By Richard Tortoriello, S&P Global Research
On June 14, the Federal Reserve raised short-term interest rates for the fourth time since 2015. With the Fed signaling further rate hikes ahead, bank investors may want to know which investment strategies have worked best in a rising rate environment historically. This paper leverages our empirical work on the SNL Bank fundamental data to aid investors in selecting bank stocks as rates rise.
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In a rising rate environment, investors should focus on valuation. When rates rise, banks are generally profitable and valuation strategies become key differentiators. Fundamental (income statement/balance sheet only) strategies are less effective during such periods.
- Two less widely-used valuation metrics – core EPS to price and pre-provision net revenue to price – have been highly effective historically in valuing banks. The latter is a banking version of the “price to sales” ratio and is the most effective investment strategy tested, with 9.2% annualized outperformance during periods of rising short-term rates from 1990 through 2017.1
- A third key valuation metric in a rising-rate environment is tangible book value to price.
- Deposit structure is the fourth important area of focus as rates rise, specifically a bank’s level of “interest free” deposits relative to total deposits. Banks with a high concentration of non-interest bearing deposits have a cost of capital advantage when rates rise, as changes in rates have little effect on the costs of such deposits.
- A four-factor model built from the valuation and deposit structure metrics identified above had long-only annualized excess returns of 11.1% during periods of rising short-term rates, with a hit rate of 75%.2 The model works equally well during periods in which rates remain flat.
- Fifth Third, Regions Financial, JPMorgan Chase, and Citigroup top the list of best ranked Russell 3000 banks (market cap greater than $1 billion) based on the most effective rising rate strategies historically.
1. The Current Banking Environment
1.1 Interest Rates and the Yield Curve
The length of the present banking cycle is unusual historically, characterized by prolonged credit quality improvement, record-low interest rates, slow economic growth, and onerous regulatory/capital requirements for many banks.
One trend that has occurred consistently across cycles is the Federal Reserve’s move toward tighter monetary policy. With four benchmark rate increases over the past two years, the Fed is signaling a likely further increase in 2017. Longer term, Chair Yellen3 expects the Fed to raise rates “a few times a year” through 2019, bringing the target fed funds rate “close to its longer-term neutral rate of 3%.”
The Fed has also announced plans to reduce its $4.5 trillion Treasury and mortgage bond portfolio, which could put upward pressure on longer-term rates. So far, however, long-term rates have remained low, and the yield curve has flattened in recent months.
Whatever the shape of the yield curve, banks appear poised to adjust. Figure 1 shows the one-year repricing gap4 for Russell 3000 banks. As of May 2017, banks are positioned near neutral, at -1.7%, and should be able to adapt quickly to changes in rates.
1.2 The Credit Cycle
Although credit quality improvement has slowed in recent months, the credit cycle remains benign. Historically, rising short-term rates and benign credit quality regimes have overlapped, so investment strategies that work during these regimes are similar.
Figure 2 shows a credit quality index we constructed from the average 12-month change of four credit-quality indicators:
- non-accrual loans + loans 90 days or more past due + OREO5 to assets
- non-accrual loans to total loans
- loan loss reserves to total loans
- charge-offs to average loans
As of May 2017, year-over-year credit quality improvement was in the mid-single digits, with continued declines in nonaccrual loans to total loans, despite an increase in charge offs. Aiding this trend, bank regulators have stepped up enforcement of commercial real estate loan quality rules. Weak spots in loan quality, including retail store and consumer (credit card and auto) loans, appear to be under control at present.
2. Bank Strategies for a Rising Rate Environment
This section examines the most effective investment strategies historically within a rising short-term interest rate regime, using the banking metrics identified in the April 2017 research paper Banking on Alpha: Uncovering Investment Signals Using SNL Bank Data.
Figure 3 shows rising and falling interest rate regimes over the past 27 years, defined as periods of extended increases or decreases in the effective federal funds rate. Over the test period (January 1990 – May 2017) there were 77 months of increasing rates and 85 months of decreasing rates.
In a rising short-term rate regime, investors should focus on valuation strategies. Figure 4 shows that three of the four top strategies (of 23 tested) during periods of rising rates were valuation strategies. During periods of rising rates, when banks are generally profitable, fundamental (income statement / balance sheet data) strategies do not perform well, leaving valuation metrics as key differentiators.
Pre-provision net revenue6 to price was the strongest valuation strategy tested in a rising rate environment. This metric is the banking equivalent of the price-to-sales ratio, which is widely used to value non-financial companies. It has a low correlation (about 0.3) with core EPS7 to price, and thus the two metrics complement each other.
Another important insight is that non-interest bearing deposits, such as traditional checking accounts, are important during a period of rising short-term rates, as the costs of these deposits are not rate-dependent. Banks with high levels of noninterest bearing deposits outperform when rates rise, while banks with high levels of savings/money market deposit accounts outperform when rates fall. Both types of deposits are low cost; however, one is affected by interest rates and the other is not.
3. Conclusion: Russell 3000 Bank Screen
The screen in Table 1 selects the top 20% of companies, based on the four strategies identified above, from the Russell 3000.8 A backtest of this screen during periods of rising short-term interest rates from January 1993 to May 2017 (71 monthly observations) generated an 11.1% annualized long-only excess return with a hit rate of 74.6% and an information coefficient (IC) of 0.0989, all significant at the 1% level.
Similarly, during periods of flat rates (167 monthly observations), the model generated long-only excess returns of 11.3%, with a hit rate of 79.0% and an IC of 0.080, also all significant at the 1% level. During periods of falling interest rates the model generated excess returns that were not significantly different from zero.
Note that the fifth quintile of this model10 also generated significant short-side excess returns during periods of both rising and flat short-term rates, so the model might also be used as a screen for short portfolios.
In order to facilitate investability, only banks with a market capitalization greater than $1 billion were considered. In addition, companies must have at least three of the four metrics available to be ranked. Individual factor ranks are averaged to arrive at a final score. Rankings shown are percentiles with one being the highest ranking and 99 being the lowest. Money center banks have been highlighted in grey.
Article by S&P Global Market Intelligence
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