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Editor's note:Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.
Today, bank valuations are about as cheap as they have been since 2008. We had thought for the past two years that the next great buying opportunity for the banks would probably come during the next downturn. Our thesis was based on analysis that showed that the banks were ready this time. However, we did not predict a downturn driven by something like the COVID-19 pandemic. The current situation is unprecedented in many ways, so we re-evaluated our thesis to make sure we are fully cognizant of the increased risks. The bear case of a second Great Depression seemingly had a probability of 0% before COVID-19, but now it's worth considering.
Today's debate is not about earnings per share; it is about capital adequacy and the solvency of the U.S. financial system. After a deep re-evaluation of what we are up against, we believe it is still appropriate to view the U.S. banks as undervalued. The risks are real, but the banks are ready for almost any hit to capital. Our base case is that the U.S. economy and financial system will be intact after COVID-19.
The banks did not look cheap to us at the start of 2020 but have since dramatically sold off. Multiple banks trade below their tangible book values, and many trade at a mid-single-digit EPS multiple compared with 2019 earnings--earnings that did not seem that unsustainable a month ago. The traditional U.S. banks we cover have sold off more than the Morningstar US Market Index and more than the Morningstar US Financial Services Sector Index. They are already pricing in a severe recession.
This Is Not About EPS; It's About the Solvency of the Financial System
If the financial system and, most important, the banks have enough liquidity and capital to survive COVID-19, then investors should be rewarded at today's prices. It will not matter if earnings decline 10%, 20%, or even 50% in the next quarter or for the entire year. Any valuation framework that directly links transitory changes in EPS with permanent changes in the intrinsic value of a firm is flawed. A decline in earnings of 40% over a finite period does not necessarily justify a 40% drop in the stock price.
We believe our long-term focus adds tremendous value in situations such as this, as we avoid some of the common valuation blunders that a short-term EPS focus can bring. Our long-term focus also allows us to pinpoint what today's prices really imply and therefore get to the heart of the matter, which is capital and liquidity.
Our Base Case Is That Government Response Will Be Good Enough
The current downturn is unique. It is not a normal business cycle. It's not normal, even in a severe recession, to potentially reach 30% unemployment and have GDP fall 30% in a month. But if you willingly turn off 30% of the economy overnight, this feat can be accomplished. Because this is unprecedented in speed and scale and also driven by government decision-making, the government will play a key part in making sure the economy comes out on the other side of COVID-19 intact.
Increased worries about the heightened risks aren't unfounded. St. Louis Federal Reserve president Jim Bullard estimated that up to 30% of the workforce could be on some form of unemployment insurance. This may not happen, but if it did, this would surpass the peak unemployment of 24.9% during the Great Depression. The bear case of Great Depression II seemingly had a probability of 0% before COVID-19, but now it's worth considering.
Even with a probability of greater than zero for Great Depression II, a lot has changed since the original Great Depression. The FDIC and deposit insurance didn't exist then, so the financial system was unable to deal with the basic risk of bank runs. The United States also did not have a developed system of social safety nets; for example, there was no unemployment system or Social Security. The economy lacked many key automatic stabilizers that exist today. Fiscal intervention during the Great Depression was also lackluster at the start. The New Deal was not enacted until 1933, years after the economy had begun to collapse. The economy of early 2020 did not seem to have major imbalances or toxic assets that would require a major recession and reallocation of human labor and capital; therefore, we see no fundamental reason why the economy can't get back to normal in fairly quick order. With an arguably better system in place, an economy that was healthy one month ago, and a much timelier government response taking place, a V-shaped recovery doesn't seem unreasonable.
Our latest economic analysis points to real U.S. GDP growth of negative 2.9% in 2020, and real global GDP growth of negative 1.4%, implying a recession on par with 2008-09. We also see a modest long-run impact on U.S. GDP of 0.9%, admittedly worse than before COVID-19, but nothing like the lasting effects of the 2008-09 financial crisis.
We think the current fiscal response is generally designed to accomplish what needs to be done, namely, keeping businesses from defaulting on their debts and having to go through the bankruptcy process, and keeping people employed, even if there isn't much work to do for the next month or two. We may see even more fiscal policy responses in the weeks ahead, which would easily put this at the highest levels of fiscal support since World War II.
