Challenging Decade for the Global Banking Industry
The global banking industry has faced a difficult operating backdrop for the last decade amid a challenging interest rate environment (see U.S. yield chart below), economic growth concerns, and a hangover from the financial crisis as it has been building capital and dealing with increased regulation. The industry has been one of the worst performers over the last decade, although it has experienced several periods of stronger performance over shorter interim periods, such as 2012/13 and late 2016 as valuations became significantly discounted and interest rates bottomed.
Down over 39% for the year through March 18, banks have been one of the worst performers this year, only behind oil & gas, hotel & restaurants and aerospace among the industries that account for at least 1% of the MSCI ACWI.1 Investor negativity has increased due to a variety of concerns: negative interest rates in Europe and Japan, the U.S. Federal Reserve lowering the federal funds rate target to the 0%-to-0.25% range on March 15, a likely global recession caused by COVID-19 and the expected credit losses that would likely occur during a recession.
Impact of Lower/Zero/Negative Interest Rates
Banks’ fundamental business is earning a spread on their capital (or NIM – Net Interest Margin) so a decrease in interest rates to zero (or negative) is a headwind to banks’ fundamental earning structure (and has been for most of the last decade). However, each bank has varying sensitivities to changes in interest rates. For example, among large-cap U.S. banks today, some banks are much more sensitive to interest rate changes than others given varying traditional lending exposures. Given this difference in sensitivity, fundamental analysis is paramount when we are evaluating the effects and potential investment opportunities.
Additionally, as interest rates were already low globally, we believe the Fed’s recent rate cut will not have as significant an impact on banks’ earnings as the last interest rate decline period during the global financial crisis. Two main factors contribute to this: 1) the cut is less significant and there is less room for rates to move down; 2) banks have been adapting to low interest rates over the past decade and many have improved their cost structures and capital positions significantly. Finally, while this environment of low/zero/negative rates may persist for some time, the next significant move in rates is more likely to be to the upside (although that may seem like a long way away) given where we are today. If that happens, just like we saw briefly in 2013 and 2016, it would be a nice tailwind for banks’ earnings. In the meantime, banks are generally trading at attractive multiples of their reduced earnings that largely account for this negative scenario continuing into perpetuity, and offer attractive return potential just through earnings and dividends if this environment does continue (and much greater potential if rates ever increase or are expected to increase).
The concerns/negativity associated with a global recession, increased credit losses, and lower interest rates along with recent significant underperformance has likely led to many investors avoiding the banks industry given the significant near-term headwinds. As a result, valuations of several banks have started to reach levels that reflect significant pessimism, potentially creating very attractive long-term investments as the negativity is already priced in, and any positive news/change could greatly benefit the banks (whether that be a rebound in growth, interest rates, lower than expected credit losses etc.).
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