In the 85 days since the election of Donald Trump, the KBW Bank Index has risen by around 23%. While that run might feel long overdue for bank management teams, forward earnings estimates for banks have only increased by roughly 8% over the same period. So with the BKX now trading at 15.7 times forward earnings (vs. the historical 15-year median of 13 times), multiple expansion is clearly responsible for the majority of the increase in bank stocks over the past three months.
What’s Driving Market Optimism?
Many observers expect bank-friendly changes under the new administration, and point in particular to potential positives such as a lower corporate tax rate, an overhaul of Dodd-Frank, and lower regulatory costs. While each of these will likely help drive incremental upside to future earnings, investors should focus on two key additional issues: the infrastructure spending program and interest rates. Let’s discuss!
Monetary Policy Wanes
In the wake of the Great Recession, the Fed embarked on a series of monetary easings involving securities purchases from member banks as a means to provide liquidity to capital markets. The program was intended to reduce yields and spur economic growth by pumping money into the economy. While easy monetary policy continues, the benefits have been partially offset by substantial personal and corporate deleveraging. Consider the gap between U.S. bank deposits and loans, which as of January 2017 stood at a record $2.4 trillion. This suggests the expansionary benefits of loose monetary policy are near their limits.
The Transition from Monetary to Fiscal Policy
The election of President Trump–whose campaign rhetoric, recall, called for a package of higher infrastructure and defense spending–suggests a policy shift which recognizes the need for increased fiscal spending as a way to boost economic growth. Outgoing Treasury Secretary Jack Lew said in an interview last year, “There has been a heavy reliance on monetary policy through this recovery. [But] I think that fiscal policy taking an equal billing is a significant move forward.” While the timeline of Trump’s $550 billion infrastructure plan remains uncertain, the base case of some fiscal expansion supported by a measured pace of rate hikes creates a strong tailwind for the U.S. banking industry. There are three key reasons for this:
- Loan Growth. With GDP growth running at an annualized rate of 2.1%, half the average of the typical postwar expansion, the current recovery has been one of the slowest on record. The administration’s economic plan aims for GDP acceleration to the 3%-to-4% range, driven in part by fiscal stimulus and tax cuts. Although the timeline for implementation remains unclear, it’s reasonable to conclude fiscal stimulus is on the way. Meanwhile, consumers and business confidence rose sharply in the weeks following the election, with consumer confidence topping a 15-year high in in January. For banks, that added confidence should provide an opportunity for loan growth as increased confidence should lead increased borrowing and spending.
- Rising Rates. A rising rate environment has the obvious benefit of strengthening most banks’ net-interest margins; however, this is particularly true today because of the amount of liquidity in the banking system. Remember that $2.4 trillion gap between U.S. bank loans and deposits? The bulk of those deposits never made it into the economy, as instead they’ve been parked at the Fed as excess reserves. These excess deposits will not only support loan growth for years to come, but will provide an added benefits to banks with strong deposit franchises, since they’ll be able to resist pressure to raise deposit rates as interest rates rise.
- The low interest environment of the last decade has forced banks to optimize their cost structures. From personnel and branch reductions (and I would argue there is still more work to be done!), to investment in IT (which will enable further cost savings), banks have figured out how to do more with less. This ability to cut costs ahead of modest economic expansion and measured rate hikes positions the industry to benefit from the operating leverage inherent in financials.
My bottom line: while the road ahead may be bumpy, stay the course because I like where this is heading!
What do you think? Let me know!