Flat yield curve drives bank stock valuations down, despite signs of continued, though slower, economic growth
The outlook for the U.S. economy continues to grow more subdues. We have not heard any predictions of a recession in 2019, but the word is appearing in more discussions these days. The consensus view seems to be that the economy will continue to grow for the rest of 2019, but growth will be lower than 2018 and lower than many economists were projecting two or three months ago. In terms of stock prices, the broader markets ground out modest gains in the month of March, enabling a continuation in the rebound we have experienced since the sharp declines in December 2018. Evidence that a number of developed country economies are slowing down further and continued uncertainty about Brexit are causing more cautious behavior among domestic investors. Concerns about growth have resulted in declines in longer-term bond yields, resulting in a slight inversion of the yield curve in late March. This event has caused some concern in the broader stock markets, but the concerns have had a very noticeable effect on bank stocks, which underperformed broader market indices during the month. Despite the less optimistic outlook, we still expect economic growth in 2019, which we believe will translate to modest overall loan growth this year, though this will be accompanied by continued margin pressures from rising deposit costs and a flat yield curve.
A look at the Fed’s H8 data through March 20, 2019 shows that loan growth remains modest. Using the data for domestically chartered small US banks, we calculate loan growth for the first twelve weeks of the year at 1.8%, which translates to 2.0% for the quarter and a full year pace of 7.9%. This represents an deceleration from the 8.5% pace we noted in our note last month for the first eight weeks of the year. On the other hand, deposit growth seems to have increased from the 0.5% implied deposit growth we noted last month to 1.1% so far for 1Q19. This translates to a 4.9% annual pace. Large time deposits still seem to be driving a significant portion of deposit growth, leading to an expectation of additional margin pressure from rising deposit betas. The yield curve flattened further during March and even inverted slightly late in the month. We still think the banks in our coverage universe can continue to generate modest EPS growth, but the pace of growth is likely to slow in 2019 and may be lower than we originally anticipated.
Fed policy on interest rates remains an important question for investors, but it seems that concerns about increasing rates is no longer the major issue. In fact, with the recent slight inversion of the yield curve, some investors have begun anticipating one or more rate cuts this year. The CME Group’s FedWatch tool suggest a plurality believe the Fed will cut rate at least once in 2019, with 23.3% believing there will be more than one rate cut during the year and only 32.3% anticipating that the Fed will leave rates unchanged throughout 2019 at the current target rate of 225-250 bps. There are good indications that inflation is slowing, and GDP growth appears to be waning as well.
Bank stocks could not maintain their rebound that had seen them regain most of the losses suffered in December 2018 during January and February this year, despite some modest gains in broader market indices during March. The SNL Bank and Thrift Index ended the month of March with a 5.3% decline, falling well shy of the 1.8% rise in the S&P 500.
In regards to economic statistics, the February employment report released at the beginning of March showed employment gains of just 20,000, well below the 180,000 expected the 304,000 originally reported for the prior month. Revisions to the prior two months were a net increase of 12,000, leading to the three-month average in nonfarm payrolls plunging 59,000 to 186,000. However, the unemployment rate fell to 3.82% from 4.0% the prior month. The workforce participation rate edged lower to 63.15% from 63.21% in the prior month. The year-over-year increase in average hourly earnings accelerated to 3.40% from the 3.14% figure in the prior month.
On the inflation front, the core PPI and core CPI slowed some from previous showings, with the core PPI remaining slipping to up 2.45% on a year-over-year basis, compared to up 2.64% the prior month. Meanwhile the core CPI edged down to up 2.08% YoY from 2.15% in the previous month. Mortgage rates have been declining in recently. Lower rates may finally be helping the housing market, as existing home sales in February improved to down 1.8% year-over-year compared to down 8.7% in the prior month. However, new home sales are down 4.1% YoY, compared to down 2.5% YoY in the prior month. Several other indicators of future sales showed a mixed message, as housing starts and permits suggest lower home sales going forward, but mortgage applications suggesting an increase.
The outlook for the banking industry remains mixed. As noted above, the economy seems to be slowing, but it still remains in growth mode. Despite the downward revision to 2.2% for 4Q18 GDP (from an initial reading of 2.6%), this still shows a healthy U.S. economy. Still, loan growth remains modest at best and an interest rate environment that’s flirting with an inverted yield curve suggests little confidence that economic growth will pick up or even maintain its current level. While an end to Fed interest rate hikes is something that has been on some investor wish lists for a while now, few of those investors wanted to see the rate hikes end due to lower economic growth expectations. The spread between the 1-year and ten-year treasuries contracted in March, falling 18 bps to 1 bps at the end of March from 19 bps a month earlier. We remain concerned about the impact of detrimental trade barriers on the economy. With price growth possibly peaking in October 2018, inflation is less of a factor in monthly economic readings. Lowered expectations for economic growth is now leading to suggestions that the Fed’s next moves may be to lower interest rates later in the year. Fears of troubled economic performance among some of our major trading partners and the ongoing trade dispute with China are adding to worries of reduced economic growth and lower bank stock valuations. We expect the yield curve and trade war fears, coupled with continued political turmoil between the White House, Senate and House of Representatives, to continue to influence bank stock prices.