Bank stocks have outperformed so far this year, with the KBW Nasdaq Bank Index soaring 13%, compared to an 8% rise for the S&P 500 index.
But Morningstar warns that the rally may not continue.
Banks have benefited from the climb of interest rates, which allows them to enjoy higher increases in interest rates for loans than the increases in rates they must pay on deposits. And they have benefited from improved sentiment for the economy.
But the possibility of a recession represents a “significant headwind” for banks, Morningstar said in a commentary. “For investors, this means treading carefully with bank stocks.” The firm forecasts a mild recession this year.
The KBW Bank Index has dropped 21% over the past year, despite the recent rebound. That has left many bank stocks trading at attractive valuations, Morningstar analysts say.
Recession Risk not Fully Priced In
But its bank analyst Eric Compton said the stocks haven’t fully priced in recession risk. U.S.-listed bank stocks covered by Morningstar analysts trade about 11% below the analysts’ fair value estimates on average.
“For a typical recession, I would expect banks to be closer to 25% to 30% below my fair value estimates,” Compton said.
As for interest rates, the key metric for banks is net interest income. That’s the difference between the rates banks charge borrowers on loans and the interest that banks pay for customers’ deposits.
Rate increases by the Federal Reserve generally boost net interest income for banks. And that’s what happened in 2022.
Rising-Rate Benefits Limited
“However, the benefit of rising rates can only go so far,” Morningstar said. The benefit to net interest margins only occurs early in a rate-hiking cycle, Compton said. Eventually, interest rates provided by bank accounts and other investment vehicles also start rising.
As those rates climb, investors tend to move their money away from their bank accounts to certificates of deposits, money market funds, or other banks, wherever rates are highest, Compton said. That’s what has happened in recent months.
Meanwhile, banks face rising expenses due to increases in loan-loss provisions. Those are funds set aside to cover losses for bad debts, which would likely rise during a recession, Morningstar noted.
Bank fee revenue also is under pressure in areas such as wealth management and investment banking. “I have a hard time seeing a strong recovery in fees until after a recession,” Compton said.
With recession looming on the horizon, he said investors may want to hold off investing in bank stocks until they reach 25% to 30% below his fair value estimates.
“Things tend to get cheaper when a recession actually happens,” Compton said. “There will be better opportunities ahead.”
