Heading into 2018, expectations for the banking industry were running high and many analysts were predicting that it would be a great year for bank stocks. You had the tax cuts to help the bottom line. Interest rates were rising which would allow the banks to increase the spread between lending rates and deposit rates. And there was an expectation that merger and acquisition activity would increase with the repatriation of overseas cash. I was one of the people that had bullish expectations for the banking industry, but so far the industry isn’t meeting expectations.
What has gone wrong and kept banks from moving up? First, the tax cuts are helping the banks bottom line, so that is one of the three drivers that has worked like people thought it would.
With the spread between lending rates, it has been the flattening of the yield curve that has hurt there. Most banks use the two-year treasury or the Fed Funds rate as the foundation for setting the deposit rates and they use the 10-year treasury to set the lending rates. The spread between the two-year and 10-year has been flattening in recent months and as of today that spread is under 0.25%. This is also the spread most people are referring to when they talk about an inverted yield curve. With the yield curve flattening, banks have not been able to increase their own spread between lending products and deposit products.
The third driver I thought would help move bank stocks higher was an increase in M&A activity as companies brought cash back to the States from overseas. The first half of 2018 has indeed seen a jump in M&A activity worldwide and in the U.S. However, a greater number of companies have been using the repatriated money to do stock buybacks. While that helps the companies themselves, it doesn’t help banks by generating M&A fees.
Another factor that could be keeping M&A activity in check to some degree are the ongoing trade disputes between the U.S. and other countries. The parties that might be interested in seeking a merger have additional uncertainties when exports could be facing additional tariffs. There is also the issue of facilities overseas that could be impacted by new or higher tariffs.
Looking at a chart that compares the SPDR S&P Bank ETF (NYSE: KBE), the SPDR S&P Regional Banking ETF (NYSE: KRE), and the S&P 500 SPDRs (NYSE: SPY), we see that both of the banking ETFs have lagged the overall market. The SPY is up 5.66% through Friday, July 13 since the beginning of the year while the KRE is up 4.12% and the KBE is only up 0.43%.
I can’t and won’t try to speak for other analysts, but this is not the performance from the banks that I expected to see. But I am encouraged by the regional banks performing better than the bigger banks.
Personally, I don’t see things changing for the big banks in the second half of the year. The Fed is expected to raise the Fed Funds rate again at the September meeting and I don’t see the 10-year treasury rate jumping sharply between now and the end of the year. I also don’t see the trade disputes getting resolved in time to boost M&A activity further.
I will say this, if I wanted exposure to the banking industry, I would go with the regional banks or the KRE. I looked at the fundamentals of the top ten holdings of both the KBE and the KRE and the regional banks look a little better. The EPS growth is slightly better and the profit margins are a little better.