US banks wake up to an easy money hangover
Balance sheets are strong, but business is going to become tougher
The editorial board
Citigroup trades below the value of the tangible equity on its balance sheet © Bloomberg
Each bad market is bad in its own way. The characteristic feature of the rout that ended 2018 was the cruelty it visited on US bank stocks. This is striking, as the US economy is steady, the big US financial institutions are well capitalised and, for the most part, nicely profitable. Shares in US banks were down over 18 per cent in the fourth quarter, far worse than the wider market.
Bank shares have bounced back this year — the first big bank to report fourth-quarter earnings this week, Citigroup, rose nicely on mixed results— but investors remain jumpy. Citi and Goldman Sachs still trade below the value of the tangible equity on their balance sheets.
The simplest explanation is that we are late in the business cycle, when economically sensitive banks perform poorly. After all, the other sectors that have been hit hardest — autos, energy, materials — are also highly cyclical.
It cannot be quite so simple, though. Other than the fact that it has been an unusually long time since we have had a recession, evidence that one is on the way is thin on the ground. US output is growing nicely. Unemployment remains low, consumer sentiment and spending is strong and — crucially for banks — credit defaults and delinquency remain rare.
All of this fits with the Federal Reserve’s unanimous decision to raise rates a quarter point last month, saying that “economic activity has been growing at a strong rate”. Yes, the Fed has also signalled flexibility on future rate rises and sees growth moderating in the months to come. But this is a long way from predicting a 2019 recession, as bank shares seem to be doing.
What can the bank rout be telling us, then? That the process of normalising crisis-era monetary policy will be neither simple nor painless. As the Fed raises rates and quantitative easing has shifted into reverse, short-term credit costs are rising. Long-term loan rates have not risen as much, resulting in tighter profit margins for lenders. But the increases have been enough to raise the costs of auto and home loans, which has made those two sectors perhaps the weakest in the otherwise healthy US economy, while damping loan growth for banks.
While the Fed kept rates low, companies took advantage and borrowed as much as they could on the longest terms they could find, often in yield-starved capital markets rather than at banks. For now, as a result, demand for more debt is subdued (the Trump administration’s corporate tax cut, by allowing many corporations to bring home cash trapped abroad, has further damped demand).
And then there is the return of volatility to markets and, more to the point, the decline in asset valuations. All the big US banks have advisory, capital markets and asset management businesses, and in the days of quantitative easing and steadily rising asset prices, business was good. Mergers and acquisitions and refinancings boomed, keeping bankers happy. Assets under management rose, doing the same for financial advisers. Business looks like it is going to get a lot tougher now.
Banks have little to complain about. The policies that are unwinding to banks’ detriment now saved many of them from bankruptcy a decade ago, and helped them get back on their feet in the intervening years. But those policies were not magic. They worked, in large part, by stimulating demand and inflating asset prices. Those effects were always going to reverse, to a greater or a lesser degree. A reversal must inevitably work itself out in the markets where banks make their money. In sum, US banks are strong, but they do face a testing 2019.
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