This article is about banks, since some of the most prominent U.S. banks released 1Q21 earnings last week including JPMorgan Chase, Goldman Sachs, Morgan Stanley, Bank of America, Wells Fargo and Citibank. The earnings were generally robust, beating analysts’ consensus expectations across the board. The outlook for banks as the pandemic slowly wanes and economies recover has improved markedly over the last 12 months. However, in spite of outstanding 1Q21 results and a more optimistic outlook, the share prices of these banks really didn’t perform that well after they released earnings. Investors seem to have a similar view of bank stocks in general, as the two financial services ETFs that I track (XLF and KRE) were nearly flat W-o-W, even as the S&P 500 was gaining 1.4%. Why are bank stocks underperforming? This article will provide some comparison of the six banks that reported earnings last week and two well-known financial services ETFs, the drivers of profitability for banks, and the reasons I think the stocks haven’t performed well. The real question – a difficult one to answer – is where we go from here.
Banks take provisions as pandemic grips the world
As COVID-19 gripped the world starting in February 2020 and governments shuddered economies in response shortly thereafter, banks were thrust into unchartered waters. With no way of knowing how borrowers with significantly less or no source of revenues would service their loans, banks were forced to take historically large provisions in anticipation of potential losses. The six banks I mentioned at the onset of this article collectively took over $25 billion of provisions in 1Q2020, a $20 billion increase vis-à-vis provisions taken in the pre-pandemic 4Q2019. In the ensuing quarters since then, these banks have gradually reversed their provisions as the outlook has improved. The most recent quarter (1Q21) has been the largest as far as provision reversals, with $9 billion of negative provisions, or a $34 billion positive variance vis-à-vis 1Q2020.
Obviously, the impact of negative reserves is one-off, artificially inflating earnings for the quarter. More on this later, but this is clearly one reason why investors might not have responded as favourably as might have been expected to the earnings beats.
Central banks, including the Federal Reserve, respond
Like many central banks around the world, the Federal Reserve took a series of steps early in the pandemic to stabilise the banking system and also to make credit readily available to borrowers both from banks and the capital markets, even though demand for borrowing was predictably weak because of a shrinking economy. One step that the Federal Reserve took in June 2020 that directly affected bank stocks is that it imposed restrictions on the ability of the largest 34 US banks to increase dividends or to repurchase shares, a restriction that has remained in place until just recently. The press release from the Federal Reserve dated June 25th 2020 announcing this restriction is here, and the relevant extract is below:
“During the third quarter, no share repurchases will be permitted. In recent years, share repurchases have represented approximately 70 percent of shareholder payouts from large banks. The Board is also capping dividend payments to the amount paid in the second quarter and is further limiting them to an amount based on recent earnings. As a result, a bank cannot increase its dividend and can pay dividends if it has earned sufficient income.”
It was interesting to see, looking back, that in the worst case scenario, the Federal Reserve was anticipating loan losses of as much as $700 billion for these 34 banks related to the pandemic, and a decline in the average capital ratio from 12% at the end of 4Q19 to as low as 7.7%. Fortunately, this scenario did not come to pass.
As the expected worst case scenario did not materialise and the economy has recovered because of unprecedented assistance from central bank and government support, both shareholders of banks and investors in T1/T2 securities of banks have breathed a sigh of relief. On March 25th, 2021, the Federal Reserve announced that it would allow these banks to resume payouts on June 30th 2021 subject to the banks meeting minimum capital requirements under a stress case scenario (see press release here). Therefore, I expect that banks will increase dividends and resume share repurchases assuming that the US economy remains on its current growth trajectory.
Looking back, it is clear now that banks over-provisioned in light of the massive amount of fiscal and monetary support provided by governments in the U.S. and other economically advanced countries around the world. Consumers were given some combination (or all, in some cases like the U.S.) of higher / extended unemployment, loan forbearance, direct money from the government (U.S. only) and other aid to see them through the period of high unemployment. Businesses were given direct aid in the form of grants or direct loans (or both), payments for furloughed employees, equity and cheap debt for singled-out industries like U.S. airlines, and other support to see them through the period(s) when they had to close their businesses or experienced significant declines in revenues. Businesses – and banks – also benefitted in many developed countries from the central bank extending the scope of their quantitative easing programmes, not only to keep long-term government yields artificially low, but also to directly buy corporate debt, driving down spreads and bond yields and ensuring that companies had access to the capital markets. In retrospect, this tremendous amount of central bank and government support worked as far as helping economies navigate through the pain of the pandemic.
How do banks make money?
