yield on the 10-has leapt just over 27% through Friday's market close to 2.359%. The last time the term premium increased with such magnitude was in June of 2009 when GM declared bankruptcy and a possible government financed buyout of both GM and Chrysler loomed large on the horizon.

While bond markets are projecting rising interest rates, inflation expectations have proved to be more of a lagging indicator well behind the current pace of increasing yields. The Federal Reserve meets in December. Along with an increase in the federal funds rates that is now almost certain, the Committee will publish its projections on inflation for the immediate and medium term. Any sizable uptick in government spending on infrastructure, especially given the ever decreasing levels of slack in the labor market as well as in industrial capacity utilization and production, will likely push prices in the greater economy higher. Higher prices will most certainly bring about an aggressive response from the Federal Reserve and quicken the tempo of rate increases for 2017 and beyond.

The strength of the dollar will also hold sway over many of the economic decisions under active consideration. The much estimated cash hoard that U.S. corporations hold abroad is now well over $2 trillion dollars. With Republicans now in control of both branches of government, a replay of the Bush-era Homeland Investment Act of 2004 is considered one of the lowest of the available hanging fruits for possibly offsetting revenue losses from tax cuts as well as enhanced governmental spending on infrastructural projects. Under the one-time cut outlined by the Act, the IRS estimated that more than $360 billion was repatriated, driving the dollar up almost 13% against a currency basket through the end of 2005. The Federal Reserve responded by increasing the federal funds rate from an effective low of 1.03% in June of 2004 to an effective rate of 5.24% by July of 2006. While the motivating feature of the Act was to create jobs and promote capital investment, subsequent research by the National Bureau of Economic Research (NBER) found that much of the repatriated funds went toward shareholder enhancement programs like dividends and buybacks underscoring the age old premise that corporate profit motives and public policy interests often diverge at critical junctures.

While Republicans control of both houses of Congress, there is no certainty that fiscal conservatives will be any more receptive to infrastructural spending program that is not offset by spending cuts than they have been in the recent past. The Budget Control Act of 2011 and sequestration were concerted efforts to match future government discretionary spending with offsetting cuts. Fiscal conservatives and deficit hawks brought the U.S. government to the brink of default over the issue of unfunded discretionary spending. Recorking that bottle will be a difficult row to hoe in Congress-even for a Republican President.

Internationally, the impact of Mr. Trump's victory is even more of an unknown. Yield on euro-zone corporate bonds soared to levels last seen in the wake of the Brexit vote, largely erasing the efforts of the ECB to directly lower corporate borrowing costs across the euro economic landscape in hopes of stimulating corporate investment. Yields strengthened and prices weakened even further as political risk intensifies with the upcoming national constitutional referendum in Italy. The spread between Italian and German government bonds, currently at 1.90 percentage points is the highest in two years-despite an €80 billion per month asset purchase program by the ECB. A 'no" vote in next week's constitutional referendum and a subsequent resignation by Mr. Renzi government will certainly elevate the political risks in the country. Investors have halved the value of Italian banks year-to-date as the banking system desperately plies for new sources of capital to lower its exposure to an estimated €360 billion in nonperforming loans. New EU rules regarding the bail-in of bank bondholders is highly controversial in Italy given the millions of small retail holders of such debt throughout the country. Private infusions of capital, such as the deal forged by JPMorgan Chase to recapitalize Monte Paschi-both the world's oldest and most vulnerable bank-is to be announced after the referendum. A "no" vote could put this deal-and most other privately funded deals to recapitalize Italian banks-on tenuous ground in the wake. Curiously, pummeled Monte Paschi has all but become a proxy for the Italian banking system, such as it is.

More political risk is in store a replay of the Austrian national elections that are set for the 8th of December where the first far-right candidate since WWII could be elected president. National elections in the Netherlands, France and Germany round out the spring and early fall of 2017, while the U.K.-EU divorce proceedings are schedule to get under way by the end of March.

The U.S. financial sector is likely poised for further market gains for many of the reasons previously cited. Yet caution should most certainly be exercised lest the exuberance of the moment turn irrational with zeal. Any backsliding on current market expectations due to Congress, the Federal Reserve or even the ability of the economy to absorb further stimulus could unwind market gains to date in very short order. Proceed with extreme caution.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.