Bank Stocks: There's More to the Story Than Rising Rates
Tuesday, April 09, 2019
In late March, bank stocks gave up approximately two-thirds of their strong year-to-date gains—falling sharply on concerns about economic and earnings growth. Banks ended the quarter up nearly 12.5% after regaining some lost ground during the last few days of the quarter.*
The primary trigger for the sell-off was the March 20th Federal Open Market Committee (FOMC) announcement that it wasn't raising rates and no longer expected to raise rates twice this year, as previously suggested. (As recently as January the Fed had expected two more 25 basis point increases in 2019.) The Fed also announced that its median GDP projection for this year and next had modestly declined to 2%, citing slowing retail sales, business investment, and job growth. It expects unemployment to remain at 4%.
Bank stocks can be more interest-rate sensitive than the market as a whole because banks garner some earnings from the spread between the rates they charge for loans and the rates they pay on deposits. In rising-interest-rate environments, rates on loans generally reset faster than rates on deposits, temporarily widening this spread.
We think the market overreacted. The widening of spreads is a temporary benefit to banks, in our opinion, because deposit rates will eventually catch up.
While changing interest rates can lead to a wiggle in bank earnings, we believe that it's actually changing credit conditions that can make them gyrate—and credit trends remain healthy. With the Fed still forecasting modest GDP growth both this year and next, we foresee little risk of rising default rates.
Why We Own Banks
The Miller/Howard Income-Equity strategies own banks that pay solid dividends, and we expect those dividends to rise. The banks that we invest in generally have balance sheets that the Fed has deemed strong enough to support continued dividend payments, even in a severe economic downturn. They also have earnings growth driven by a combination of loan growth, expense reduction, and share buybacks, as well as attractive valuations at 9 to 12 times forward earnings.
On June 30th, the Fed will announce the results of banks' 2019 stress tests, and whether it has approved each bank's dividend and buyback request. Last year, banks issued press releases the same day, announcing sizable dividend increases as well as buybacks with dollar values more than twice as large as the dividends.
We expect dividend increases again this year driven by earnings growth. But further support could be provided by banks' ability to reallocate available cash to shareholders from buybacks to dividends. Also, by reducing the number of shares outstanding since last June, buybacks can increase both earnings per share and dividends per share, even if total earnings and dividends don't rise.
We expect that first-quarter earnings reports will provide us with more information about trends in loan quality and earnings. We seek bank stocks that best match the changing economic landscape while providing dividends, prospects for dividend growth, financial strength, and consistent earnings growth.
* Based on the S&P Banks Select Industry Index total returns from December 31, 2018 to March 31, 2019. S&P Select Industry Indexes are designed to measure the performance of narrow GICS® sub-industries. The Index comprises stocks in the S&P Total Market Index that are classified in the GICS asset management & custody banks, diversified banks, regional banks, other diversified financial services, and thrifts & mortgage finance sub-industries.
Gregory Powell, PhD, oversees the Portfolio Management Team. Greg is the designated lead or co-lead Portfolio Manager on the firm’s core portfolios. In addition, he holds a position on Miller/Howard's Executive Committee. Greg joined Miller/Howard in 2017 and served as a portfolio manager and Deputy Chief Investment Officer. He was promoted to CIO in 2020, after the retirement of founder Lowell Miller. Prior to joining MHI, Greg had a distinguished 19-year career as a portfolio manager and director of research at AllianceBernstein. At AB, he managed a team of 12 analysts and a suite of products with $11 billion in AUM. He also served as head of fundamental value research there, redesigning the analyst role with an emphasis on investment success and training analysts in all aspects of the position. He holds a BA in Economics/Mathematics from the University of California Santa Barbara, and a PhD and MA in Economics from Northwestern University.
