Uncertain credit quality remains a cloud over bank valuations, but capital and reserve levels remain healthy. COVID-19 disruptions not nearly over.
Another month of rising COVID-19 infections and hospitalizations across most of the U.S., and evidence that deaths are rising on a lagged basis and still the stock market seems to take no notice. The S&P 500 posted a total return of 5.5% for the month of July, leaving the index roughly where it was in late February 2020, as the market was just starting to plunge at the start of the pandemic. The tech-laden NASDAQ Index, on the other hand, posted a gain of almost 6.8% in July, substantially exceeding its pre-COVID highs. While certain companies, including some of those with the biggest market caps, have actually benefitted from the COVID-19 shutdowns, those companies do not represent the bulk of the companies in the broad market indices. It seems obvious that there will be lasting negative economic impacts from the pandemic. It seems equally obvious that total employment, industrial production, and GNP, among many other economic indicators, will be weaker in 2020 and 2021 compared to 2019. We still believe the economic outlook remains much weaker now than it did six months ago. Even rapid approval and distribution of an effective vaccine cannot undo the damage that has already been inflicted on the economy by COVID-19.
The performance of the stock market is not only disconnected from the outlook for the economy. It also seems to ignore the social and political upheaval affecting the country. Protests related to racial injustice and police use of force has been met with uninvited, unwelcome, and unapproved intervention by federal forces in U.S. cities, a move that has been met with alarm on one side of the political spectrum and support from the other. The coming presidential election is likely to get nastier in the final three months of the campaign. We can debate whether a possible Biden victory would be good overall, but the increased taxes that are likely to follow would not benefit corporate profits, which is another disconnect evident in the rising stock market.
The economic reports released in July seemed to quash much of the optimism that the economy might bounce back from the COVID-19 shutdowns more quickly than anticipated. The U.S. manufacturing sector has been hit very hard this year. However, the ISM Manufacturing Index rose 9.5 points to 52.6 in June, posting its first month of expansion after three straight months of contraction. The Empire State manufacturing index also moved into expansion territory, rising 17.4 points to up 17.2 points in July, its first positive reading since February.
Oil prices held fairly steady in July, bouncing around a bit but ending the month not far from where the month began. West Texas Intermediate crude prices dipped from around $40.65 per barrel on July 3rd to $40.27 at month end. Over the same period, Brent crude rose from $42.80 to $43.52.
A look at the Fed’s H8 data for small domestically chartered banks through July 22, 2020 shows two significant spikes in loan originations in late March and late April-early May. These spikes coincided with the heavy activity in government emergency loan programs, particularly the Paycheck Protection Program (PPP) run by the SBA. Using the data for domestically chartered small US banks, we calculate loan growth for the first twenty nine weeks of the year at 9.2%, which translates to a full year pace of 16.8%. Reflecting the importance of the PPP program to this growth, the C&I segment posted YTD growth of 38.7% or 70.7% annualized over these same periods. Meanwhile, deposit growth was better overall loan growth. The first twenty nine weeks of 2020 exhibited deposit growth of 16.5% or 30.1% annualized. After turning negative in June as the Federal Governments programs wound down, loan and deposit growth have picked back up, posting solidly positive growth in recent weeks.
The outlook for net interest margin is a bit complicated. We still expect core (excluding the impact of federal relief efforts – primarily PPP) margin pressure for banks due to low interest rates overall and a yield curve with only a slight upward slope. However, the PPP program could provide some banks with a boost to net interest income, as the government provides loan forgiveness on many of these loans and the fee income is accelerated into NII. On the funding side, many banks have utilized the low-cost PPP Lending Facility to fund the PPP loans, while many of the borrowers have parked their PPP loan proceeds in noninterest bearing accounts at the originating banks. Those banks that originated a large amount of PPP loans relative to their outstanding loan portfolio are likely to see the biggest positive NIM impact. Investors expect rates to stay near 0% for the rest of 2020, as the CME Group’s FedWatch tool currently shows a 100.0% probability that the Fed will leave rates unchanged at every scheduled meeting through March 2021.
