1st Quarter Market Recap

Brad Combs Baby Announcement

We would like to congratulate Paradigm’s Brad Combs and his wife Emily on the birth of their new son, Ryan.  Ryan was born Thursday, April 14th and weighed 8lb 13oz!  Mom and baby are doing great!

 

1st Quarter Market Recap

Markets have been hyper sensitive to headline news thus far in 2016. In early January, concerns about a slowdown in China and slumping crude oil prices worried investors. Major stock indices recorded their worst ever start to a year; with losses of 10% or more, they quickly entered correction territory. Investors appeared content to “sell-first, ask-questions-later” as sentiment turned excessively negative, culminating at one point with fears of an imminent recession. In a rush for safety, investors favored government bonds and gold; the yield on the benchmark 10-year U.S. Treasury Note fell to a 3½-year low.  Then, following the worst January results for stocks since 2009, the mood began to shift in mid-February. People started to realize that maybe things weren’t as dire as they thought; encouraging economic data and stabilizing oil prices helped reverse the outlook. Fears of a recession quickly faded and the markets rallied to recoup most of the earlier losses.

We think the market action so far this year has been contrary to the fundamental data that has been reported.  This type of illogical market movement is a reminder of the importance of having a long-term perspective.  So, in the near-term, stocks may move in response to positive or negative market sentiment; but in the long run, prices will reflect the underlying business fundamentals.

 

U.S. Banks: overcapitalized and undervalued

U.S. Banks continue to have a “black cloud” that still lingers over them since the financial crisis of 2008.  The global selloff in the equity markets during the first few months of the year pulled bank stock prices down 3 times that of the overall market.

The poor year-to-date performance of bank stocks has investors wondering if a banking crisis could trigger the next recession. Banks have been under strain for some time from the sluggish global economy and low interest rates, but the latest downturn is more directly related to fears of profit losses from negative deposit rates, U.S. banks’ exposure to energy loans, and European banks’ exposure to the fragile European economy. This uncertainty has driven U.S. and European banks to exceptionally cheap relative valuations versus the broader market. The ECB recently eased some of the strains on European banks by providing cheap, long-term financing, but negative deposit rates (charging banks to hold funds with the central bank) still present a troubling headwind. Despite these challenges, however, bank balance sheets and capital ratios in both regions have become much healthier since the end of the global financial crisis, and we believe that systemic risks from U.S. and European banks are very low.

U.S. banks have significant exposure to U.S. consumers and the housing market, both of which are bright spots of the global economy. U.S. consumer income has risen thanks to improving employment, higher wages, and low oil prices.  At the same time, household leverage has fallen. Since the financial crisis, consumers have managed to greatly reduce their debt-to-net-worth and debt-to-income ratios, enabling them to repay their debts and, of course, keep buying things they want and need, including houses. Increasing household formation rates and low housing supply have helped heat up the residential real estate market, creating another tailwind for U.S. banks.

U.S. banks have also improved their balance sheets and they are now stronger and more capitalized than they have been in many decades. Following the financial crisis, a tighter regulatory environment made banks less profitable but much more stable by reducing their leverage and increasing capital and liquidity requirements. In addition, banks’ underwriting standards became tougher, which helped improve the quality of their loan books. Banks have been forced by government intervention to become overcapitalized and tight underwriting standards that were imposed on them hurt their earnings which resulted in stock prices that are significantly undervalued.  The government intervention has been scaled back over the past 18 months and banks are finally allowed to make loans again.

One of the biggest factors in the historic slow recovery after 2008 has been Government intervention in the banking industry which has restricted economic growth dramatically after the recession.  Some of the new regulations curtailing certain risky bank activity and many conflicts of interest were needed to ensure the safety of our financial system.  However, many of the government directives given to banks after the crisis went way too far and were detrimental to the economic recovery.  Banks were told by the Government to go out and revalue properties that they held as collateral on many business loans.  When they were forced to do this it resulted in many businesses that had not missed a payment on their loans being forced to put more capital into the bank which otherwise would have been injected into the economy as they used that capital to buy new property or start a new project.  The key now is to see small and mid-size businesses get enough confidence to go out and get a loan to grow their businesses.  Loan demand has quietly improved nicely over the past year and should help bank earnings in the next few quarters.

Many investors are nervous that U.S. banks’ exposure to oil companies could cause problems if oil prices stay low and energy companies, suffering from markedly lower revenue, are unable to repay their loans. I find these worries valid but overstated: Energy-company loans represent approximately 2% – 5% of total bank lending, and that debt is senior secured (high in the capital structure) and well collateralized. In all likelihood, concerns about exposure to energy have contributed to the drop in bank share prices versus the broader U.S. stock market.

Bank valuations have reached the point of being unjustifiably low.  Year-to-date performance has left banks trading at a price-to-book multiple roughly 35% of the broader market.

Bank of America just reported that loans were up across the board, rising $28.4 billion to $901.1 billion.   Total average deposits were up $64.1 billion to $1.2 trillion in Q1 2016.  Most of the negative sentiment for banks thus far in 2016 has been tied to their energy exposure and the loan losses that would arise from the drop in oil prices.   Like most of the “noise” this has been completely overblow relative to the banks actual exposure.   BAC has doubled their loan loss reserves to $1 billion for “possible” soured energy loans.   Which in our opinion is more than adequate and probably too conservative. The latest quarterly report from Bank of America shows that the fear of large losses due to energy loans has been blown out of proportion.  Bank of America reported that total nonperforming loans decreased to $9.23 billion down from almost $12.1 billion in Q1 2015 and down almost $600 million from Q4 2015.

European banks also have to navigate a confusing mix of accounting rules and banking laws from various countries. Regulations are becoming more homogeneous, but they are still relatively new and untested. Rules on how creditors are treated during times of banking stress are murkier than in the U.S., for example, potentially reducing European banks’ access to financing. The U.S. and Europe also have had different approaches to non-performing loans (NPLs). In the U.S., banks tend to set aside reserves for NPLs earlier and more aggressively than in Europe. As a result, European banks are often saddled with more bad loans.

In Europe, the refugee crisis and the risks of a British exit from the European Union have elevated the level of political and economic uncertainty and created a tenuous environment for businesses and consumers. If bank lending falters on weakening confidence, the fragile recovery in Europe could grind to a halt. And, in the unlikely event that banks respond to negative yields by raising fees and lending rates, credit growth in the region could decline, further inhibiting growth.

 

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