The banking sector is facing its deepest correction in almost three years. Ever since the 2016 election put Donald Trump in office, financial stocks have gone straight up. The primary sector ETF, the Financial Select Sector SPDR ETF (NYSEARCA:XLF) traded around $20 at election time and ran up to as high as $30/share earlier this year. That’s a 50% gain in just 18 months. Bank of America Corporation (NYSE:BAC) did even better over that stretch. BAC stock doubled from November 2016 to January 2018.
But now financials in general and BAC stock in particular are heading in reverse. The tailwinds that powered financial stocks up are rapidly fading. And now new fears are escalating, causing banking stocks to move sharply lower, even as other indices have traded reasonably well. What’s gone wrong with the sector and what does it mean for BAC stock?
The Yield Curve Is About to Invert
Banks make a large portion of their profits from borrowing short and lending long. To put it more simply, banks pay low interest rates on short-term deposits such as checking and savings accounts and 1-year CDs. In turn, they use these funds to offer mortgages and other longer-duration loans. In theory, they can charge much more for the mortgage than they pay the depositor.
Nowadays, however, this process isn’t working so well. The Fed has hiked interest rates from essentially zero to 2.0% on the short end, forcing the banks’ interest rates on deposits to rise by a similar degree. On the other hand, mortgage rates are going up more slowly, since 10- and 30-year treasury yields topped out earlier this year and are now going back down again.
This is bad for banking profitability for obvious reasons. It also is an alarming omen for something worse — a recession. When short-term interest rates rise above long-term interest rates, it means that investors think the economy is in danger of slowing down sharply. And with good reason. The last three times that the yield curve inverted (1989, 2000, 2006), recessions followed not long after.
Financial Stocks Sliding
The combination of falling bank profitability and rising recession fears are a noxious brew for banking shares. Banks do best in an environment where interest rates are rising across the board in tandem with strong demand for new loans.
Instead, investors are now forced to think about falling profit margins combined with a potential recession. This is a far bleaker outlook than the market was pricing in just six months ago.
As a result, the XLF sector ETF has declined 10% since its high this past winter. That’s the worst pullback since late 2015, when Chinese market concerns caused a significant decline in growth-related equities including major banks. Interestingly, China is again at the center of current jitters, particularly with the potential for a trade war. Large banks, including Bank of America, derive significant revenues from investment banking and international transactions, and are thus more exposed to a global slowdown than your local mom and pop bank.
Is the Market or the Fed Right?
Ultimately, the big question for investors in BAC stock is whether the Jerome Powell-led Federal Reserve is correct or not. Mr. Powell has demonstrated with recent comments that he is primarily focused on the strength of the domestic American economy. He notes that inflation is mounting and that unemployment numbers speak to an unusually strong labor market. That’s all true.
But these things can shift quickly. While the American economy is booming, that could soon turn. The stimulative effects of the tax cuts will fade with time. Other economies, such as Japan and much of Europe, are showing much less strength. And emerging markets are turning into quite a problem in 2018, with crises in Argentina, Turkey, Brazil and, now, the trade dispute with China.
An inverted yield curve, which we could see as soon as the next Fed hike, signals that the market thinks the Fed is acting too aggressively. By hitting the brakes too forcefully, the Fed risks sending the economy into a recession and triggering a global credit disturbance. The Fed doesn’t seem to see this as a real risk. What happens next, for both BAC stock and the economy more broadly, depends on which read of the economic indicators is more accurate.
Bank Of America Is Performing Well
Now, some credit where it is due: Bank of America is doing a great job. The company continues to outpace its industry in both growth and profitability. That has led BAC stock to outperform on the way up and has helped it hold its ground, to a degree, as the sector has slumped this year.
Perhaps most importantly, Bank of America is boosting its profit margins. Over the past year, is has run a fairly consistent 7%-or-so revenue growth rate while keeping its expenses at a flat level. That generates massive margin expansion. This makes for 13 quarters in a row in which the company has managed to grow revenues more quickly than expenses.
This discipline on the cost side, combined with reasonable expansion on the revenues side is leading to above-average earnings growth. In addition, the tax cut gave Bank of America a lot of fresh earnings power, which the company has used to raise the dividend and buy back stock. With the dividend at 1.7% today, however, there’s plenty of room for more dividend hikes.
BAC Stock Verdict
In some cases, a phenomenal performance from an individual company can overcome weakness in its sector. This doesn’t appear to be one of those situations. As well as Bank of America is performing, it is still stuck in a sector that ran up too fast on Trump-related optimism and is now paying the price.
While the corporate tax cut provides a real and ongoing benefit for the financial stocks, the other perks may not materialize. Interest rates are heading in the wrong direction. Analysts are growing increasingly concerned about a potential major economic slowdown in 2019. And turbulent conditions in foreign markets may weigh on Bank of America’s investment banking profits. All in all, after a huge run over the past two years, BAC stock could correct further, despite its ongoing strong earnings.
At the time of this writing, the author had no positions in any of the aforementioned securities.
