U.S. banks can offer untapped potential—once the economy returns to normal
What started out as a promising 2020 for U.S. banks was upended by the coronavirus outbreak. Through much of late February and into early April, uncertainty over the duration of the public health crisis and its human and economic toll became so pervasive that any short-term investment outlook became highly speculative.
Markets welcomed the U.S. Federal Reserve’s aggressive and rapid response, but one aspect of its initiatives—a series of interest-rate cuts—darkened the outlook for banks. The combination of ultralow rates and elevated risks from loan losses weighed heavily on the industry, and bank valuations fell to extreme levels.
However, fundamentals came into clearer focus in mid-April as banks began to report first-quarter results as earnings season opened. While U.S. banks had plenty of ground to make up from their recent underperformance relative to the broader equity market, the initial batch of earnings bolstered our belief that banks remain a source of untapped potential. We believe that attractive valuations and the industry’s record of compounding book value provide a favorable entry point for long-term investors. While short-term hurdles remain, initial earnings reports suggest that banks remain financially well positioned to weather the current economic storm. Looking out further, we believe that many of these banks are likely to return to pre-COVID-19 earnings levels fairly quickly once the health crisis eases and the economy begins to return to some semblance of normalcy.
A conservative approach to helping protect against loan losses
Our outlook is rooted in our views on banks’ loan loss provisions—reserves set aside to cover future loan losses. While most loans continue to perform, loss provisions have become critical as banks allow customers to temporarily postpone or reduce loan payments—known as forbearance—and otherwise modify terms to temporarily alleviate customers’ current financial stress. As of late April, our tracking of first-quarter results showed that banks have been substantially expanding their reserves in anticipation that a certain percentage of borrowers won’t be able to meet debt obligations when the economy reopens.
The industry’s buildup in reserves has accelerated relative to reserve expansions in prior economic downturns because of a tightening of accounting standards; banks are required to provide for cumulative expected credit losses over the entire lives on loans on their balance sheets, rather than covering only for losses over the next 12 months. The Coronavirus Aid, Relief, and Economic Security Act—the initial government response to the economic crisis, best known as the CARES Act—allowed banks to opt out of the tightened accounting standard. However, according to our analysis of first-quarter reports through late April, all large banks indicated they had opted to not exercise the right to revert to the old standard. In maintaining the tighter standard, these banks have taken a hit to their short-term results, as they’re subtracting from current earnings in order to build up their balance sheet cushions more quickly than they could have done under the old standard.
Depending on the trajectory of the economy’s reopening from coronavirus-related restrictions, we believe banks are likely to continue adding to their reserves in coming quarters.
If this trend materializes and the economy reverts to a growth track, we believe the buildup in reserves could actually help accelerate a recovery in bank earnings, as banks would have reserves in place to cover most expected future loan losses. In essence, banks are realizing credit expenses well in advance of when potential losses may actually occur. This is an important differentiator relative to recoveries from past economic downturns. Under old accounting standards, banks could spread the negative earnings impact from loan losses over longer periods.
Revenue and fee resiliency amid a crisis
In addition to building up their reserves, many banks have generated significant deposit and loan growth; initial first-quarter reports showed that banks reported stronger-than-expected loan growth of an average 7.3% relative to the same quarter a year earlier.1 These gains have largely been the result of corporate borrowers drawing down revolving lines of credit during a period of extreme market volatility in March. This extension of credit highlights the key systemic role that banks can play during periods of economic and market stress by helping to absorb shocks and meeting clients’ liquidity needs. Banks also benefit, as they can potentially generate profits from increasing their interest income when clients draw down revolving lines of credit.
As for revenue, banks’ initial first-quarter results came in better than expected, with operating revenue rising 4.0% from the same quarter a year earlier.1 We attribute this to several factors. For one, the steps that banks have taken to alleviate systemic shocks have returned loans and deposits to bank balance sheets. Known as reintermediation, this process supports banks’ net interest income. Consequently, it helps to offset some of the headwinds to banks’ net interest margins—a measure of a bank’s yield on interest-earning assets—resulting from recent interest-rate cuts.
Additionally, net interest income has been supported by interest-rate hedges that many banks implemented over the past year. Furthermore, our analysis shows that banks have recently maintained strong income from fees, supported primarily by two sources. First, mortgage banking revenue was strong over the first quarter as borrowers refinanced in the wake of the recent rate cuts. Some banks also commented that their mortgage pipelines remained strong—a factor that should support future fee income. In addition, some larger banks reported increasing trading revenue related to strong capital markets activity given the spike in market volatility.
Positioned to ride out continued uncertainty
This revenue resiliency and the capital strength that’s evident from many banks’ balance sheets have allowed the industry to build up its reserves. Amid these changes, banks have largely remained profitable and, on quarterly conference calls, executives have expressed intentions to stand by the dividends that their banks issue, rather than reducing or suspending them. These factors have bolstered our expectations that banks may continue to serve as long-term value generators, despite the abundant headwinds they’ve recently faced—and will likely to continue to confront to some degree amid continued uncertainty.
1 “KBW Bank Earnings Wrap-Up 1Q20, v. 2: Bank Results Continue to Reveal Unusual 1Q,” Keefe, Bruyette & Woods, April 24, 2020.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.
The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.
This material, intended for the exclusive use by the recipients who are allowable to receive this document under the applicable laws and regulations of the relevant jurisdictions, was produced by, and the opinions expressed are those of, Manulife Investment Management as of the date of this publication, and are subject to change based on market and other conditions. The information and/or analysis contained in this material have been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only as current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.
Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained herein. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. Past performance does not guarantee future results. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit nor protect against loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management.
Manulife Investment Management
Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than 150 years of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams—along with access to specialized, unaffiliated asset managers from around the world through our multimanager model.
These materials have not been reviewed by, are not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at www.manulifeim.com/institutional
Australia: Hancock Natural Resource Group Australasia Pty Limited., Manulife Investment Management (Hong Kong) Limited. Brazil: Hancock Asset Management Brasil Ltda. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area and United Kingdom: Manulife Investment Management (Europe) Ltd. which is authorised and regulated by the Financial Conduct Authority, Manulife Investment Management (Ireland) Ltd. which is authorised and regulated by the Central Bank of Ireland. Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Investment Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad (formerly known as Manulife Asset Management Services Berhad) 200801033087 (834424-U) Philippines: Manulife Asset Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G) South Korea: Manulife Investment Management (Hong Kong) Limited. Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan) Co. Ltd. United States: John Hancock Investment Management LLC, Manulife Investment Management (US) LLC, Manulife Investment Management Private Markets (US) LLC and Hancock Natural Resource Group, Inc. Vietnam: Manulife Investment Fund Management (Vietnam) Company Limited.
Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance
514672
