Equity View: Depressed Banks Present an Opportunity

Summary

• Markets appear to have returned to near-normal after the Silicon Valley Bank crisis and now the Fed meeting.
• But bank equities remain near the lows since the SIVB failure, and the 3-month T-bill is still at flight-to-quality levels.
• Banks are stressed because of uncertainties about future and tighter regulation, further potential problems with commercial real estate exposures, and potential hits to earnings as they raise deposit rates to compete with money market funds.

Market Implications

• We expect the flight-to-quality trade will ease in coming weeks and bank equities – particularly money centre banks – will recover.
• We suggest investors increase exposure to banks such as JP Morgan Chase (JPM) and Citigroup (C).

Watch for Riptides Below That Calm Surface

With the Fed meeting behind us, what stands out after the Silicon Valley Bank (SIVB) crisis is how the broader equity markets have essentially returned to normal (Charts 1 and 2). The S&P 500 dropped 4.5% in the days after SIVB failed but has recovered and is down 1.5% since 3 March, a week before SIVB failed. Concerns about further bank runs have faded for now.

But while things may appear calm, or even normal, riptides lurk under the surface.

The performance of bank-related equities displays this most clearly. The flagship bank ETFs KBWB (all banks) and KRE (regional banks) are down about 27%, about flat with the days after the SIVB takeover. Major money center banks Citigroup (C) and JP Morgan Chase (JPM) and are down 10.5% and 14.7%, respectively, and are also slightly down since 10 March.

In the rates market, the 2-year Treasury is now pricing in a Fed pause or even an outright end to further rate hikes. The 3-month T-bill, normally the key indicator of upcoming Fed policy, is still trading near 4%, about 100bp below its pre-crisis level. This is not a market pricing in aggressive future Fed cuts – it is a market still in full-fledged flight to quality.

In short, while the initial panic has subsided, the banking sector is still in crisis mode. Investors remain extraordinarily concerned about what might come next.

Why Bank Equities Are Still Down

The broader equities market is confident the Fed will cut rates before the economy falls into recession – a growing threat as banks appear likely to restrict lending further. A slower economy will hit earnings, but lower rates mean a lower discount rate on future earnings.

The banking sector, on the other hand, faces several hurdles.

First, many more banks are likely in a similar situation as SIVB, with underwater bond portfolios and losing deposits. Regulators have made implicit assurances that uninsured deposits will be covered – although vigorous debate continues about whether this should be made more formal. The Fed is also providing liquidity on generous terms.

For now, these steps appear to have stanched the deposit outflow, reducing the risk of having to sell bonds at a loss. But apart from the uninsured deposit issue, government money market funds offer substantially higher rates than most banks. As current CDs and other term deposits mature, banks continue to face the risk of losing deposits unless they raise rates – which will hit net interest margins.

Second, the regulatory failings that led to the SIVB and Signature Bank failures may well lead to tighter oversight and regulation, which will further hit profitability.

Third, there remains much uncertainty about bank exposures to commercial real estate mortgages, and whether there is another crisis brewing here. Mortgages are accounted for at book value with no requirement to report market values. Issues here will not show up until property owners start failing to make payments and delinquencies rise. Given ongoing reports about high vacancy rates in some markets due to people working from home, it seems a matter of time before some banks start reporting losses on commercial real estate holdings.

Major Banks Are Attractive

We think bank equities are already pricing in a lot of bad news. We suggest increasing holdings in the major money market banks such as JPM and C. These banks are already heavily regulated and less likely to see capital or regulatory demands raised significantly.

As markets continue to settle down (as indicated by the 3-month T-bill returning to a more normal level vis-à-vis the 2-year Treasury), we expect banks generally and major banks especially will outperform the S&P 500 (SPX). 

More conservative investors may consider long/short positions: long banks, short the SPX via the SPY ETF.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)