The markets are pricing the Federal Reserve (Fed) to raise interest rates in the wake of October’s employment report, which showed vibrant job creation and accelerating wage growth. As of Nov. 11, Bloomberg’s World Interest Rate Probability function suggested a 68% probability of a rate hike as soon as Dec. 16.1The high probability of a rate hike is underscored by the recent surge in the two-year Treasury yield, which jumped from a low of 0.55% on Oct. 14 to a recent high of nearly 0.88% on Nov. 11.1
Bank stocks have been among the biggest beneficiaries of interest rate prognosticating. Since Fed Chair Janet Yellen testified in front of Congress in early November and left open the door for a rate hike, bank stocks have generally outperformed. Between Nov. 3 and Nov. 11, the PowerShares KBW Bank Portfolio has outpaced the S&P 500 Index by 4.13%.1
Looking ahead, I believe there are a number of reasons for investors to be optimistic about bank stocks.
Margin expansion – Historically, bank stocks have often displayed a positive correlation to interest rates. As the Fed begins to normalize monetary policy, higher interest rates could feed through to increased bank profitability. The Taylor Rule uses targeted inflation and unemployment numbers to gauge the equilibrium level of the fed funds rate. Right now, the Taylor Rule argues for a fed funds rate of just below 3.00%. This compares with a current targeted fed funds rate of 0.12%.1 Clearly, the Taylor Rule indicates there is plenty of room for the Fed to boost interest rates.
The relationship between net interest income (the difference between interest earned and interest paid by banks) and the fed funds rate isn’t perfect, but year-over-year net interest margins expanded when the fed funds rate rose sharply in 1987, 1993, and 2003.1 Net interest income has already started to creep higher, but could get an added boost if the targeted fed funds rate rises.
Entering a sweet spot – Banks could be entering the sweet spot of their profit cycle, with rising net interest margins likely to be complemented by low default rates and low loan-loss provisions, in my view. The Federal Deposit Insurance Corporation (FDIC) reports that the ratio of non-current loans (loans at least 90 days past due) as a percentage of total FDIC-backed loans was down from over 5.0% in 2010 to less than 2.0% in the second quarter of 2015. This level is nearing pre-financial crisis levels, which generally hovered below 1.0%.2
Inexpensive valuation – Bank stocks are inexpensively valued relative to the S&P 500 Index. In fact, price-earnings multiples for many bank stocks haven’t expanded much since the 2008/2009 financial crisis. With an improved profit outlook, there is room for multiple expansion that would lift the price of bank shares both outright and relative to the broader market.
Credit demand is strong – Demand for credit and corresponding growth in lending are both robust. Commercial and industrial (C&I) and real estate loan growth are expected to grow at a brisk pace in 2016 as well. As of the end of October, C&I and real estate lending were up 10.9% and 5.2%, respectively, on a year-over-year basis.3 As shown in the chart below, both measures are near their post-recession highs and highlight a healthy demand for credit, which should benefit bank profitability, in my view.
What are the risks to bank stocks?
Although tightening labor markets are likely pushing the Fed closer to a rate increase, the current environment is not without risk. Growth in US industrial production has been slowing, and Europe is seeing ongoing political instability – including a leadership change in Portugal, an upcoming election in Spain, terrorist attacks in France and protests over economic policy in Greece. Political risks in Europe are difficult to quantify, but they could inflame credit stress and reduce risk appetite to the detriment of global economic growth.
It is unusual for the Fed to tighten monetary policy during periods of decelerating industrial production, but the Fed has dragged its feet waiting for clear signs of wage inflation, and the services and consumer sectors are helping to carry US economic growth. The Fed is also pushing banks to raise capital to levels that allow for loss absorption, which always has the potential to reduce bank profitability.
After consulting with an advisor, investors looking for an opportunity to invest in bank shares may wish to consider the PowerShares KBW Bank Portfolio (KBWB). Based on the KBW Nasdaq Bank Index, the fund seeks to reflect the performance of companies that do business as publicly traded banks or thrifts.
1 Bloomberg L.P., Nov. 11, 2015
2 FDIC Quarterly Banking Profile, Second Quarter 2015, Volume 9, Number 3 – As of date?
3 Bloomberg L.P., Oct. 30, 2015
Read more Expert Investment Views by Nick Kalivas.