Fed Rate Cut, Easing Worries Over Trade and Economic Growth Propel Bank Stocks in September.
The dark clouds of worry that caused a general stock market decline that hit the banking sector particularly hard in August gave way to a much less pessimistic attitude in September. Trade disputes and the yield curve continue to be cause for concern, but Fed rate cut rates of 25 bps at the September 18 FOMC meeting helped push short-term rates down, avoiding further inversion of the yield curve, while economic readings showed that the economic expansion continues. The confusion over Brexit in the U.K. continues to confound everyone, but it seems to be having limited impact on U.S. investors at the moment.
Economic reports during September were mixed once again, with some showing further slowing, but others showing encouraging signals. The lack of any clear signs of a downturn seems to have put investors in a good mood. Additionally, some conciliatory gestures from both sides in the U.S.-China trade dispute also contributed to the lift in markets. While broad market indices, such as the S&P 500 recorded gains of around 2.0% for the month, bank stocks rode the Fed rate cut to substantially outperform the broader markets.
Last week, the BEA revised its estimate of 2Q19 GDP down slightly to 2.00% from the second reading of 2.02%. This compares to the 3.1% growth recorded for 1Q19. In terms of stock prices, the broader markets posted solid gains in the month of September, as noted above. We remain concerned that the mixed messages in recent economic readings still suggest noticeable recession risks. On balance, however, economic readings remain positive. While the most recent Fed rate cut has helped lessen the inversion in the yield curve, the curve remains far from its normal upward sloping posture. The current slope still warns of the potential for a recession. We maintain our expectations of modest overall loan growth this year, though even our modest expectations continue to fall. We also anticipate continued margin pressures.
A look at the Fed’s H8 data through September 18, 2019 shows that loan growth was solid, maintaining the rebound recorded in August after a very weak July. Using the data for domestically chartered small US banks, we calculate loan growth for the first thirty eight weeks of the year at 3.2%, which translates to a full year pace of 4.4%. This represents an acceleration from the 3.8% pace we calculated a month ago, but well below the 6.1% figure from three months ago. Meanwhile, deposit growth accelerated. The first twelve weeks of 3Q19 exhibited slight deposit growth of just 1.3% (5.2% annualized). Year-to-date growth of 5.0%, which annualizes to 6.9%, is down from the 6.3% annualized year-to-date growth we reported a month ago. Large time deposits have been the driving force in deposit growth for much of the year. This category has grown at a 12.4% annualized year-to-date pace, but this is down from a 13.5% pace as measured a month ago, indicating that large time deposits were a smaller component of total deposit growth in September. Still, we anticipate continued margin pressure from rising deposit costs. As noted above, the yield curve remains inverted, despite the most recent Fed rate cut.
Fed policy actions remain a major driver of bank performance and stock market valuations. Investors are now placing a 42.2% probability on another 25 bps rate cut at the October FOMC meeting, according to the CME Group’s FedWatch tool. Furthermore, the odds of the Fed cutting rates by 50 bps or more by the December 2019 FOMC meeting is shown as a small, but not inconsequential, 16.2% according to
FedWatch. Bank stocks enjoyed a very strong performance in September, as anxiety about trade frictions and the possibility of an oncoming recession both eased during the month. The SNL Bank and Thrift Index ended the month of September with a 6.4% gain, reversing most of the 7.9% drop in August. This performance was significantly better than the 1.7% rise in the S&P 500 during the month.
In regard to economic statistics, the August employment report released at the beginning of September showed employment gains of 130,000, falling short of the 150,000 expected, and also lower than the revised figures of 178,000 for June and 159,000 for July. Revisions to the prior two months were a net decrease of 20,000. However, the three-month average in nonfarm payrolls rose 23,000 to 156,000. Meanwhile, the unemployment rate remained at 3.7%, where it has now been for three months. The workforce participation rate inched up to 63.18% from 63.02% in the prior month. The year-over-year increase in average hourly earnings decelerated to 3.23% from the 3.28% figure in the prior month.
On the inflation front, the core PPI and core CPI both accelerated in August. The core PPI increased to up 2.34% on a year-over-year basis, compared to up 2.08% the prior month. Meanwhile the core CPI rose to up 2.39% YoY from 2.21% in the previous month. While both of these measures exceed the Fed’s stated target of 2.0% inflation, the Fed’s preferred inflation measure, the core PCE, has remained below this threshold in recent periods. However, the core PCE rose to up 1.77% YoY, compared to 1,65% a month ago. Mortgage rates rose modestly in September, but they were down in August. As a result, existing home sales in August were up 6.6% year-over-year compared to up 0.6% in the prior month. New home sales, on the other hand, climbed to up 18.0% YoY compared to up 9.4% YoY in the prior month. Meanwhile, mortgage applications appeared to be weakened by the rise in mortgage rates in September.
Our view has not changed much since last month, We believe the mixed economic outlook is not favorable for the banking industry. The combination of a flat or inverted yield curve and slowing economic growth are likely to lead to restrained bank earnings growth. While most major economic indicators (labor market, GDP, consumer sentiment) suggest continued, albeit slower economic expansion, the trends for most of these measures are not encouraging. Consumer spending remains strong and is the primary factor behind solid GDP numbers, but business investment is not so healthy. The ISM Manufacturing Index declined for the fifth consecutive month in August and construction spending was up for the first time in three months but remains down 2.7% on a Y-o-Y basis. Furthermore, the U.S. leading indicators for August remained stable at 112.2, unchanged from July, and Challenger, Gray & Christmas reported a 37.7% spike in layoff announcements in August. Durable goods improved 0.2% in August, but this was driven by defense spending, as non-defense capital goods orders slipped 0.6%. Retail sales remain one of the bright spots for the economy, rising 0.36% from the prior month, while industrial production rose 0.65%. Loan growth remains modest at best, and despite some improved investor sentiment, we expect the recent concerns reflected in low medium- and long-term interest rates could still slow loan growth further. We remain concerned about the impact of existing tariffs and highstakes trade negotiations on the economy. Inflation could become a renewed concern if recent trends continue, while expectations for slowing economic growth support the notion that the Fed will cut rates further. It seems unlikely that our international trading partners can provide any boost to our economic fortunes, as most of them face challenges of their own. The ongoing trade dispute with China remains one of the top concerns for investors. While we had hoped that falling short-term interest rates could restore some normalcy to the slope of the yield curve, this has not yet proven to be the case, and this has been a negative influence for bank stock valuations.
