Banks are the largest sector of the global investment grade market, representing around 27% of the index by market value. Whilst macroeconomic conditions strongly influenced 2023 bank credit results and are expected to have a similar impact this year, we currently have a favourable view of the sector. Any future volatility is likely to provide an opportunity to build exposure.
To understand where the opportunities lie, an understanding of various market scenarios is imperative. Market expectations have shifted from scenario one, a narrative of policy rates remaining higher for longer, towards scenario two, anticipating a soft landing where inflation continues to fall towards target and rates are eased. However, the lingering of scenario three, a recession occurring in the US and Europe, remains.
Looking ahead, banks are generally well positioned for all three outcomes, though some are more favourable than others.
Scenario one: Higher for longer
A higher for longer environment helps banks sustain higher net interest margins, particularly for those with higher allocations to floating-rate mortgages compared to those with fixed-rate mortgage books. For instance, French banks, with their multiple-decade mortgages, experience lower revenue gains from high interest rates compared to their European peers.
In the US, larger money centre banks are set to thrive in a prolonged high-rate scenario, while regional banks may face challenges due to increased deposit costs, adding pressure to net interest margins and earnings.
Scenario two: Soft landing
The unwinding of the higher for longer environment challenges net interest margins but provides a more positive outlook for banks’ alternative sources of income, including fees, commission, asset management and insurance. Although falling rates provide a more challenging backdrop, banks can mitigate some of this risk through interest rate hedges, whose use varies at a regional and individual bank level.
It is also important to remember that the favourable higher interest rate environment has attracted increased political scrutiny, leading some European countries to impose windfall taxes on banks. A lowering of rates could ease some of these pressures.
Scenario three: Recession
As banks effectively trade as proxies for the macroeconomic environment, a recession would be a challenge. Investors may seek a premium for exposure to highly levered institutions.
While fundamentals across the sector are generally good, as a recession scenario is factored in, investor attention would shift towards banks’ asset quality and potential loan losses. US regional banks could face heightened scrutiny, with the perception that they are not as stable as the larger money centre banks, potentially resulting in underperformance.
In China, a recession could lead to increased deterioration in asset quality, particularly in the small to medium enterprises sector, contributing to a rise in non-performing loans.
Regardless of these scenarios, fundamentals within the banking sector are the strongest in decades. We hold a favourable view of the sector, and any future volatility is, from our perspective, likely to provide an opportunity to build exposure.
Fallout from the mini banking crisis
March 2023 saw a mini crisis within US regional banks, beginning with Silicon Valley Bank. Regulators responded by proposing stronger capital requirements. While these regulations may temporarily impact the bond market by increasing the supply of bank bonds, they are expected to enhance banks' long-term capital positions, ultimately having a positive credit effect.
Lessons from the crisis underscored the importance of deposit base stickiness and quality, along with the need for caution concerning liquidity position and composition. This experience also showcased the rapid response capability of central banks in providing liquidity during times of crisis and highlighted that size matters in banking. The latter could potentially drive increased merger and acquisition activity in the sector, although current macroeconomic conditions make this prospect challenging and unlikely.
Investment opportunities and risks
Despite the non-US regional banks having the strongest fundamentals in decades, they currently offer a spread over corporate credit globally. The additional spread reflects the more favourable technicals for non-financial credit, ongoing macroeconomic uncertainty, and residual concerns about US regional banks.
Over the past few years, bank bond issuance has been high to meet capital requirements, contrasting with relatively low issuance undertaken by non-financial corporates. If this dynamic continues, with banks issuing high volumes of debt and little corporate issuance, banks could remain priced at a premium over corporates. On the other hand, if bank issuance eases, the spread over corporates should narrow.
The macroeconomic environment, with banks frequently priced as proxies, is another key factor. As macroeconomic fears recede, the spread differential between banks and corporates should, all else being equal, close. Conversely, if recession fears resurface, it would likely lead to further spread widening.
Regional disparities and opportunities
While banks in Asia offer little value at current levels – with Chinese banks, for instance, being priced to perfection – there are pockets of value, particularly in Hong Kong.
In the US market, a solid reporting season has helped to assuage concerns about potential further fallout from the regional banking crisis, which has given us comfort to increase exposure.
Arguably, the most promising opportunity lies in Europe, where banks are trading with wider spreads than their US and Asian counterparts. This is despite European banks being at the end of the regulatory regime and therefore having high capital buffers and strong fundamentals.
Drilling down further into the European market, we are finding opportunities within Spanish, Irish and Greek banks – entities nationalised in the aftermath of the global financial crisis and European sovereign debt crisis. Since then, they have cleaned up their balance sheets, significantly improving their profitability and fundamentals.
Moreover, the underlying economies of these countries are some of the strongest in Europe, marked by positive GDP growth, low inflation relative to other European nations, and corporate and household debt sectors that have undertaken significant deleveraging over the last two decades. All these factors bode well for banks’ asset quality in the years ahead.
Edward Harrold is a fixed income investment director at Capital Group. The views expressed above should not be taken as investment advice.