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US Banks – Why the Malaise?

US Banks – Why the malaise?

Bank BuildingBy Jean Rosenbaum, CFA and Portfolio Manager, Hotaling Investment Management, LLC 

Banks are a key component in the economic jig saw puzzle. They make up between 6-8% of the S&P 500 and roughly half of the financial sector of the index. Banks as a whole have modestly underperformed the S&P 500 for the last two years. The industry continues to struggle with the “pricing” environment. The low interest rate environment, coupled with ample liquidity, has led to ever lower rates banks can charge for loans and earn on their securities. While loans continue to grow, the revenue line for banks has been almost stagnant as the price they can charge continues to decline.

Banks have been able to grow earnings in this weak top line environment through an improvement in credit quality. Following the financial crisis, banks significantly increased their loan loss reserves. In the subsequent years, as defaults (or net charge offs) came in lower than initially anticipated, banks have been able to reduce their reserves providing a tailwind for earnings. Loan loss reserves are now approaching previous lows, so this improvement appears to be ending, or at least slowing.

The next driver of earnings for the industry may be operating expense control. Many banks have been experiencing cost growth ahead of revenue growth due in part to additional regulatory expenses. The banks have also been reluctant to limit their branch networks. However, with earnings drivers limited, it appears that some management teams have begun to take action. Going forward, physical infrastructure (a bank on every street corner) is likely to be replaced by more digital infrastructure at an accelerating pace.

Many bank management teams have been hoping for a Fed rate increase and a steeper yield curve, but the ability to wait may be coming to an end. The recently announced hiring and wage growth data was nothing short of robust. This may give the Federal Reserve the impetus to raise rates later this year, and potentially offer some relief to the banking sector.