Stock market investors have been blessed by the artificially low interest rates dating back to just after the financial crisis of 2007- 2008. The easy access to cheap money has allowed Corporate America to load up on massive amounts of debt in order to grow their businesses, invest in their employees, and launch stock repurchase programs that send share prices soaring. This environment of low interest rates has forced investors out of safe assets and into the stock market in search of high returns, driving up stock prices into near bubble territory.
It is known that the biggest consumer banks such as JP Morgan Chase ($JPM) Wells Fargo ($WFC) and Bank of America ($BAC) have been growing their deposits at a much faster pace than the rest of the players in the industry, as pointed out in Barron’s “ Rising Rates Create Winners and Losers”. As interest rates rise the banks mentioned above should benefit the most due to the fact that they will now start earning more on the high cash balances they hold. However when you factor in the 2.7% year over year increase in the consumer price index; rates are still negative. The Federal Funds rate target is currently targeted between 2% and 2.25%. My attention is not on the increasing interest rates as much as it is on the yield curve.
As we head into Q4 2018 and Q1 2019, the probability for a yield curve inversion is growing. I expect the curve to be inverted by mid-2019 and this means trouble for the large banks. Banks tend to borrow short and lend long and as the curve becomes flat or even worse becomes inverted earnings will start to deteriorate. As the spread between the 2 year and the 10 year becomes flat earnings will start to suffer and banks will become less profitable, lowering earnings targets. Even though many of the banks posted positives earnings reports this past week it is important to have a world view 6 – 12 months in the future. In addition to the risk of an inverted yield curve, banks will also need to monitor default rates and their exposure to bad debt.
This past week U.S. consumers now owe a record $4 trillion spread between student loans, auto loans, and credit cards. This past earnings season many banks posted a healthy increase in credit card borrowing with JP Morgan seeing a 5% increase and a 4% jump at Citi Group. As interest rates rise going into 2019, it will get increasingly harder for corporations and consumers to service their debt and perhaps lead to higher default rates. The good news is that the economy is humming along with the unemployment rate at record lows last seen during the Vietnam War. Americans by and large are employed and making more money (due to hours worked) allowing them to take on more debt and comfortably service it…. For now. I would like to think that we are very late in this economic cycle and the further we head into 2018 and 2019 the more worried I become. The Trump stimulus fueled by tax cuts and increased government spending should start to dwindle by mid-2019 and with debt at record levels and corporations leveraged to the max this could spell trouble not only for banks stocks but for the economy as a whole.
The outlook is worse for European banks especially those exposed to large amounts of Italian debt. Notably Deutsche Bank ($DB) due to the fact that they have credit default swap (CDSs) exposure of 2X global GDP. At this point there is only one way for this to end for the once top dog on Wall Street. With Brexit problems in March and a looming Italian debt crisis European equities do not look attractive at the moment. Perhaps a short set up on EUR/USD will present lucrative opportunities in the near future in addition to short exposure to European Construction and Real Estate through iShares STOXX Europe 600 Construction and Materials ETF as well as iShares STOXX Europe 600 Real Estate ETF.
In the past rising rates have been a positive for banks, but this time due to the fact how far along we are in an economic cycle on top of a narrowing yield curve the outlook does not look as bright. At least in my opinion. Specifically I am looking to target $GS, $MS and XBD Broker Dealer index, $AMTD, and $ETFC.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in MS, GS over the next 72 hours.
Additional disclosure: In and out of Put Options and spreads across the board XBD broker dealers and targets listed in the article