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Are Banks the New Defensive Play?
Charu Chanana
Chief Investment Strategist
Key points:
- Strong 2024 Earnings: Major banks like JPMorgan Chase and Bank of America reported robust earnings due to a resilient U.S. economy, increased consumer and business activity, and market volatility boosting trading revenues.
- Positive Outlook: Banks are expected to benefit from a steeper yield curve, potential deregulation, and high tech valuations driving investments into financials, alongside increased mergers and acquisitions activities enhancing revenue streams. This stands out especially because most other sectors are facing a threat of tariffs and trade realignment.
- Investment Opportunities and Risks: While large banks offer attractive valuations and dividends, regional banks present both opportunities and challenges, with risks from economic sensitivity and competition. ETFs provide diversified exposure, but investors should consider economic and geopolitical risks.
Banks are in the spotlight after a series of strong 2024 earnings reports from major players. JPMorgan Chase, Bank of America, Wells Fargo, Goldman Sachs, and Citigroup all posted robust results last week, benefiting from a variety of factors. With banks proving their resilience yet again after years of regulatory pressure, it’s worth asking – are they becoming the new defensive play in today’s uncertain market?
Why Banks Have Done Well in 2024?
Resilient Economy
Economic conditions have remained resilient in the US, leading to increased consumer and business activity. Loan growth has surged, bolstering banks' interest income and overall profitability. Elevated credit card usage has also bolstered banks’ interest income and fees despite concerns over rising credit-card delinquencies.
Wall Street Revival
Corporate optimism has surged, leading to increased debt issuance and bond activities. This uptick was particularly notable around the presidential election and following President Trump’s victory, as companies sought to capitalize on favorable market conditions.
Trading Gains
Market volatility, influenced by various economic indicators, boosted revenues for banks’ trading desks. Institutions like Bank of America and Citigroup reported notable increases in trading income due to higher market activity.
Asset Management Growth
Healthy financial markets and an expanding client base enhanced fee-based income from asset management services, contributing to the overall profitability of major banks.
Which Banks Are Leading the Pack?
The big names are showing strength across different business lines, but some are outperforming others in specific areas:
JPMorgan Chase (JPM)
Known as the best-in-class among the megabanks, JPMorgan continues to excel in investment banking and trading. The bank’s fixed-income and equity trading businesses outpaced rivals, generating billions in fees from surging client activity. Its consumer banking division also saw robust loan and credit card growth, signaling a confident U.S. consumer base. CEO Jamie Dimon is interested in acquisitions, with recent deals and organic efforts indicating UK expansion as a new retail growth channel beyond the US. While questions about CEO succession remain, a strong leadership team and corporate culture reduce the risk.
Bank of America (BAC)
BofA is leading when it comes to net interest margin (NIM), benefiting from its heavy exposure to consumer banking. With interest rates ticking lower, the bank’s core business of lending to households and businesses has delivered outsized gains.
Goldman Sachs (GS)
The king of Wall Street dealmaking, Goldman saw another stellar quarter of investment banking fees. A flurry of mergers, IPOs, and bond underwriting helped drive revenues, and deregulation hopes are also driving the stock higher.
Wells Fargo (WFC)
After years of regulatory issues, Wells Fargo is turning things around. The bank’s core lending business is showing signs of recovery, especially in mortgages. However, its heavy reliance on consumer credit means it may be more vulnerable in an economic slowdown, and expense efficiency will be a key focus area for investors in 2025.
Citigroup (C)
Citi reported solid gains in international markets, leveraging its global presence to outperform in areas like foreign exchange trading and treasury services. It also announced a $20 billion share buyback program, boosting shareholder returns. However, the bank continues to face questions about its strategic direction and efficiency compared to peers.
Morgan Stanley (MS)
Morgan Stanley shone in wealth and asset management, which now make up the majority of its revenue.
Why Makes the Outlook Rosy?
The U.S. economy remains resilient, and markets continue to be buoyant despite a political shift being underway. In addition, the following factors can support U.S. bank earnings in the upcoming quarters:
Steeper Yield Curve
With the Fed still expected to cut rates, short-end yields should move lower while long-end yields could continue to move higher in response to the loose fiscal policies, resulting in a steeper yield curve, where long-term rates are higher than short-term rates. This continues to benefit banks as it allows them to borrow cheaply in the short term and lend at higher rates for mortgages and business loans, widening their profit margins.
