2nd October 2014
Simon Laing, head of US equities at Invesco Perpetual, looks at how much benefit banks will get from rate rises and how much capital can be returned to shareholders…
It’s been quite some time since we were surprised by a Federal Open Market Committee (FOMC) meeting, due to the fact that with forward guidance the US Federal Reserve (Fed) has sought to nullify investor anxiety. But the long-term interest rate guidance for 2017 of 3.75% did cause us to raise our eyebrows. As stockpickers, we are always on the lookout for where we could be wrong and so the Fed statement seemed a good reason to review our positions in the financial sector, and banks in particular.
Having recently spent time in the US and specifically at a conference focussing entirely on US financial companies, the dominant investor themes had not changed – how much benefit will banks get from interest rate rises? How onerous will the regulatory burden be for banks? How much capital can be returned to shareholders?
While investors understand the sensitivity of banks to interest rates, experience has taught us that when fundamental metrics start to turn, the stock market struggles to keep pace with the amount of improvement. We wouldn’t be surprised to see the benefits to many banks of interest rate rises exceed the market’s estimates. Particularly as we see good reason for decent loan growth to accompany these rises.
The annual Comprehensive Capital Analysis and Review (CCAR) stress test event is set to lose its importance to investors, in our opinion. Most banks have ample capital such that it is hard to envisage any major quantitative failures. However, we do expect to see annual qualitative failures that could impact a bank’s ability to return capital for a year.
The reason qualitative CCAR failures occur is because the test is such an opaque process and banks can never be sure of where they stand, relative to what the regulator is looking for. This position seems to help the regulator achieve its goal of improvement in risk and compliance and a deeper integration of these functions within banks.
CCAR has developed from an annual event into an ongoing process for banks. As such, the cost of regulation is a permanent part of the cost structure and not something we should expect to fade away. We expect qualitative failures to be met with frustration as investors miss out on a year of capital return. But a failure won’t necessarily be met with alarm as this is the regulator’s way of ensuring all banks are improving and upgrading risk and compliance processes on a continual basis.
Over the last three years in particular, S&P 500 companies have returned a significant amount of cash to shareholders. However, as we look at balance sheets from here, banks are the stand out group from where there is still ample opportunity to return cash to shareholders on a large and consistent basis. Even considering Systemically Important Financial Institution (SIFI) capital requirements and listening to what Fed Governor Tarullo would like to impose, there are many banks in the US that have excess capital on top of these requirements. We believe cash return to shareholders has the potential to rise to 100% of net income for some of them. And while it is very unlikely to see returns of over 100%, there is the potential that future asset growth occurs with a limited increase in equity. Income is a necessity of many investors and for them the appeal of banks looks set to rise.
If we turn to the issue of credit, conditions in the US are excellent, and that in part goes hand-in-hand with the disappointment in overall loan growth that we have seen in the last few years. Underwriting standards remain very prudent. This is to be expected and as the economic and business cycles mature we should expect some loosening and a move in credit metrics back towards the mean. We wouldn’t look at this as a deterioration in credit necessarily, but a normalisation.
But while credit will probably never look this good again, banks have climbed the hump of legal fees and fines. It’s impossible to know when all the settlements will be over but the hard lifting has been done and we think we are past the point of maximum pain. We are likely to see several settlements over the next few years but expect them to be of diminishing impact, compared to recent events.
As we consider all these factors and look to how we want to position our portfolio for the next couple of years, we like the set up for several US banks. And in a market that’s not offering consistent broad value, some banks appear to us as a stand out opportunity