We also think the current monetary policy response is robust and targeted enough to ensure that liquidity isn't a threat to the solvency of the financial system like it was during the 2008 downturn. The banks have unique backing from the Federal Reserve, and given moves from the Fed to open the primary dealer credit facility, reduce the cost of and limits to borrowing through the discount window, and more, we don't see the banks running out of cash. This is a unique position to be in as many others in the economy struggle to find enough cash.
We expect second-quarter results to be especially difficult for the banks, and we expect the strictest social distance and lockdown measures to remain in place through April and May. However, we think the government will get its response right enough, and aggregate demand will eventually return in time to get the economy recovering in the latter half of the year.
It's Not the Banks' Fault This Time
Unlike in 2008, the banks have not been a key part of the buildup of risk in the system. They will be a necessary part of the economy's survival of COVID-19, whether that is through directly lending to and providing the liquidity for companies to survive, or by being a conduit for the government to provide those same things. Without the banks, no one else gets through this intact. The government recognizes this, and regulators have been extremely proactive about supporting the banks so that the banks can support the rest of the economy.
If industries like the airlines or airplane manufacturers (or others) are so valuable that the government has pledged to prop them up, we believe the banks are even more indispensable. If the banks fail, many industries will follow. Because the banks will be so instrumental in getting through COVID-19, and because it is not their fault this time, we don't think the government will want to harm bank shareholders, even if things get really bad.
Bank Profitability Will Be Negatively Affected in 2020
Net interest margins will be under pressure. With the federal-funds rate at zero and the 10-year Treasury also falling, there is no shelter under the yield curve for the banks. We estimate that with the Federal Reserve's latest 100-basis-point rate cut, net interest income could be down close to 8% on average for our coverage list this year, with a lot of variability among the banks we cover. There may be some upside to our estimates, as loan growth could exceed our estimates as undrawn credit lines are drawn down.
But even with an unattractive rate environment and falling net interest income, we still can't get to today's valuations. We modeled what fair value estimates might look like if rates stayed low forever, and today's prices still look cheap, even under this scenario.
We expect almost all fee items to be under pressure. Investment banking revenue is under pressure already, with newly announced M&A volume almost nonexistent. Payment revenue will be under pressure as people sit at home and are more reluctant to spend, and as merchants receive fewer payments. Deposit service fees will feel the heat too as banks begin to waive fees in an effort to help customers navigate the current situation. Wealth-related fees are often linked to market levels and therefore will also come under pressure. The two bright spots will be trading profits and mortgage fees.
Trading profits will only benefit the money center banks, namely JPMorgan Chase JPM, Bank of America BAC, and Citigroup C. We expect trading profits to be very healthy in the first quarter but potentially come down after that if more clients decide to sit on the sidelines in the face of “bad” volatility. We also expect nice gains on securities books for the banks, given the lower rate environment. Mortgage fees from refinancing will be up in the first quarter and potentially even the second quarter but will probably tail off after that. We still expect fees to be net down for the banks in 2020, with the largest positive offsets occurring for the largest banks.
We don't expect a big response from the banks on the expense side. There is no way for the banks to cut expenses enough to counteract the revenue pressure we anticipate. Many of the banks we cover have stressed that they plan to invest in the business through the cycle, meaning that they don't want to hurt their franchises by underinvesting when times get tough just to meet a certain operating margin target. If anything, expenses could go up. Multiple banks have announced one-time bonuses for front-line employees to help them navigate these uncertain times. If defaults start to increase, workout expenses will go up. Even if defaults don't increase, we still expect expense pressure will emerge from the extra work involved with keeping track of and staying on top of the loan modifications the banks will have to make in order to support clients.
We expect strong loan growth in the near term as commercial clients draw down existing credit lines to prepare for the upcoming cash crunch. Stress-induced loan growth is not ideal, but we expect this strategy of providing liquidity when it is needed will result in lower credit losses for the banks than the opposite strategy of cutting clients off. With the additions of liquidity from the Fed and the increasing drawdowns of credit lines, we expect strong deposit growth in 2020.
We Think the Banks Are Prepared for Almost Any Hit to Capital
The banking system has fortified itself with significantly more capital than in 2007, all while derisking balance sheets. Almost any scenario we run has the banks coming out on the other side of COVID-19 intact. We calculate that, short of permanent impairments to future profitability, current prices are pricing in roughly a 50% hit to common equity Tier 1 capital; the losses would be unprecedented. In almost all cases, losses would have to be double what the Comprehensive Capital Analysis and Review's severely adverse scenario predicts, and these losses would have to occur in a single year, not over the course of nine quarters (as in CCAR).
