Modest Recession? No problem! Economists are busily trying to reassure investors that a recession isn’t going to happen any time soon, but so far they haven’t done much to stop the bleeding as some parts of the U.S. economy may already be in recession. Bank stocks in particular are not doing very well, as the BKX has tumbled 19% so far year to date, compared to the S&P 500’s 9.4% decline in the same time frame, but even with a modest recession, bank stocks could already be attractive.
Morgan Stanley analyst Betsy Graseck and her team point out in their report on U.S. banks dated Feb. 11.
Modest recession – Bank valuations look attractive
They said bank stocks have fallen into a “modest recession” and that their valuations are “rarely so attractive.” Indeed, there’s no denying that there are risks aplenty, from rising risks of corporate credit losses to oil prices, the fragility of the world’s stock markets, and currency battles to boot. However, the Morgan Stanley team emphasizes that it’s important to cut through all these worries and focus instead on what’s actually priced in.
They said bank stocks seem to be pricing in a corporate credit recession, comparing today’s situation with what happened in the early 2000 during the TMT Fallen Angeles era. They’re expecting to see commercial loan losses increase, but at a third lower than what bank stocks are currently pricing in. They add that because the valuations in this segment of the economy are already at recessionary levels, it looks like the risk/ reward profile of bank stocks is improving.
Things might get worse before they get better
Graseck and team said a “deep recession,” which they describe as “affecting the consumer with sharply higher unemployment,” could push stocks down by an additional 17%, on average. This is their bear case, which they compare to the situation in the early 1990s when unemployment climbed 2 percentage points as the commercial real estate market moved into a recession. Morgan Stanley’s analysts and economists have repeatedly said that we’re not in a recession yet but that the risk of one occurring is on the rise.
However, Graseck does expect things to improve, as her team’s base case models stable rates, a 5% increase in revenues, a 3% increase in expenses, and provisions of about 50% higher than where they were in 2015. She believes that even with this conservative credit model, bank stocks could have an average upside of 27%, noting that they are trading at only 40% of the S&P 500’s multiple on a book basis, which she said is right at the low levels seen in the prior cycles.
If there is no recession, the Morgan Stanley team prefers large caps Bank of America, Capital One and Synchrony Financial and mid-caps BankUnited, Signature Bank, and SVB Financial.
A dim near-term view of bank stocks
Oppenheimer analysts Ben Chittenden and Dominick Gabriele made similar comments in their Feb. 10 report titled “The Risks that Keep Us Up at Night.” They said that in the current environment, it’s going to be difficult for bank stocks to outperform, and thus, they expect them to underperform for the next 12 to 18 months, based on the fundamental risks they’re seeing.
For example, they expect loan growth to decelerate, which is a contrarian view. The consensus expects an acceleration between this year and next, but the Oppenheimer team notes that in the past, when loan growth slowed, bank stocks underperformed the S&P 500, just as they are right now. A related issue is credit quality, particularly in the commercial sector, and Chittenden and Gabriele say this isn’t surprising because of what we’re seeing in energy and commodities. They note though that this appears to be a broader concern because lending standards are tightening, which usually precedes high-yield defaults by about a year.
In terms of high-yield defaults, the Oppenheimer analysts note that usually unemployment changes go along with them, which in turn drives losses among consumers. Currently consumers have a higher debt capacity, and while there are concerns that the consumer side of the credit market will turn too, they don’t expect it to be of the magnitude we saw from 2008 through 2010. Despite all the problems, they do see “pockets of opportunity.”
“Bank stocks have historically had difficulty outperforming in an environment where loan growth is slowing, credit costs are rising and earnings expectations are falling,” the Oppenheimer team wrote. “Maybe history won’t repeat itself this time, but we think the historical relationships we outlined represent real risks worth analyzing. Banks will likely look harder at expenses which could accelerate M&A. We’d be positioned in a basket of companies that might be attractive to acquirers.”
