A case in point was the Fed’s aggressive raising of interest rates in 1994. The following period, which extended into the beginning of the next decade, was a fruitful period to invest in the banking sector as the Fed maintained a normalized interest rate range. For instance, the price-to-book ratio (P/B ratio)¹ across the banking segment expanded from less than 1.5 times in 1994 to 3 times by 1998 (Chart 1). In fact, the banking sector represented by the S&P Composite 1500 Banks Index returned over 49% annually from January 1995 to December 1997.

Will returns be as robust following the current rate hiking cycle? There will certainly be differences, but there are many reasons to believe that a similar stretch of sustained strong performance may materialise.

Bank revenues are expected to move higher

Most banks are currently underearning. In 2023, following the rapid increase in short-term interest rates by the Fed, deposit costs rose faster than loan yields. This negatively affected profit margins and earnings as the cost of the banks’ liabilities increased more quickly than their earning assets. However, we believe this negative impact has nearly run its course, as deposit costs have stabilized (Chart 2). Even with rate cuts on the horizon, regional banks’ revenues are expected to spring higher over the next few years as the banks have a significant amount of loans and securities set to reprice meaningfully higher. Coupled with an increased prospect of lower deposit costs, we believe this creates a strong outlook for net interest revenue over the medium term. 

The median bank has 45% of its loans at a fixed interest rate, meaning the interest rate is constant until maturity.² Typically, these loans have a five-year maturity. As such, the portion of its loans that originated in the low interest-rate environment of 2020-2022 will mature and be replaced with loans at much higher levels over the next few years. This could significantly boost revenues.

Additionally, banks' securities portfolios are commonly four to five years in duration and comprise 10-20% of earnings assets. Similar to their loan portfolios, we believe banks will see additional revenue growth when these securities mature and are replaced with higher-yielding assets. In short, we believe that most bank revenues are at an inflection point and will move higher over the next few years, irrespective of the timing and pace of Fed rate cuts.

Lower valuations further enhance the return potential

Typically, when a company is underearning, its earnings multiple (price-to-earnings ratio) will often trade at a premium as investors expect a near-term recovery. This was observed during the period (2006 to 2014) surrounding the global financial crisis when banking stocks consistently traded above their long-term average compared to the earnings multiples seen across the broader market (Chart 3).

Yet, this is currently not the case. Banks are trading at just over 50% of the broader market’s earnings multiple, which is below their long-term average of 78%. This leaves significant room for valuation expansion as revenues move higher.

Even with the recent outperformance – which we believe may have been aided by the expectations of a Fed cut and the improving fundamentals evident in Q2 earnings results – valuations are still significantly discounted relative to the broader market. Specifically, regional banks are trading at 11.0 times their 2025 forward P/E ratio compared to the broader US market at 20.2 times for 2025³. We believe the attractive relative valuation of banks coupled with expectations for double-digit earnings growth in 2025 and 2026 signals the potential for continued strong outperformance.

Could rate cuts spoil the opportunity?

We don’t think so. The market has reacted favourably toward US regional banks following
Chairman Powell’s announcement that strongly suggested an interest-rate adjustment by the Fed is forthcoming. We believe a monetary easing cycle may act as a catalyst that helps unlock value, as bank valuations have been hampered by investors’ concerns over the impact of the Fed’s aggressive tightening cycle. Over a 16-month period from March 2022 to July 2023 the fed funds rate increased by over five percentage points to a target of 5.25% – 5.50%.

In the event incoming data following rate cuts leads the Fed to reverse their course and there are additional rate hikes, it may raise deposit costs and lead to a further erosion of net-interest margins. In turn, it could also have delayed any revenue growth from the asset repricing we are beginning to see.

Secondly, a hike may increase the persistent fears about the health of the commercial real estate market. We believe that the apprehension surrounding commercial real-estate risk on bank balance sheets has been overstated and somewhat disconnected from reality.

While banks do have exposure to commercial real estate, most underwriting to real estate property firms have had conservative loan-to-value ratios. Moreover, regional banks have minimal exposure to large office assets located in central business districts, where most of the risk lies in this asset class (Chart 4 and Chart 5). In fact, in the second quarter of 2024, the median small- and mid-sized bank experienced only nine basis points of net loan charge-offs, a historically low level⁴. While there may be some credit losses, we do not believe the issue is systemic. Additionally, banks have established substantial reserves to absorb potential loan losses.

The concerns over higher deposit costs and commercial real estate exposure should be dampened given expectations of a rate cut in September. Lower borrowing costs for commercial real estate borrowers should act as a catalyst to bank multiples as fears around their debt service burden subside. If we look back to mid-1995, when the Fed began pivoting towards monetary easing, it sparked a significant improvement in bank valuations. While we don’t know how the market will treat such a move in 2024, history tells us it should benefit valuations.

1 The price-to-book (P/B) ratio measures the market's valuation of a company relative to its book value. Assume the book value remains unchanged, a raise in P/B ratio indicates the stock price increases. 2 Data from Janney Montgomery Scott, 6/3/2024. 3 Source: FactSet, data as of 31 May 2024. Regional banks are represented by S&P Regional Banks Select Industry Index. Broader US market is represented by S&P 500 Index. It is not possible to directly invest in an index. 4 Data from KBW as of 8/2/2024.