I mentioned six banks at the beginning of this article, all of which are large, global financial institutions. Two might be considered more investment banks and asset managers (than commercial / financing banks): Goldman Sachs and Morgan Stanley. These investment banks “converted to” commercial banks during the Great Recession, so are now regulated by the Federal Reserve like the other four. They tend to rely more on trading and investment banking (M&A, advisory, capital markets) than on lending, and therefore, have smaller balance sheets. As such, they are more reliant on dynamics in the M&A and capital markets for revenues, and these businesses have been robust the last several quarters with record amount of new corporate bond issuance, high equity trading volumes (some because of the growth in retail investors and meme stocks), and a significant increase in IPOs many related to SPAC’s. Naturally, these are arguably all near peak activity, so this activity is probably not sustainable.
The other four banks – JPMorgan Chase, Wells Fargo, Bank of America and Citibank – generally rely more on lending and financing for their revenues. As a result, they tend to have significantly larger balance sheets. Also, net interest income makes up a much higher percentage of their net revenues (40%-70%) than it does for Goldman Sachs or Morgan Stanley (circa 10%). This is a more stable form of income, but it is an income stream that has its own drivers, two of which are overall demand for loans and the shape of the yield curve (since banks tend to “borrow short and lend long”). Also, the four banks that rely more on lending have different business mixes amongst themselves, with for example JPMorgan Chase being much more balanced as far as lending, investment banking and wealth/asset management, whilst Wells Fargo is much more skewed towards lending. Also, five of the six banks have very international profiles, whilst Wells Fargo is clearly the most domestic of the six banks.
It is generally thought that the more a bank is tilted towards advisory, M&A and capital markets businesses, the more reliant it is on the quality and retention of its professional staff (with remuneration handed out accordingly as motivation and to encourage retention).
Pandemic leads to unexpected growth in deposits
The pandemic did lead to one very unexpected effect – an increase in deposits at banks. Intuitively, as the economy shut down and unemployment skyrocketed, it was expected that consumers and businesses would drain liquidity from the banks just to keep their heads above water. Instead, people and businesses hoarded liquidity, most of which found its ways into the hands of people and businesses through trillions of dollars of fiscal stimulus, which consumers had difficulty spending (due to shuddered economies and closed subsectors like restaurants and travel). Some of this excess liquidity found its way into assets like stocks and real estate (creating discussions now of potential bubbles), but much of which found its way into checking and savings accounts at banks. This liquidity (as a funding source) would be welcome under circumstances in which there was loan growth, but unfortunately for banks at the moment, loan growth remains very weak in the US even though the economy is recovering. The table below shows how deposits have changed at the six banks I am discussing in this article.
Comparing these six banks
Below is a summary profile of the six banks I have been discussing.
Some of the things I mentioned in the preceding section, e.g. size of assets and business mix, are apparent in this table. You can see that all six of these banks have very strong Tier 1 capital ratios, providing buffers for economic downturns in the future. All pay dividends, and four of the six have ROE’s in excess of 20%. All of these stocks have outperformed the S&P 500 over last 12 months (+49.5%), delivering returns (ex-dividends) ranging from 68.4% (WF) to 110.8% (MS). Since the beginning of the year, the relative performance has shifted to the laggard for the 12-month period – WF (+45.7% YtD) – as its domestic focus on lending (and the fact it was arguably undervalued) has boosted its share price. MS has haf the worst performance YtD, perhaps because it was the most overvalued, although it also paid a price for its losses on Archegos.
Two financial services ETFs: XLF and KRE
The XLF and the KRE are both passive ETFs based on S&P 500 sectors. The Financial Sector Select SPDR Fund (NYSE: XLF) tracks the financial sector of the S&P 500 index, one of 12 such sectors. It is broad, including not only banks, but also asset managers, REIT’s and insurance companies. The six banks I am discussing in this paper comprise the 2nd through the 7th largest holdings of XLF, representing around one-third of the ETF’s total AuM. KRE is also a State Street Global Advisors (SPDR) ETF, focused only on mid-tier US regional banks. It is considerably smaller that the XLF as far as AuM, and its purpose is to track the S&P® Regional Banks Select Industry Index. This is much more of a pure bank play and a pure US play. Below is a summary of these ETFs.
For investors that aren’t sure which bank to invest in but who might want exposure to the financial services sector, both ETFs represent ways to express this interest although they are very different in terms of profile. Having said this, both ETFs underperformed five of the six banks I profiled over the last 12 months, and both also underperformed four of the six banks YtD. One could easily conclude that investors should stick to those “franchise” banks with global footprints across a wide selection of businesses rather than having such performance be diluted by the inclusion of other banks, smaller banks and / or other sorts of financial services firms.
