That is the title of Icap’s latest cycles strategy report — and the answer to the broker’s self-posed question is, perhaps unsurprisingly, an emphatic yes.
Here’s the thrust of the thesis, as put forward by Icap’s Bijal Shah (emphasis ours):
Globally, bank shares have doubled from their lows of early March. Investors now fret that with demand for borrowing poor, banks may struggle to generate substantial growth in their earnings per share. Predictably, with this level of bearishness, the bank sector in the US and in Europe is trading on a price to book of just around one, despite doubling in value.
Loss provisions & bank eps cycle
However, in the initial two years of the economic upswing it is not loan demand, but reduction in bad loss provisioning that drives bank eps [see chart at right]. The sharp improvement in the newsflow on corporate profits, on aggressive cost-cutting and the levelling out of demand, has dramatically diminished default risk; junk credit spreads have fallen from around 20% to 8%. Unsurprisingly, bank share prices have doubled in six months, smartly outperforming the broader market.
Manufacturing utilisation rates in the US, Germany and Japan are all edging higher. And as utilisation climbs so do profits for the corporate sector. It is very likely that the rally in corporate debt will extend further over the coming year.
And US house prices may also rise. With greater backlog of orders, US firms are no longer cutting working hours, and unemployment rates are now only edging higher having moved up substantially in Q4 and Q1. The resulting rise in consumer confidence is feeding through to the housing market: the traffic of prospective home buyers is up; existing home sales are off their lows; and most importantly for banks, house prices appear to be forming a bottom. With a sharp reduction in loss provisioning, bank eps ought to rise through 2010.
Playing the yield curve
Moreover, the steep yield curve is currently exceptionally profitable for the existing book of US banks; about half of bank assets are lent at long- term rates, and 3-month LIBOR is just 0.4%. And in the absence of substantial demand for credit, banks can add to their Treasury holdings to further benefit from the yield curve. Bank holdings of Treasuries have already risen by $200bn over the past year and may increase substantially more. In addition, the yield curve is likely to remain steep — the Fed is unlikely to raise rates over the coming year with unemployment rates high and core inflation dormant.
Intriguingly, in each of the last three major cyclical recoveries, 1982-1983, 1991-1992, 2002-2003, the price-to-book of banks continued to increase along with bank eps and return on equity. Growth in book value and a return to a more normal price-to-book can only propel bank share prices higher over the next two years. The fact that equities are currently overbought and likely to consolidate presents opportunities. The story is not over for banks globally; use dips to increase exposure.
We’re rather dubious that the chance of corporate and personal defaults is actually diminishing. However, the idea that banks will (rightly or wrongly) soon be decreasing their bad loan loss provisioning is probably accurate. What with various government support measures, including that steep yield curve, banks, and conversely their shareholders, could be in for a stunning 2010 if those defaults don’t emerge — and massive trouble if they do.
Full note available in the Long Room.
(FT Alphaville caveat – We have not altered the above chart in our traditional MS Paint-style. That’s the font used by Shah).
Related link:
Whitney: “I call this the great government momentum trade” – FT Alphaville
Dissecting bank results - FT Alphaville