Earnings season kicks off this week with the largest banks starting to report third quarter earnings. While we do not have a clear view of the future, we’re pretty good at staring into the past. Consequently, based on recent trends we expect most banks to report positive quarterly results, with the largest banks continuing to lead the parade. We believe the fundamentals driving these expected results remain strong and we do not see any significant risks that could create negative surprises. As always, we could be wrong, but our assessment is based on a number of core factors that all seem positive. Specifically, we expect positive results and trends in a number of financial metrics.
· Net Interest Margins – Most banks of any size have focused on cleaning up and configuring their balance sheets to adapt to a high-interest rate environment. And, while interest margins have come under some pressure over the past few quarters, the decline has not been as precipitous or disastrous as some pundits predicted. As a result of these moves, balance sheet risk has decreased significantly, and banks are now in a position to take advantage of declining interest rates to optimize balance sheet mix and begin seeing increases in Net Interest Margins.
· Funding – We expect a large part of the strengthening of interest margins to come from the interest expense or funding side of the ledger. A primary focus for most banks over the past couple of years has been to both attract and retain adequate funding at a reasonable cost. Consequently, many banks had to exercise strategic and tactical muscles that had been neglected during a period when funding was both readily available and cheap. While it is true that cost of funds has increased industry-wide but it has stabilized recently and liquidity within the industry and most banks has remained at acceptable levels. We expect cost of funds to decrease this quarter and for the foreseeable future, creating strong tailwinds for earnings performance.
· Loan Growth – It appears that the Fed has helped to engineer a soft landing while battling inflation and supporting liquidity requirements. Consequently, the economy has remained resilient and strong, despite many analysts predicting a doom and gloom recessions. We do not currently see any macro risks to the economy and consequently expect to see increased and continued loan growth.
· Credit Quality – One element driving the banking sector’s positive earnings momentum over the past year or so despite some economic headwinds has been pristine credit quality across the industry. Many analysts had predicted significant consequences for those banks that have high concentrations of and exposure to Commercial Real Estate (CRE) loans. In a few instances that prediction has proven to be true (e.g., New York Community Bank), but not generally. Although we continue to see some risk in a couple of lending categories – specifically Commercial Real Estate and Credit Cards – we believe that the risk is manageable and well-understood. The good news, is that a few very high performing banks have seen their stock prices unduly punished because of their CRE portfolios. We believe this may present a potential strong buying opportunity in a few specific companies.
· Efficiency – As banks were combatting Net Interest Margin pressures, tepid loan growth, and expensive funding, many focused on expense management and control to hit earnings targets. Over the last couple of years many banks have invested in productivity-enhancing technology, exited low potential markets and businesses, and adopted more rigorous processes to monitor and control expense levels. We expect that these efforts will yield positive results over the foreseeable future as other fundamentals improve.
How Does the Market Feel?
At the beginning of the year, the banking sector came under increased pressure due to concerns about Commercial Real Estate exposure and further predictions of interest margin declines caused investors to flee bank stocks in search of less risky alternatives. A funny thing happened on the way to the exits, though: none of these dire predictions came through, banking stocks rebounded smartly, and have now caught up with the performance of the broader market. This rebound has not been universal, however, as smaller banks have lagged both the sector and market, overall. As a result we believe a few of these smaller banks (especially those that we have identified as top performers) represent significant upside potential, both relative to the banking sector and broader market. In fact, our two highest rated Super Community banks, Bank OZK and Wintrust, have underperformed over the past few months. If the market continues to be strong we would expect these banks to represent potential attractive buying opportunities.
A Cautious Outlook
While we expect banks to emphasize their positive earnings results, we also expect management to express a cautious outlook based on potential environmental risks. After all they are bankers. These risks include potential political chaos as a result of a very divisive presidential election and further escalation of the conflict in the Middle East, among others. While we do not underestimate the potential of these events to cause some level of economic disruption, we believe the economy is resilient enough to absorb any potential shocks and the market has already priced in some level of environmental risk.
Become a Member
Our members have access to in depth analysis of the industry and selected companies, as well as timely assessments of market trends and performance. To become a member, just click on the “Subscribe” button above It’s fast, it’s fun, but it ain’t free.
Comments