I have included more about these two ETFs in the Appendix of this paper, should you be interested.
So why are bank stocks and financial services ETFs moving sideways?
In this article, I have touched on many of the reasons that bank stocks are treading water, especially since early March, even as the broader market has advanced. The reasons include:
Bank stocks have had an excellent run, generally outperforming the S&P 500 in the last year and in 2021 YtD. Perhaps it is time for bank stocks to pause and consolidate, trending back in line with the market indices at large.
Reversal in provisions played a significant role in the uplift of bank earnings across the board in 1Q2021. These are “one off”.
Investment banking and trading businesses like IPOs (especially of SPACs), debt issuance and trading (retail-driven) have accelerated at unprecedented paces, and will probably cool going forward.
Loan demand has been tepid, something all of the reporting banks have mentioned. This will prove to be a larger drag on banks that are more dependent on lending / financing as a source of revenues. Although vaccinations are increasing, the recovery from the pandemic is likely to continue to be choppy and unpredictable.
Concerns about inflation have abated, and the yield curve has flattened slightly off of highs a few weeks ago. This negatively affects banks’ profitability once loan demand picks-up.
Is there an opportunity ahead?
Every investor has to decide for themselves, but the outlook for banks is generally good. I lean into middle-market US lending banks at this point (i.e. KRE ETF types or Wells Fargo), because I expect loan demand to increase as the recovery takes hold. There is more likelihood of rates increasing and the yield curve steepening than the other way around. The Federal Reserve has policies in place that should limit defaults / loan write-offs and encourage financial markets activity whether it be ongoing high trading volumes or a robust new issue market. Lastly, I suspect that banks will increase their dividends and resume share repurchases in 3Q21 once stress tests are completed, in the first case providing floor levels on the share prices of many banks.
Conclusion
Banks are an interesting sector, one that should benefit from the economic recovery as it gains steam. However, even with strong earnings, banks have been trending mainly sideways over the last few weeks, perhaps pausing to consolidate and reflecting the strong price performance since the summer 2020. However, there are concerns about future earnings growth, related to both tepid loan demand and the sustainability of certain underwriting and trading businesses. Even so, there are plenty of good reasons to look at banks, although their appreciation over the last year has been nothing short of spectacular, perhaps leaving little on the table for investors entering now.
APPENDIX
ETF 1: XLF
The Financial Sector Select SPDR Fund (NYSE: XLF) is one of many ETF’s managed by one of the world’s largest ETF managers, State Street Global Advisors. The XLF is a passive ETF that mirrors the financial sector of the S&P 500 index. The six banks I reference in this article are the second to seventh largest holdings of the XLF and comprise over one-third of its holdings of stocks in 66 different financial institutions. Keep in mind that this is a financial institutions ETF, with a focus that is broader than just banks, so it includes asset management firms, insurance companies and REITs, for example. In fact, the largest component of the XLF is Berkshire Hathaway, a conglomerate but a firm that is characterised as a diversified financial services company for purposes of the S&P 500 financial sector index and of XLF. Below is a list of the top 20 holdings and the subsector breakdown of the ETF.
As a passive ETF, the management expenses for XLF are low, at 0.12%/annum. The 30-day SEC dividend yield is 1.58% (S&P 500 yield is 1.38%), the price/book is 1.57x (S&P 500 is 4.55x), the trailing P/E of the fund is 16.34x (S&P 500 index is 42.6x) and the forward P/E of the fund is 14.57x. The S&P 500 data I used is from multpl.com. You can find more information about XLF here.
ETF 2: KRE
KRE is also a State Street Global Advisors (SPDR) ETF, focused only on mid-tier US regional banks. It is considerably smaller that the XLF, with $4.5 billion in the fund (vs $39 billion for the XLF), and its purpose is to track the S&P® Regional Banks Select Industry Index. This is much more of a pure bank play, focused on middle market US commercial banks. Not only is it bank focused, but as you can see from its top 20 holdings, some of the regional banks might have modest investment banking components, but most of the banks are more or less pure commercial banks.
The annual management fee for KRE is 0.35%, nearly triple that of the larger and more diversified XLF. The 30-day SEC dividend yield is 1.96% (S&P 500 yield is 1.38%), the price/book is 1.40x (S&P 500 is 4.55x), the trailing P/E of the fund is 19.26x (S&P 500 index is 42.6x) and the forward P/E of the fund is 14.56x. The S&P 500 data I used is from multpl.com. You can find more information about KRE here.
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