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Weak Data Could Hasten Rate Cut: Can Banks Cope?

Swarup Gupta

On Jul 3, a Fed rate cut became a near certainty following the release of soft economic data. Benchmarks closed higher at the end of trading on expectations that the central bank would announce a reduction in rates later this month. The spate of weak economic reports include weaker-than-expected readings for services and private sector job additions.

Banks are expected to feel the pinch since lower rates weigh on their net interest margins. At the same time, U.S. banks have emerged creditably from recently conducted stress tests, subsequently announcing higher dividend payouts. In this context, it is important to examine whether investors should view a rate cut as a buying opportunity or avoid banks altogether after such a move.

Spate of Soft Data Puts Rate Cut in Focus

On Wednesday, Automatic Data Processing, Inc. ADP released its latest private sector jobs numbers, per which U.S. companies have added only 102,000 jobs in May. Though this is significantly higher than the level of 41,000 created in May, it has come in below most analyst estimates for June’s numbers.

Meanwhile, the Institute for Supply Management’s services index declined from 56.9% in May to 55.1% in June. This is lower than the consensus estimate of 55.9% and the poorest level recorded in nearly two years. Also, Markit’s services index only managed to inch up from the 39-year low it hit in May.

But any sign of weakness in services, the bulwark of the U.S. economy, is worrying. Additionally, factory orders declined 0.7% in May, far worse than the consensus expectation of a 0.4% decline. Incidentally, on Jul 1, the ISM manufacturing index slipped from 52.1 to 51.7 in June.

Can Banks Ride Out Softer Rates?

The net interest margin of a bank is the gap between the revenue gained from payments on loans and the interest paid to depositors. So when the Fed raises rates, banks receive higher interest payments on their loans, raising their net interest margin in the process. But when rates are reduced, margins decline.

This is why a rate cut could lead to a self off in bank stocks. Some market watchers think that this represents a great buying opportunity, others naturally differ. But it is important to keep in mind that banks, especially sector majors, have emerged with flying colors from the recently conducted stress tests.

Regulators allowed a majority of the 18 institutions to raise dividends and buy back shares. All these banks exhibited financial strength by showing that they had enough capital to withstand a potential economic downturn. These include PNC Financial Services Group PNC, Bank of New York Mellon BK and State Street STT.

Analysts are particularly favorably disposed toward JPMorgan JPM, Bank of America BAC and Citigroup C. JPMorgan has a Zack Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

All of these banks have increased their dividends by 10% or more. Further, they have been authorized to engage in share repurchases amounting to a combined worth of $81 billion following the results of the stress tests.

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The Bank of New York Mellon Corporation (BK) : Free Stock Analysis Report
Citigroup Inc. (C) : Free Stock Analysis Report
Bank of America Corporation (BAC) : Free Stock Analysis Report
State Street Corporation (STT) : Free Stock Analysis Report
JPMorgan Chase & Co. (JPM) : Free Stock Analysis Report
The PNC Financial Services Group, Inc (PNC) : Free Stock Analysis Report
Automatic Data Processing, Inc. (ADP) : Free Stock Analysis Report
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