After the anemic economic growth and overregulation of the past decade, what banking themes can we expect in 2017 amid current market optimism?
For an immediate impact, Trump and the Republican Congress need to lower the corporate tax rate first. Other policy agendas will have long-term effects. The true unemployment rate is over 10 percent, not 4.6 percent, when factoring in a normal labor participation rate, which is currently close to a 40-year low. Almost all employment growth from 2005 to 2015 is part-time, temporary or contract work. The economy is still not well, yet inflation continues to build, for example, with rising healthcare costs, government services and education costs. Most assets are overpriced with artificially low rates contributing to a torrid stock market and average price/earnings ratios at a 20-year high. This should keep rate hikes to 1 or 2 percentage points versus the 3 or 4 percentage points most are predicting. Rate hikes will create a nominal positive effect on net interest margin for banks of 5 to 10 basis points.
Corporate debt ratios are higher, particularly those with high yield. Most banks have thankfully chased high grade customers and credit since the crash. However, many are at or over the 300 percent real estate or 100 percent construction and development loan thresholds. Expect a real estate pullback. If the stock market retreats 5 to 10 percent, a mild recession may result. We are due for a credit correction over the next 6 to 18 months. It will hurt non-bank lenders more than banks. Loan growth should remain steady and provisions need to increase.
If bank stock prices can stay above 16 times earnings, expect more initial public offerings (IPOs) due to pent-up demand from 2016. Many banks are trading at 20 times price to earnings or more, and banks are in favor with investors. Bank stocks have been a greed and fear trade since 2008 with a near 100 percent correlation. Consumer and investor confidence is running high presently. Optimism abounds about interest rates, the economy, tax cuts and deregulation. While it all seems to be priced into bank stocks right now, investing in government optimism versus company fundamentals feels a bit awkward at best. Expect a pullback, but for the sector to remain strong with good, core earnings growth of 15 percent or more and with more IPOs in quarters two through four. There has been an increasing interest from yield-starved investors in bank stock loans, subordinated debt and preferred stock. Expect that to continue.
The volatility in the markets in 2016 were driven by China, energy, and Brexit, so renewed confidence could be a good thing for M&A. Do prospective sellers, frustrated with lackluster returns and burdensome regulations, have newfound optimism and upward price exit expectations? Perhaps, but there is room to run here. Volume was down 10 percent in 2016 with 242 deals. But there was an increase in exits or restructuring, as private equity investments matured and investor activists pressured banks to sell. Confidence and high buyer currency should lead to increased volume in 2017, especially given the seller expectations being average to below average, while buyer currencies are at 20-year highs. But if volatility and fear get too high, then M&A will slow.
One or two rate hikes shouldn’t be an issue as bankers will wait to raise rates on deposits. At some point, depositors will gain confidence in the market and push for higher returns. This will be interesting as many bankers think they have core deposits, even though they don’t, and will realize they have a liquidity problem when the deposits run.
Complaints about the Dodd Frank Act are still rampant industry wide, but bankers will be found thinking, “Hey, I’ve spent the money and adjusted. I need certainty, not uncertainty.” While there are still parts of Dodd-Frank that haven’t been implemented, deregulation could be the developing theme. Also, what happens to the Consumer Financial Protection Bureau? This is an entity which basically usurped power from the other regulatory agencies, and plenty of senators and representatives would like to curtail its power.
Lastly, banks will have to work on improving customers’ experience. Take note of the retail industry. After a robust Christmas shopping season, Macy’s is closing 59 stores and Sears even more. If your product is clothing at a good price, then online retailers have stolen your product. Retail needs to provide an experience to differentiate. Some banks are already delivering a coffee shop or networking experience. Amid the fake news perpetuated online, and failed deliverables from Wall Street, the country is desperate for a trusted refuge and harbor of safety they can believe in. Perhaps, banks that deliver an experience anchored in a theme of trust will do well.