Higher interest rates are a trap for bank stocks

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Banks are in a much stronger financial position than a dozen years ago.

Photograph by Hector Retamal/AFP/Getty Images

Banks have proven their durability time and time again since the pandemic, but making outsized gains in banking stocks requires a healthy consumer — and that could get tougher.

Understanding what is happening with banking stocks these days leads to circular reasoning. Going into 2022, banks were expected to outperform as it was widely understood that the Federal Reserve should raise interest rates to fight inflation. Higher interest rates are good for banks because they increase the amount of interest banks can earn on the loans they make. The problem is that inflation that requires higher rates can harm bank customers. Feeling strapped for cash due to rising costs, customers may begin to miss payments on existing loans or be hesitant to make large purchases because more of their income is tied to necessities.

The sweet spot for banks is to have a rising rate environment, but not an environment that limits consumer demand. Wall Street is not convinced that the banks will land there.

So far this year, the

SPDR S&P Bank ETF

(ticker: KBE) is down 12.5%, better than the 17% drop in the

S&P500

but not showing the signs of the great year hoped for by Wall Street.

“Ultimately, we believe consumer health continues to be critical to the performance of banking stocks,” Erika Najarian, analyst at

UBS
,

wrote in a note in which the bank examined consumer strength in the face of inflation hovering around a 40-year high. “Our survey indicates that it is too early to call victory on consumer resilience in the face of inflationary pressures.”

UBS found that 51% of survey participants cut discretionary spending to keep spending levels stable in a higher inflation environment. Still, 60% of those surveyed in August said they were spending more, compared to 57% in July.

These higher prices delayed or prevented respondents from making major purchases such as buying a house or a car. For banks, this is bad news because, coming out of the pandemic, they hoped that loan growth would return after households had exhausted their stimulus cash. While bank earnings for the first half of the year showed loan growth picking up, it could start to slow before it’s really had a chance to take off. Meanwhile, customers are placing more emphasis on paying off their credit card debt. This is good news for households and the risk management side of banking, but bad news for the size of banks’ loan portfolios.

Despite headwinds, Najarian is still bullish on banks, favoring

Bank of America

(BAC),

Wells Fargo

(WFC), First Republic (FRC),

PNC Financial Services Group

(PNC), and

M&T Bank

(

MTB

). She notes that banks are equipped to weather a tough credit cycle and should post “normalized” earnings in 2023, meaning they will benefit from higher rates and their results will not be clouded by changes in reserve levels.

Write to Carleton English at [email protected]

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