Are Banks the New Defensive Play?

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.