Warren Buffett (Trades, Portfolio), the greatest value investor of all time, is a major holder of U.S. bank stocks. In the third quarter of 2018, Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial)Â bought more than $13 billion worth of bank stocks. Clearly, the Oracle of Omaha holds a positive outlook for the U.S. banking sector’s future prospects. Should you too? To answer this question, we must look at how interest rates affect the banking sector.
Why are higher rates good for banks?
Rising interest rates benefit banks and other lenders, as they are able to earn higher interest from their customers, which of course correlates directly to higher profits. This makes bank stocks unusual, in that most equities tend to react poorly to interest rate hikes, as these raise the cost of borrowing money. In this sense, banks are somewhat of a hedge against rising interest rates, provided the underlying economy is in good shape (more on this below).
The Federal Reserve hiked rates four times in 2018, boosting U.S. bank net interest margins (the difference between a bank’s interest income and the interest paid out to borrowers) to 3.30% in the third quarter of 2018, the highest that it has been since the fourth quarter of 2012. The Fed has signaled two further hikes in 2019 in its forward guidance.
However, increasingly, it seems like this will not come to pass. The futures markets are currently pricing in a 71.4% chance that the benchmark rate will remain unchanged throughout 2019. Prominent investors like Paul Tudor Jones (Trades, Portfolio) have gone on record saying that they do not believe that the Fed will raise rates. And even members of the Federal Reserve Board of Governors are signaling a more dovish stance, with Raphael Bostic (president of the Atlanta Fed) stating that he is now only sees one hike this year.
No-lose scenario?
So is this game over for bank stocks? Not necessarily. The worry is that if the Fed continues with its promised hikes at the current pace, the recent economic weakness could develop into a full-blown recession. This would certainly not be good for the financial sector, as demand for credit would dry up in such a recessionary environment.
One school of thought holds that banks are in a no-lose scenario: either the economic slowdown worsens and the Fed steps in to juice the economy with lower rates, and banks reap the benefits of monetary expansion, or the market shakes off this weakness on its own, and the Fed proceeds with its planned hikes, thereby padding out the banks’ profits.
Although this point of view is not without merit, it feels like too much wishful thinking. In the short-to-medium term, any economic disruption that could cause the Fed to reverse course and lower rates would be significant enough to weigh on banks as negative business and consumer sentiment put the brakes on borrowing. More importantly, it does not look seem like the Fed can realistically raise rates this year, certainly not multiple times, without pulling the rug out from beneath the economy.
Doesn’t tax reform help?
The Trump administration’s tax cuts definitely benefited U.S. financials. Big banks posted total revenues of $60.2 billion in the second quarter of 2018, and increased earnings 25% compared to the same period in 2017. However, once the tax cuts were accounted for, U.S. banks actually performed worse year-on-year. US Dow Jones Bank Index is down almost 17% year-on-year, signalling that the market is similarly skeptical of these inflated earnings.
A bigger boost for banks may come in the form of increased deregulation. The Crapo Act, passed in 2018, is estimated to have unlocked approximately $250 billion in assets from having to comply with Dodd-Frank. With the Democrats back in charge of the House, however, future regulatory reform is uncertain.
Summary
Overall, banks do not look like a slam-dunk bet, at least in the near future. Concerns over the health of the economy are making interest rate hikes seem increasingly unlikely, putting a dampener on expectations of higher net interest margins. Tax reform and deregulation failed to deliver positive returns on financial stocks last year, and now some of these changes are in danger of being rolled back due to political uncertainty. It may pay to explore more profitable sectors.
Disclosure: The author owns no stocks mentioned.
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