Why bank stocks may not be ready to bounce back

Operating conditions for banks are poised to shift notably in 2023 — from a growing economic environment to one defined by the specter of recession, concern about credit quality, and heightened caution around slowing growth and elevated costs.

Investors already braced for this, a development that sent bank stocks tumbling in 2022. Shares of bank stocks continue to trade gingerly at the start of this year. The KBW Nasdaq Bank index is down more than 25% over the past 52 weeks.

To be sure, as the Federal Reserve boosted interest rates several times last year, banks' lending profitability improved, and their net interest margins expanded.

Most analysts expect that fourth-quarter earnings reports, due out this month and early February, will show continued strength in revenue and profits. But analysts also are sharpening their collective focus on the downsides of rapidly rising rates.

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Traders work on the floor of the New York Stock Exchange in New York. With recession looming and loan losses possible, bank stocks have been under pressure.

The Fed vowed to continue to move up on rates with haste early this year to combat surging inflation, given only gradual success to date. The federal measure of consumer inflation topped 9% last June, more than four times policymakers' preferred level. It moderated to 7.1% in November, but it remained higher than at any point since the early 1980s.

Historically, the combination of rapidly rising rates and lingering high costs has tilted the U.S. economy into recession. Downturns, by extension, hamper loan demand and tend to diminish credit quality. Often, borrowers either pull back to avoid problems — slowing banks' growth — or they struggle to make loan payments, resulting in credit losses for lenders.

As such, investors are looking past fourth-quarter earnings and toward the 2023 outlook, "which carries greater uncertainty, particularly around the health of the economy and the impact on interest rates and asset quality," said Keefe, Bruyette & Woods analyst Christopher McGratty.

Raymond James analysts agreed. They noted in a report that rising rates are beginning to push up deposit costs. As this trend continues, it could shrink the margin between what banks pay for deposits and what they earn on loans. This is likely to hinder profits. At the same time, should a recession materialize, banks would have to set aside more in reserves to cover possible loan losses, adding to costs. And this would all come atop the overall lofty inflation that banks and all other businesses waded through over the past year.

"With net interest margins nearing a peak, loan growth slowing from strong levels in 2022, and rising credit costs and reserve builds likely in the coming year, we believe bank stock performance will be volatile in 2023, with the winners and losers determined more by performance (and reputation) than in prior years," the Raymond James team said.

They said banks with diverse revenue streams and low-risk credit profiles are among the best situated to navigate a recession. Lenders with proven histories of weathering downturns with relatively little damage also may be in a favorable spot.

Banks with excess capital could also step into the spotlight, said Robert Bolton, president of the bank investor Iron Bay Capital.

Many banks are sitting on extra capital after years of building buffers at the behest of regulators following the 2008 financial crisis. Bolton said many banks unloaded some of the excess over the past couple years. But others still have plenty of room to return more capital to shareholders via dividend hikes or stock buybacks. While dividends are payments to investors, share repurchases can bolster earnings per share because buybacks reduce shares outstanding.

"I think you could see more of both" in 2023, Bolton said, "and they could be catalysts for those banks."

Mergers and acquisitions are also key, according to Bolton. While M&A proved choppy over the past two years as banks negotiated the pandemic, lenders are eager to gain scale to invest in technology and gain geographic reach.

This likely will drive continued, albeit volatile, levels of M&A this year, Bolton said. Banks able to strike profitable deals could win new support for their stocks, he said. Acquirers are often able to cut overlapping costs from the expense bases of their targets while gaining new talent, business lines or markets that can propel revenue.

"It's all about the cost saves and the revenue drivers," Bolton said.

In the big picture, "inflation — and all the problems it creates — is still a big issue," he said. "We're still feeling it. It's not an easy start to a new year. But there are a lot of banks out there with positive options and levers to pull."

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