Focus on quality US banks amid rate-cut expectations
A bumpy disinflationary trajectory is expected, but there is potential for further easing if inflation data continues to show improvement
THE US Federal Reserve reduced the interest rate by 50 basis points in September, bringing it to a range of 4.75 to 5 per cent. We see this move as a cautious risk management strategy rather than a reaction to a troubling economic forecast.
The increase in unemployment appears to be supply-driven, while US consumer demand remains strong. Additionally, near-term challenges, such as the war between Iran and Israel, along with long-term trends such as deglobalisation, continue to present upside risks to inflation.
As a result, we expect a bumpy disinflationary trajectory, but also acknowledge the potential for further easing if inflation data continues to show improvement.
In the changing macroeconomic landscape, US consumers expect lower borrowing costs, while banks hope for a rebound in loan demand to boost earnings. However, our analysis indicates that loan rates may not decline as much as anticipated.
Net income relatively robust, but limited upside
Since the second quarter of 2023, the federal funds rate has remained stable, yet banks’ deposit costs have continued to rise, outpacing the growth of loan yields. Intense competition for deposits and expectations of sustained high rates are squeezing net interest margins (NIMs).
As the Fed begins to ease, investors may lower their expectations for high cash yields, which could help banks manage elevated deposit costs in the short term. If inflation continues to cool in 2025 and prompts additional rate cuts, we anticipate that loan yields will decrease more than deposit costs, resulting in further compression of NIM.
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Higher interest rates have allowed banks to charge more for loans, but have also dampened borrowing activity. In Q2 2024, the year-on-year loan growth rate was just 2 per cent, one of the lowest in two-and-a-half years. With the Fed unlikely to expedite rate cuts, we expect loan recovery to be gradual.
In the US, where most mortgages are fixed-rate, we observed a slight uptick in refinancing activity in September. However, we remain cautious about its growth potential. Since the federal funds rate rose to 0.75 to 1 per cent in May 2022, refinancing needs are at historically low levels. Given our belief that the neutral interest rate will remain well above pre-pandemic levels, a significant increase in refinancing is unlikely.
New loan origination is also likely to recover gradually. Market speculation about rate cuts has driven down the 10-year Treasury yield before the actual cuts occurred. The average 30-year fixed-rate mortgage fell from 7.48 per cent in April to 6.59 per cent in August 2024.
We believe the impact of the September rate cut has already been reflected, and further declines in mortgage rates will likely be slow, unless the Fed signals deeper-than-expected cuts ahead. The recent steepening yield curve is also keeping mortgage rates elevated.
While we expect some reductions in rates for credit cards and car loans, overall loan growth remains uncertain due to high annual percentage rates (APRs). With average APRs exceeding 8 per cent for car loans and surpassing 24 per cent for credit cards, a 50-basis-point rate cut in September is unlikely to significantly reduce APRs or stimulate loan demand in the near term.
The rebound in personal loans will depend on the size of rate cuts in 2025 and, given our expectation of a gradual process, we foresee a slow recovery in personal loan demand.
As the Fed aims for a soft landing for the US economy, we anticipate a resurgence in capital market activities. Larger banks with diversified revenue streams are likely to benefit the most from looser monetary policy, as lower funding costs will enhance dealmaking capabilities.
While initial public offerings and mergers and acquisitions are recovering, they are doing so more slowly than anticipated. Our expectation of a persistently high interest rate environment suggests that investment banking activities will continue to experience a protracted recovery.
We believe that a lower – yet still elevated – interest rate environment will continue to compress banks’ NIM, delaying the recovery of lending and capital activities, and ultimately affecting net income. The overall topline growth in 2024 and 2025 appears limited. However, we still believe banks can sustain stronger net interest income compared to pre-pandemic levels.
Credit concerns remain
Over the past two years, net charge-offs and delinquency rates have risen due to higher borrowing costs and dwindling savings – particularly among lower-income families. In Q2 2024, net charge-offs increased by three basis points to 0.68 per cent, surpassing the pre-pandemic average, largely driven by credit card debt.
However, signs of stabilisation in delinquency rates suggest a slowing pace of charge-offs, especially among larger banks such as JPMorgan Chase and Bank of America (BOA), which have more resilient consumer bases.
In contrast, regional banks like Capital One and companies such as Discover Financial continue to face rising delinquencies. In a lower, yet still elevated interest rate environment, regional banks will continue to experience huge pressure from net charge-offs.
Banks heavily invested in commercial real estate (CRE) may find limited relief from recent rate cuts. About US$1.7 trillion in CRE mortgages, originating during the near-zero interest rates of 2019 to 2021, will need refinancing between 2024 and 2026 at significantly higher rates.
Regional banks will continue to face greater challenges than larger, well-capitalised banks such as JPMorgan, BOA, Wells Fargo and Citigroup. While these top banks have substantial CRE loan portfolios, they also maintain significantly higher capital reserves to keep CRE exposure below 100 per cent. In contrast, regional banks with assets under US$250 billion often find themselves overexposed to CRE risks, with exposure levels exceeding 300 per cent.
Valuation appears excessive
The financial sector currently appears overvalued, with the price-to-book ratio of the S&P Global 1200 Financial Sector GICS Level 1 Index at a historical high of 1.67 times, significantly above the 10-year average of 1.23 times.
Limited net income growth and ongoing credit concerns raise doubts about the sustainability of rapid multiple expansion. Additionally, a recent pullback in technology stocks has prompted a sector rotation, leading to a faster increase in financial sector prices compared to earnings.
With modest upside potential, we believe strategic stock selection will be crucial for generating alpha and achieving superior returns beyond the sector level. Given the ongoing volatility and uncertain path to rate cuts, investing in quality companies is a prudent defensive strategy. We favour larger-rated banks for their diversified revenue streams and stronger credit positions.
The writer is a research analyst with the research and portfolio management team of FSMOne.com, the B2C division of iFast Financial, the Singapore subsidiary of iFast Corp
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