Unsurprisingly, the reopening of economies in many states that began in May, and some optimistic developments in regard to COVID-19 vaccines, bank stocks continued to underperform the broader markets in July due to the unknowns regarding asset quality. The SNL Bank and Thrift Index ended the month of July with a 0.1% decline, adding to the 0.6% reduction in June and the 4.0% drop recorded in May. The July performance was considerably worse than the 5.5% rise posted by the S&P 500 during the month.
While economic reports were somewhat mixed in July, It appears that a reversal in the infection and hospitalization rates during the month was reflected worsening economic readings. The June employment report released early in the month showed another strong rebound in jobs, logging a gain of 4.8 million jobs during the month compared to expectations for job gains of 3.1 million. Revisions to the prior two months added a net 90,000 jobs. Meanwhile, the unemployment rate improved to 11.1% from 13.3% the prior month. The workforce participation rate improved to 61.5% from 60.9%. The year- over-year increase in average hourly earnings was 5.04% compared to the 6.64% figure in the prior month.
Any worries about inflation seem to be unwarranted at least in the near-term. The core PPI slowed to 0.08% on a year-over-year basis, compared to up 0.34% the prior month. Meanwhile the core CPI slipped slightly to up 1.19% YoY from 1.22% in the previous month. Both of these measures remain well below the Fed’s stated target of 2.0% inflation. The Fed’s preferred inflation measure, the core PCE Price Index, held steady, as the May report showed the core PCE deflator up 0.9% year-over-year, down slightly from up 1.0% YoY a month ago. Mortgage rates declined noticeably in July with the 30 year fixed rate falling 14 bps from the prior month according to Freddie Mac data. Existing home sales in June were down 11.3% year-over-year compared to down 26.6% in the prior month. New home sales were up 13.8% month-over-month in June, but they slipped to up 6.9% YoY compared to up 13.7% YoY in the prior month. Meanwhile, mortgage applications decreased 0.8% Wk/Wk in the latest weekly report, their first decline in the month of June, while purchase applications are up 21.0% YoY.
Though the housing market has been a positive for the economy as mortgage rates remain near historic lows, most other major economic indicators (labor market, GDP, consumer sentiment) reported in July continued to show considerable weakness. The drop we had been seeing in unemployment claims seems to have stalled in recent weeks and they still show massive job losses. The pace of new weekly jobless claims has picked back up, with the most recent report showing 1.43 million new claims, up 18k from the prior week. This remains far above historical norms. The initial 2Q20 GDP estimate was released last Thursday, and it showed a 32.9% decline on an annualized basis, compared to the 5.09% drop reported for 1Q20. The 2Q20 decrease is the largest on record. We will remind you that 1Q20 only included two weeks of the shutdowns while the 2Q20 report reflects a full quarter impact of COVID-19- related disruptions. With some government stimulus programs ending as of July 31st and negotiations to restore them in some form between Democrats and Republicans still ongoing, the outlook for 3Q20 GDP remains murky. As noted above, loan growth was very good in the July seemed to rebound from a down month in June, but this trend has been affected by fits and starts in different government programs as well. The yield curve flattened slightly again in July, making earnings growth more of a challenge for banks. Though reported results from 2Q20 still don’t show significant asset quality deterioration, it seems certain that the temporary shutdown of many businesses will lead to increased loan defaults, despite government efforts to offset the impact of the shutdown of some sectors of the economy. For at least the rest of 2020, there appears to be little chance that the Fed will move interest rates. Inexplicably investors seem to be expecting an immediate recovery from COVID-19 related economic disruptions, or that a vaccine will immediately lead to the reopening of businesses shuttered during the pandemic. Though politically unpalatable, we are not sure we won’t see stay-at-home restrictions re-imposed in some areas. In any case, it appears unlikely that economic activity will return to its pre-pandemic levels anytime soon. Re-opening international supply chains or forging new ones will take time, as will consumer comfort with flying, going to restaurants or any number of other activities that involve close contact with many other people.