Deregulation and M&A Expectations
The new Trump administration has pledged to prioritize deregulation, which could mean easing capital requirements and rolling back restrictive rules on banks, allowing to free up more resources for lending, investments, and shareholder returns. Additionally, mergers and acquisitions (M&A) activities are likely to increase, which bodes well for banks’ underwriting and advisory volumes and fees, and increased IPOs are also likely to aid secondary volume.
High Tech Valuations Drive Flows
With the tech sector reaching sky-high valuations, some investors are rotating out of growth stocks into financials, where valuations appear more reasonable.
No Tariff Risks
Banks face no direct threat from President Trump’s tariff posturing, although second-round effects may be expected if inflation is reignited.
Regional Banks: Hidden Gems or Riskier Bets?
Regional banks have historically offered investors exposure to local lending and deposit markets, often with higher dividend yields and lower valuations than larger national banks. However, in the current environment, they face unique challenges alongside opportunities. Here’s a breakdown of the pros and cons of investing in regional banks today:
Pros:
- Local Market Strength: Regional banks are often deeply embedded in their communities, benefiting from close relationships with small businesses and individuals. Many banks in fast-growing areas, such as the Sun Belt, are well-positioned to capitalize on local economic growth.
- Valuation and Yield Appeal: Regional banks frequently trade at lower price-to-earnings ratios than their larger counterparts. Additionally, they often offer dividend yields in the 3.5% to 5% range, making them attractive to income-focused investors.
- Restructuring Initiatives: Some regional banks are aggressively pursuing cost-cutting and efficiency improvements, which could boost profitability over time. Consolidation within the regional banking space may also create opportunities for growth and scale.
- AI Investments and Technology Upgrades: To stay competitive, regional banks are starting to invest in artificial intelligence (AI) and digital banking platforms, enabling them to improve customer experiences and reduce costs. These tech upgrades can help bridge the gap with larger institutions.
Cons:
- Economic Sensitivity: Regional banks, which rely heavily on traditional lending and are less diversified compared to larger banks, are more vulnerable to local economic downturns. Sluggish small-business activity or softening in consumer demand can quickly impact their bottom line. Reduced expectations for Fed rate cuts, as a result, has weighed more on regional banks compared to the large caps.
- Poor Asset Quality: Many regional banks are grappling with deteriorating asset quality due to higher exposure to commercial real estate (CRE) loans and underperforming loans. This could force some banks to increase loan loss provisions, cutting into profitability.
- Competition from Larger Banks: National banks like JPMorgan and Bank of America are increasingly encroaching on regional banks’ markets with competitive digital offerings and larger branch networks.
- AI and Technology Spending: While technology investments are necessary, they require significant upfront spending. For smaller banks, these costs can be challenging to absorb and may weigh on near-term earnings.
- Restructuring Risks: While restructuring and cost-cutting initiatives offer long-term benefits, they often involve short-term expenses and potential layoffs, which could disrupt operations or hurt customer satisfaction.
Risks to Consider
While banks are showing resilience, they are not without risks:
- U.S. Economy and Consumer Strength: Banks rely on a strong economy to drive lending, credit card spending, and consumer confidence. A slowdown could lead to weaker earnings and higher default rates.
- Deregulation Delays: If deregulation initiatives are postponed or fail to materialize, banks may face challenges in freeing up capital and expanding profitably.
- Tariffs and Fiscal Risks: Trade disputes, tariffs, and fiscal uncertainty could pressure markets and reduce investment banking revenue. Capital markets income, a key driver for megabanks like Goldman Sachs and JPMorgan, could take a hit if economic or geopolitical tensions escalate.
Valuations: Still Room to Run?
Bank stocks currently trade at attractive valuations relative to the broader market:
- Price-to-Earnings Ratios: Most large banks trade at P/E ratios between 10x and 16x, compared to the S&P 500 average of 21x and also below S&P 500 equal weighted P/E of 17.5x.
- Price-to-Book Ratios: Many banks now trade above book value, suggesting market doesn’t see the increased trading revenue as a risk.
- Dividend Yields: With yields ranging from 1.5% to 3%, banks offer strong income potential, making them an attractive option for dividend-focused investors.
Valuations appear rich but attractive, and possibly do not fully reflect the risks associated with the sector, including sensitivity to the economy and interest rate changes. Investors should weigh the upside potential against these risks when allocating capital to financials.
Investor Takeaways
Banks are increasingly looking like the new defensive play for investors. With solid dividends, attractive valuations, and growth catalysts on the horizon, they could provide a balanced mix of stability and opportunity in a portfolio.