Why bank stocks still have plenty of upside

Michael Nagle/Bloomberg

After a bruising 2023 in which bank stocks dropped on multiple occasions and struggled to sustain momentum, lenders' shares have recovered ground in recent months.

But bank stocks are treading lightly and may need further signals from the Federal Reserve that interest rate cuts are in the cards for this year to mount a serious rally.

Henk Potts, market strategist at Barclays Private Bank, said he sees the realistic possibility for "the Fed to start cutting rates in June," but "the path of policy still remains very data dependent."

The Fed on Wednesday balked at a March rate reduction but hinted cuts are coming. The KBW Nasdaq Bank Index rose more than 2% on the day. Still, while the index is up more than 20% from the lows of March 2023, when Signature Bank and Silicon Valley Bank each failed, the index is ahead just about 4% year to date.

The regional bank downfalls — followed by the failure of First Republic Bank last May — intensified already heated competition for deposits, drove up funding costs and cast a long shadow over bank investor sentiment.

The challenges came atop simmering credit quality concerns following the Fed's efforts over the course of 2022 and early 2023 to drive up rates and counter inflation that surged in the wake of the pandemic and Russia's invasion of Ukraine. Analysts cautioned that, historically, rising interest rates tended to dampen new investments and tilt the economy into a recession. Banks often suffer higher loan losses during downturns.

Bank stocks last year hit their lowest levels since the immediate shocks of the pandemic in 2020.

In recent months, however, federal data showed that inflation, while choppy, has come down dramatically. At a 3.2% annual rate in February, it was barely a third of the 2022 peak of 9.1%. The Fed appeared to tackle the worst of the inflation challenge while avoiding a recession and has paused its rate-hike campaign since last summer.

Yet inflation remains above the Fed's targeted 2% level and the job market, while strong, is not entirely rosy. Companies across technology, finance, media and other industries have announced layoffs early this year, and the unemployment rate ticked up to 3.9% in February from 3.7% the prior month. Job openings also declined.

Robert Bolton, president of Iron Bay Capital, further noted that sizable portions of recent job gains involved lower-paying positions and second jobs.

"There's a lot of unknowns still," said Bolton, explaining why many bank investors remain on the sidelines. "Inflation is not the one and only concern."

On Wednesday, Fed policymakers reiterated prior suggestions that rate cuts were on the horizon, perhaps as soon as this summer. While Fed officials kept their target rate in the 5.25% to 5.50% range, a majority of policy officials projected in a report that three rate cuts were possible this year. They next meet in May and then again in June.

For the near term, however, "the path forward is uncertain," Fed Chair Jerome Powell said during a press conference Wednesday. "We are strongly committed to returning inflation to our 2% objective."

With a higher-for-longer rate policy, the Fed could further cool the job market and the economy. This would help to further drive down inflation, but it would not bode well for loan demand or, potentially, banks' credit quality, Bolton said.

Employers collectively reported six-figure job gains every month last year — and again in January and February of this year. Employers added 275,000 jobs in February, according to the Labor Department. But the pace has slowed. The economy created 353,000 jobs during the first month of this year.

The pace of economic growth has also eased. Gross domestic product advanced at an annual rate of 3.2% in the fourth quarter, down from third-quarter growth of 4.9%, according to the Commerce Department.

"With the U.S. economy posting two consecutive quarters of 3%-plus GDP growth, recession calls have quieted down," said Larry Adam, chief investment officer for Raymond James.

Community banking

Deepening downturn in U.S. agriculture economy red flag for banks

February 23, 2024 12:30 PM

But, he added, "there have been some warning signs over the last few months that suggest growth could slow. … While the labor market is on solid footing, cracks are forming."

The Atlanta Federal Reserve projected first-quarter GDP growth of just over 2%.

Piper Sandler analyst Scott Siefers said that the latest weekly Fed data, covering the week that ended March 8 for the banking industry, showed deposit stability but loan growth of just 2% from a year earlier. Lending, he said, "is simply bobbing around a very weak level."

From an investor perspective, Siefers added, "as the year marches on, it becomes increasingly important for bank loan growth to inflect upward to meet existing expectations" for stronger interest income and profitability in 2024.

"But realistically," he added, "lower rates and better macro clarity may be necessary to make this a reality, reinforcing the notion of how heavily tied this group's fortunes are to factors outside banks' direct control."