Banking stocks on both sides of the Atlantic and internationally currently look attractively priced. Despite core interest rates rising throughout 2022, something which is usually beneficial to bank valuations because it boosts income from lending, many banks saw their values fall last year.
Among the major UK banking stocks, the Barclays share price fell by a little over 15% in 2022 while Lloyds returned a loss of 5% for the year. Spain’s Santander, a bank with a major high street presence in the UK also saw its valuation slide last year. Even exceptions like HSBC, up 15% for 2022 and NatWest, which returned 9%, are seen as currently significantly undervalued.
Wall Street-listed banks had an even worse time of it last year. Financial markets data company Morningstar reports that the KBW Nasdaq bank index fell 23.7% last year to underperform the market’s 20.7% decline. Among the bank stocks with big losses in 2022 were First Republic Bank FRC, down 40.1% and Bank of America BAC, which lost 23.8%.
Source: Morningstar
Banking stocks have started 2023 well despite disappointing Q4 2022 results
2023 has started much more positively for banking stocks. Despite an 8% dive on the day it released its Q4 2022 results showing a 14% drop in pre-tax profits for the full year, the Barclays share price is up over 6% so far in 2023. Lloyds Banking Group is up 8.5% for the year-to-date, also despite seeing a fall of over 4% in the past week.
The NatWest share price has fallen almost 6.5% today after releasing its own disappointing Q4 results and Spain’s Banco Santander has leapt a
In the USA, Bank of America has returned 4.4% so far in 2023, Citigroup is up 11.6%, Wells Fargo 12% and JPMorgan Chase 4.4%. However, even after those gains, Morningstar reports the U.S.-listed banking stocks its analysts cover are, on average, trading about 11% below their fair value estimates.
Why do many expect banking stocks to have a good 2023?
If, as expected, interest rates rise further this year to add to last year’s leaps, that will benefit banks by further boosting income from outstanding loans with a variable rate and higher interest rates on new lending. The Fed’s base rate began 2022 at 0.25% and has now reached 4.5%-4.75%, while the Bank of England’s rate has risen from 0.25% to 4%.
Commercial banks that offer accounts to business and retail customers still make most of their money by lending. Lending has been a tight margins business over the last decade or so with interest rates at historic lows, which goes a long way to explaining the general underperformance of most banking stocks over the same period.
From that point of view, a significant leap in core interest rates has the potential to multiply the revenue and profits commercial banks earn from loans. That has provided positive momentum for banking stocks so far this year. As has growing market confidence the U.S. economy will avoid a significant recession this year, potentially even altogether. And that recessions elsewhere, including the UK economy, will be milder than feared until recently.
Why might some of the optimism around banking stocks be misplaced?
A majority of stock market analysts, and investors, are currently bullish on banking stocks, which they think still look attractively priced given the coming interest rates windfall they see revenues being swelled by. However, there are also reasons to urge a degree of caution when it comes to expectations around valuation performance over the coming period.
The first headwind is that the boost higher interest rates give banks tends to be frontloaded. Banks usually increase the rates and profit margin on new lending very quickly after their central bank has hiked the base rate. They are significantly slower to increase the interest rate they offer on deposits and savings products.
However, despite the lag these interest rates do start to rise in competitive markets, squeezing net interest income – the margin between rates charged borrowers on loans and the yields that banks pay out on customers’ deposits.
Banks will still have better net interest income than over the period since 2009 which was characterised by historical lows because they raise rates offered by less than they charge when the base rate rises. But the improvement will be capped by the need to also offer competitive rates on deposits and savings products.
Another factor to consider is last year’s fears over the impact of a recession and rise in bad loans and drop in borrowing and business activity that brings which was a drag on banking stocks. The threat of recession, even if it is receding in terms of its expected severity, remains. And there are several uncertainties such as the risk of an escalation in the war in Ukraine that could still result in a worse recession than markets now appear to be pricing in.
The reality is we remain in a period of heightened risk and uncertainty. Morningstar strategist Eric Compton notes that banking stocks have historically been discounted to fair value estimates by between 25% and 30% during periods of recession. Right now, after recent gains, they are seen as less than 10% below fair value.
That means that there would be potentially significant downside if fears around the threat of a more significant recession become heightened again for any reason. He also notes there are already signs that net interest income is starting to contract for major banks in the USA, namechecking JPMorgan Chase. And other major banks such as Wells Fargo and Bank of America have announced lower-than-expected revenue guidance for the first quarter of 2023, even before a compression in net interest margin.
The major UK banks all disappointed markets with their fourth quarter results for 2022, which came in short of analyst forecasts.
A further drag on the net income of major banks on both sides of the Atlantic this year and next is expected to be their need to increase loan-loss provisions. They are coming off low levels established when banks released the reserves they had set aside for the feared fallout of the Covid-19 pandemic and need to be bolstered this year to meet the threat of a recession.
Loan loss provisions jumped between the third and fourth quarters of 2022 and Compton expects banks to continue to increase them this year and next if there is indeed a mild recession before the end of 2023.
Another squeeze on banking income that the current sluggish economic conditions bring, which could yet deteriorate, is a drop in fees being earned for wealth management and mergers and acquisitions activity. Fees income is unlikely to improve before 2024, though it could bounce back strongly if major economies do.
However, one reason why banking stocks may not see their valuations fall to the usual level of recession discount of between 25% and 30% is the extent to which any 2023 recession will have been anticipated.
There are few if any historic examples of a recession approaching in such clear sight as the one currently on the horizon. And if it turns out to be a relatively mild recession as recessions go, or is miraculously side-stepped altogether, at least in the USA, markets could decide to pay it minimal attention.
UK banks could have less downside than U.S. peers
If market sentiment does turn sour again on banks, the UK’s banking stocks could well hold up better than peers in the USA. Beaten back down by Brexit at the time U.S. and other international banking stocks were moving past the 2008 international financial crisis, London-listed banks never really did.
They have been shunned by markets for years and have looked oversold and good long term value for some time, compared to international peers. U.S. banking stocks, meanwhile, recovered best and trade at higher multiples. As a result, UK banking stocks may have less downside in a negative scenario for the sector.
Banking stocks could well have a good 2023 as markets have anticipated by pushing up their valuations over the past few months. But investors should also be aware of the potential headwinds for the sector and why another year of negative returns is not out of the question.
