Fed Rate Cut, Easing Worries Over Trade and Economic Growth Propel Bank Stocks in September.
The month of November showed little volatility in the markets, but what it lacked in drama, it made up for in good vibes. The markets moved steadily upward during the month, with several of the major market indexes hitting records late in the month. Economic reports have not been as robust as last year or early in 2019, but despite showing slower growth, many economic readings are still coming in better than expected. There are several issues that still have the potential to disrupt the ongoing growth, including trade disputes, tensions with Iran, North Korea and other rivals, and an unfavorable yield curve. Political turmoil has so far not affected economic performance in the U.S., but there is some possibility that deep partisan divides could lead to some paralysis as the impeachment process progresses. As of last week, with about 96% of S&P 500 companies reporting 3Q19 results, roughly 75% had reported better-than-expected results, but this leaves 3Q19 earning down roughly 3% yearover- year. In addition, modest increases in medium- and long-term interest rates have helped drive a very slight upward tilt to the yield curve.
Economic reports during November were mainly positive. Signs in the U.S. manufacturing sector remain uneven, as several regional Federal Reserve manufacturing indices have turned or remain in negative territory, though others still show expansion. In addition, trade disputes have had a clear negative impact on many trade-dependent enterprises. However, consumer spending remains strong, but consumer confidence fell for the fourth consecutive month. Broad market indices, such as the S&P 500 recorded gains of 3.4% for the month, and bank stocks rose a similar amount, after outperforming the broader markets in the two prior months.
Last week, the BEA reported its revised estimate of 3Q19 GDP, which showed growth of 2.11%, an increase from the original estimate of 1.91%, and up slightly from the 2.00% growth posted in 2Q19. In terms of stock prices, the broader markets posted solid gains in the month of November, as noted above. The same concerns we have voiced for months regarding tariffs and trade, international tensions, and an unfavorable yield curve remain, but developments over the past month continue to reduce concerns about these issues. We maintain our expectations of modest overall loan growth for banks this year, though even our modest expectations continue to fall. We also anticipate continued margin pressures.
A look at the Fed’s H8 data through November 20, 2019 shows that loan growth remains slow. Using the data for domestically chartered small US banks, we calculate loan growth for the first forty-seven weeks of the year at 4.1%, which translates to a full year pace of 4.6%. This is up modestly from the 4.4% pace we calculated a month ago, but well below the 6.1% figure from five months ago. Meanwhile, deposit growth also seems to have picked up recently. The first eight weeks of 4Q19 exhibited deposit growth of 1.4% (9.6% annualized). Year-to-date growth of 6.7%, which annualizes to 7.5%, is also up from the 6.9% annualized year-to-date growth we reported a month ago. Large time deposits have been the driving force in deposit growth for much of the year, but this growth has been slowing as interest rates have declined. This category has grown at an 10.7% annualized year-to-date pace, but this is down from a 11.3% pace as measured a month ago and 12.4% pace recorded two months ago, indicating that large time deposits were a smaller component of total deposit growth in November. Still, we anticipate continued margin pressure, as declines in loan yields are likely to exceed falling deposit costs. As noted above, the yield curve has started to show a slightly upward slope, but we are still far from a normal yield curve.
Fed policy actions remain a major driver of bank performance and stock market valuations. Investors are now placing a 95.6% probability on the Fed leaving rates unchanged at the December FOMC meeting, according to the CME Group’s FedWatch tool. Instead of the remainder expecting a rate cut, we now see that the odds of the Fed raising rates by 25 bps at the December meeting is at 4.4%. The majority of investors see rates remining at current levels through the January and March FOMC meetings, with 80.1% projecting no change, while 16.2% anticipate rate cuts of 25 bps or more, and 3.7% projecting a 25 bps increase according to FedWatch.
Bank stocks enjoyed a very strong performance in November, as anxiety about trade frictions and the possibility of an oncoming recession continued to ease during the month. The SNL Bank and Thrift Index ended the month of November with a 3.3% gain, a smaller gain than the 4.1% posted in October and the 6.4% recorded in September, but still impressive. This performance was similar to the 3.4% rise in the S&P 500 during the month.
In regard to economic statistics, the October employment report released early in the month showed job gains of 128,000 in the month, surpassing the consensus estimate of 75,000. Revisions to the prior two months added a net 95,000 jobs, though this still resulted in the three month moving average declining 1,000 to 156,000. Meanwhile, the unemployment rate edged up to 3.6% from 3.5% the prior month. The workforce participation rate held steady at 63.3%, up slightly from 63.2% in the prior month. The year-over-year increase in average hourly earnings accelerated to 3.0% from the 2.9% figure in the prior month.
On the inflation front, the core PPI accelerated and the core CPI both decelerated in September. The core PPI decreased to up 1.63% on a year-over-year basis, compared to up 1.99% the prior month. Meanwhile the core CPI slipped to up 2.31% YoY from 2.36% in the previous month. While these measures bracket the Fed’s stated target of 2.0% inflation, the Fed’s preferred inflation measure, the core PCE Price Index, has fell again, as the October report showing the core PCE deflator up 1.59% year-over-year compared to up 1.71% YoY a month ago. Mortgage rates declined modestly in November with the 30 year fixed rate dipping 10 bps from the prior month according to Freddie Mac data. Existing home sales in October were up 4.6% year-over-year compared to up 3.5% in the prior month. New home sales climbed to up 31.6% YoY compared to up 21.6% YoY in the prior month. Meanwhile, mortgage applications increased 1.5% Wk/Wk in the latest weekly report and they are currently up 69.0% yr/yr.
Consistent with the shift in our view reported last month, we believe a downturn in the economy is still a possibility, but modest or slow growth seems to be the more likely path. In either case, the outlook is not particularly favorable for the banking industry. The combination of potential further Fed rate cuts, a flat or slightly upward sloped yield curve, and slow economic growth are likely to lead to restrained bank earnings growth. Most major economic indicators (labor market, GDP, consumer sentiment) suggest continued slow economic expansion. Consumer spending remains the main support for GDP growth, but business investment and trade figures are not so healthy. The ISM Manufacturing Index rose in October, but remains in contractionary territory. Meanwhile, construction spending was up for the third month in a row, climbing 0.5% in September, but it remains down 2.2% on a year-to-date basis. Furthermore, the U.S. leading indicators for October fell 0.1% to 111.7. Durable goods rose 0.6% in October. Transportation equipment spending led the increase, aided by strong defense aircraft spending. Retail sales, which has been one of the bright spots for the economy this year, rebounded in October after a September drop, rising for the seventh time in eight months, climbing 0.26% from the prior month, while industrial production declined 0.84%. Loan growth remains modest at best, and despite some improved investor sentiment and a slightly improved yield curve, we are not expecting a significant acceleration in loan growth. Though recent signals in the US-China trade dispute are encouraging, we remain concerned about the impact of existing tariffs and high-stakes trade negotiations on the economy. Despite year-over-year wages & salaries growth of 4.89%, inflation still appears to be under control. In addition, expectations that the Fed will cut rates further have diminished considerably. This suggests that the investors expect slow economic growth to continue. It still seems unlikely that our international trading partners will provide any boost to our economic outlook, as most of them face challenges of their own. The mood is currently upbeat about our trade dispute with China, but this issue has been through several cycles of joy and panic over the past year. We are encouraged that falling short-term interest rates are finally resulting in movement toward a more normal slope of the yield curve and hope that further movement could prove beneficial for bank stock valuations.