Time to Fade That Great Bank Rally

Summary

• Financials, and banks particularly, soared after the US election, gaining a whopping 75% versus 47% for the S&P 500.
• Gains have come as it becomes more likely that banks will avoid the significant losses and loan defaults that many feared last year.
• Any expectations of further outperformance depend on rising rates and burgeoning loan demand as the economy fully reopens.
• However, as long as the Fed’s QE program continues, banks will see net interest margins fall and struggle to grow their loan portfolios.

Market Implications

• Banks will likely underperform if equities rally or selloff.
• Underweight financials ETFs (XLF) and particularly bank ETFs (KBWB, KRE).

The small stock Russell 2000 has had a strong run since the election, gaining 45%. But this pales in comparison to financials and banks particularly, which are up 75% (albeit from admittedly depressed levels). Plenty of reasons exist to think that banks will underperform the broader market and nonfinancials in coming months or more.

How We Got Here

During much of 2019, the major financial and bank ETFs performed roughly in line with the S&P 500, then they lagged somewhat as the tech sector rallied strongly in late 2019 and 2020 (Chart 1)^[1]. When the market crashed in March 2020, financials severely underperformed. Two bank ETFs, covering big banks (KBWB) and regional banks (KRE), lost half their value. XLF, which covers the broader financial sector, was down 43%, and the S&P 500 was (only) down a third (Table 1).

Between March and the election, XLF and KBWB lagged; KRE tracked SPY. After the election, as noted above, IWM and financials soared on hopes that Joe Biden’s victory would soon translate into a robust recovery.

In 2021, IWM stalled. But financials kept soaring, especially once the 10-year yield crossed 1% in early January. Once the 10-year settled into a 1.6-1.7% range, financials have mostly range traded.

In March 2020, the spectre of large-scale loan defaults and losses crushed bank equities. Indeed, during 1H 2020, bank loan loss reserves jumped from 1.2% of loans to 2.25%. However, by the election, it was becoming clear that the federal government support to unemployed people homeowners/renters, and smaller businesses renters and homeowners would likely prevent most of those potential bankruptcies and loan defaults. The rally in financials since the election has been largely repricing bank equities for what will likely be a release of loan loss reserves into earnings in coming quarters.^[2]

So, financials are pretty much back to where they were vis-à-vis the S&P 500 in late 2019.

The Case for Outperformance…

The primary case for continued strong performance by financials is twofold. First is the prospect of rising rates. The idea is that higher rates and a steeper yield curve will allow banks to increase their net interest margins. The problem here is that many bank loans are floating rate with maturities in the one- to three-year range. As long as the Fed keeps the short end of the curve near zero, a steeper yield curve will not help much.

The second hope is that a robust recovery will generate fresh loan demand and thereby add to net interest margins. That, however, is unlikely to happen until the Fed curtails its quantitative easing (QE) program.

…And Underperformance

It will be difficult for banks to make much progress rebuilding their businesses after the pandemic while the Fed continues QE.

Here, briefly, is how QE works. The Fed buys bonds from primary dealers, which are mostly banks. The banks buy bonds from investors and pay for them by creating demand deposits that investors can use to buy other securities. The bank then sells the bonds to the Fed. The Fed ‘pays’ for them by crediting the bank’s reserve account at the Fed. This shows up as an asset on the bank’s balance sheet as cash or reserves. Essentially, the bank receives cash for the bonds and deposits it at the Fed.

What does this mean for lending? Chart 2 shows the cumulative change in banks’ cash holdings and loan portfolios, and the Fed’s total reserve liabilities since 2007. Before the GFC, there was little change in cash balances and reserves, while loan portfolios expanded by $1 trillion. When the various iterations of QE and other support measures started in late 2008, banks’ cash and Fed reserves rose in sync. Meanwhile, loan portfolios shrank for several years. They did not recover to 2008 levels until 2013, largely due to small-scale lending by small banks not involved in QE. Loan growth only started accelerating in 2014, when the Fed started its tapering program.

When the pandemic crisis hit in March 2020, the Fed suddenly resumed large-scale QE, causing bank cash balances and Fed reserves to jump. Amazingly, bank lending jumped too – but soon dropped because banks were acting as agents, making loans on behalf of the Small Business Administration rather than for their portfolios. Lending has stagnated since then.

Banks end up holding a huge amount of cash as a result of QE. But they cannot lend it other than to other banks through the Fed Funds market. The Fed pays a paltry 10bp on reserve balances. Consequently, banks’ net interest margin on earning assets dropped from 3.3% in 4Q 2019 to 2.7% in 4Q 2020. To put it another way, if the resources tied up as reserves and earning 0.1% were deployed as loans, they could be earning a NIM of 3.3%. To make matters worse, banks have to hold capital against their reserve balances. That further constrains them from lending.

In short, as long as the Fed is pursuing its QE strategy, banks’ NIM will decline, and loan portfolio growth will be very sluggish at best – hardly the right mix to fuel a continued rally.

Time to Underweight Banks

We see little prospect that the banking sector can outperform nonfinancials or the broader market until the Fed starts reducing QE. That in turn will depend on how quickly the economy and labour market reopen. Until then, banks are largely on hold, even as most other businesses eagerly ramp up as the recovery takes hold.

And while banks wait, emerging fintech competitors will be looking to make inroads to banks’ businesses. Also, the Fed is finally starting to work on developing a digital currency, which could further disrupt the bank business model. But that is a story for another day.

As long as equities remain in a narrow trading range, financials and banks should perform in line with the broader market. But if (when?) there is a sustained move up or sharp selloff, we expect banks to underperform.

We would underweight financials ETFs (e.g., XLF) and bank ETFs (KBWB, KRE) at this time.

1. Note: The chart shows the price performance of several broad market ETFs. SPY and IWM track the S&P500 and Russell 2000, respectively, XLF tracks the broad financial sector, and KBWB and KRE track large and regional banks, respectively. ↑

2. Under Generally Accepted Accounting Principles, banks are required to hold loss reserves against projected loan losses. If they turn out to be low (as in March 2020), they must be increased; likewise, if they are too high, they must be reduced. The underlying idea is to prevent banks from ‘managing’ earnings by selectively adding to or reducing reserves to meet earnings targets. ↑