North America: US banks set to bounce back
Prices ‘irrational’; profitability questionable; Much depends on avoiding European contagion
Bank stocks were the worst-performing sector of 2011. While the S&P500 ended the year flat, US financials were down 18% as a group. The Stoxx Europe 600 index dropped 11% during the year, with European financials falling 32%. Are there any reasons to hope 2012 will be better?
US banks probably have more positive fundamentals for the year ahead, and some analysts say their fall in stock price has been exaggerated.
Richard Bove, a senior banking analyst at Rochdale Securities, says: "The US banking system is strong. It is well capitalized now. Its deposit base is growing. They are seeing an increase in commercial and industrial lending, and the housing market seems to have bottomed out. There is also evidence that the economy is expanding. GDP growth forecasts for 2012 are around 2.25%. One has to assume therefore that the banking sector outlook is positive for 2012."
Jason Goldberg, US large and mid-cap bank analyst at Barclays Capital, adds: "The economy is not robust by any stretch but things are improving. Pending home sales are up. Consumer sales were up over the holiday period. At the banks, loan growth should continue and credit quality will continue to improve."
He expects dividends and share repurchases by US banks to increase over 2012 because they are well capitalized. In particular, Goldberg likes Wells Fargo, US Bancorp and PNC, and says investors might want to start looking at Citi and JPMorgan.
Irrational price falls
Bove says the stock price falls of US banks are irrational. News on December 28 that the European Central Bank had increased lending by €214 billion to eurozone banks the previous week caused the Dow Jones Index to drop 1.3%, led by a fall in US financial stocks. He says the news should have been positive. "It seems to signal that the ECB is going to provide as much liquidity as it can to the eurozone banks, which should alleviate fears around US banks, not fuel them."
The perceived risk of contagion from European sovereigns to US banks might be overstated. According to analytics firm Trepp, their direct exposure to sovereign debt of Greece, Ireland, Italy, Portugal and Spain is less than 1% of US banks’ total assets, and "most are less than 10% of their tier 1 capital" says the firm’s December report Happy Days are Gone Again.
"The ultimate cost of the European crisis is not yet known, but it appears that the losses – even in the most extreme scenario – will be relatively contained for US banks," say authors Matthew Anderson and Alex Micic.
Standard & Poor’s December 15 report also highlighted that the US banks will have limited direct impact from solvency concerns and large-scale European bank recapitalization. The report’s authors, however, do note that a recession in Europe could lead to a recession in the US, which would reverse recent gains in asset quality and capitalization for the US banks.
For now, Bove says the US banks are benefiting from the lack of confidence in the European banking system. US banks have enjoyed inflows in deposits as customers redistribute their money away from European banks. "European banks are giving up customers, and packages of loans at a discount, as they are forced to shrink and recapitalize," he says. "That’s a meaningful benefit to the US banks."
KBW analysts, echoing the views of Goldberg and Bove in their 2012 bank outlook, say they are expecting capital deployment from US banks this year through dividends and buybacks, as well as increased syndicated-lending activity, and the purchasing of assets from European banks.
Despite the somewhat improved economic environment and earnings of the US banks, profitability is expected to remain muted. S&P points out that excluding loan-loss reserves and accounting gains last year, pre-tax operating return on revenues for the first three quarters of 2011 would have been 18.5%, 19.1% and 16.2% compared with the respective reported 25.4%, 25.7% and 29.2%. The ratings agency is projecting the pre-tax operating RoR for the US banks to be 19% to 20% for 2012 and 17% to 18% for 2013.
"Revenue growth likely will remain muted because of the low interest rates, spread income likely will remain constrained as long as the yield curve remains compressed, and market- and transaction-related income should remain depressed because of the sluggish US economy and the high volatility in the global capital markets," says S&P analyst Rodrigo Quintanilla.
"Operating expenses should remain high as banks incorporate the regulatory changes that the Dodd-Frank Act mandates. And last, we believe that credit costs should be higher than we previously anticipated after seven consecutive quarters of credit-quality improvement. We also expect net charge-offs to decline at a much slower pace."
Trepp’s report states lower profits will also put pressure on US banks to trim expenses. "Since Q1 2010, banks have added 83,000 jobs, or 42% of the 196,000 jobs that were shed during 2008 and 2009," write Anderson and Micic. "However, this growth is set to top out in 2011, as banks see a diminished profit picture. We expect job cuts will outweigh gains during 2012, resulting in bank employment posting a 0.2% decline for the year."
"We expect investment banking revenues to be skinny still, so even in the more solid names, such as JPMorgan and Goldman Sachs, we are not expecting big returns"
Oliver Pursche, president at boutique money-manager Gary Goldberg Financial Services, is cautious on US banks. "We don’t expect much of a turnaround in the housing market or consumer market," he says. "And expect investment banking revenues to be skinny still, so even in the more solid names that we like, such as JPMorgan and Goldman Sachs, we are not expecting big returns."
Pursche is even less optimistic about Bank of America and Citi. "They are like BNP Paribas, Commerzbank and Crédit Agricole in the sense that – can you make an argument that these are a good investment? Or is it just speculation?"
There are some individual bank names that will do well, says Pursche. He points to Asian banks and Latin American banks, such as Bradesco, but overall he says the banking sector "is one of the least attractive for 2012".
Bove understands the nervousness around US banks but still expects a better year in their stock performance as investors begin to feel more comfortable.
"You can’t blame people for being skittish, but US bank stock prices do not make sense at the moment," he says. "Of the 23 domestic banks I follow, the average earnings increase was 13%, yet the average price decline was 30%. If investors are anticipating some huge global collapse of the financial system, why do they suppose social networks or Apple stock will not be impacted too? At some point in 2012, one would hope that investors start to look at the fundamentals once more."