We calculate that undrawn balances are likely to put a strain on common equity Tier 1 ratios of about 100 basis points or less, and we account for this strain in each of our scenarios. This won't be the make-or-break factor for the banks, but it does increase the strain on bank balance sheets. Disclosures around the loans that investors are most concerned about (airlines, hotels, retail, restaurants, small businesses, and so on) are limited. We expect a lot of questions around this in the upcoming earnings calls. However, the limited data available suggests that these tend to be some of the smaller exposures on bank balance sheets. After combing through the exposures of all our banks, our biggest takeaway is that they are, for the most part, fairly diversified. It is unlikely that the collapse of any one sector will kill the banks this time around.
We calculate that dividends are likely to be sustainable under almost any scenario. All banks under our coverage would have been able to pay dividends without breaching the 7% CET1 barrier under the most recently available Dodd-Frank Act Stress Test severely adverse scenario.
Running our own scenarios, the banks would be able to pay out dividends while enduring major hits to net interest income and fees, while also enduring credit costs that match the worst single quarter of losses since 1984 for each loan type, for a whole year. We also ran an extra-harsh scenario, where credit losses are 5 times what we expect them to be through the cycle for each bank. Almost all of the banks we cover have enough capital to continuing paying dividends under this type of scenario for at least a year (except for U.S. Bancorp). After two years, we expect over half of our banks would probably have to stop dividend payments. This would be an extremely harsh scenario.
Aside from the worst downturn in the last 100 years, we can imagine one more potential scenario where dividends are cut. Regulators might simply decide to signal that capital is the focus for the industry, and they might order all banks to cease paying dividends for now, even if many of these banks could ostensibly continuing paying these dividends. This move could be used as a signal that the industry is being as conservative as possible and also could serve as cover to remove the stigma of cutting dividends, just in case any banks in the U.S. do come under severe stress. We don't view this as likely, but it is a possibility.
Go for Highest Quality or Go for Highest Upside
We see two primary ways to approach investing in banks today: focus on quality or focus on upside. Overall, we tend to agree with the current “sort” the market has for the banks, with the riskier options generally trading at cheaper valuations and the higher-quality names generally trading at higher (but still cheap) valuations.
Top quality picks: While these aren't the cheapest names on our list, they are still much cheaper than they usually are, as they typically trade at premium valuations among the banks. Our top quality picks are Cullen/Frost CFR, M&T Bank MTB, Bank of America BAC, U.S. Bancorp USB, and JPMorgan JPM. These banks offer a combination of exemplary stewardship and narrow or wide economic moat ratings.
Top “higher risk but higher upside” picks: These are some of the cheapest names on our list, but they also present some elevated risks. If these banks can navigate the risks successfully, we believe it is likely that their stocks will have the highest upside at today's prices. Our top higher risk/higher reward picks are Comerica CMA, Citigroup C, and Wells Fargo WFC.
There is also a bucket of midsize regional banks that are among the cheapest names under our coverage, but we have a more difficult time identifying the obvious risk the market is worried about. These banks are Fifth Third Bancorp FITB, KeyCorp KEY, and Huntington Bancshares HBAN. One common factor among these three is that they all did poorly during the 2008 downturn, and they all caused permanent impairment of capital for shareholders. Perhaps this is why they have sold off more than most, as the market simply doesn't trust them yet. Based on our analysis, we believe these banks have made improvements in risk management and underwriting, and our base case is that all three will make it through the current downturn intact. Therefore, we think these regionals are also worth considering.
Where Might We Be Wrong?
If the next Great Depression occurs and the whole economy falls apart in an unprecedented way, this could put enough strain on the banks and the financial system to the point where no one is safe. This is not our base case, and we think it is unlikely. We also think the government would bear an increasing portion of the burden under this scenario, potentially insulating the banks.
We may also be missing some hidden risk in the system. Perhaps the Fed won't be able to quell liquidity concerns in some corner of the market, or certain assets are more toxic than we realize. The financial system is complex, and anytime it comes under this much strain, new and unpredictable risks can emerge.
Because of the increasing uncertainty around the economic outlook, and especially with regard to how bad the ultimate bear case might become, we have increased our fair value uncertainty rating to high for all of the traditional U.S. banks and to very high for Comerica and Citigroup due to their uniquely high interest-rate exposure (Comerica) and international and credit card exposure (Citigroup).
This information was published April 7 as part of a Financial Services Observer, which is available to Morningstar's institutional clients.