Improved Yield Curve and Reduced Trade Tensions Boost December Bank Stock Gains, Capping Off a Strong Year. Outlook for 2020 Remains Positive, but Unlikely to Match 2019.
The month of December was generally a positive period for the markets, with relatively little volatility. After a brief slide early in the month, many of the major market indices moved towards new all-time records as the month progressed. Economic reports were generally positive in December, particularly the November jobs report, but manufacturing still seems to be on shaky footing. While tensions with Iran and North Korea still have the potential to be very disruptive, the outlook for a resolution of the Brexit stalemate and the chance of at least a preliminary trade deal with China could provide considerable clarity for investors. Meanwhile, the yield curve continues to slowly shift toward a more normal upward sloping shape. With the start of the Presidential primaries just a month away and the upcoming Senate impeachment trial, domestic political events will remain front and center for the foreseeable future. With almost all of the S&P 500 companies having reported 3Q19 results, roughly 75% had reported betterthan- expected results, but total S&P 500 3Q19 earnings are down roughly 0.3% year-over-year. In addition, continued modest decreases in short-term interest rates coupled with increases in long-term interest rates have helped drive a slight upward tilt to the yield curve.
Economic reports during December remained largely positive. Signs in the U.S. manufacturing sector remain uneven, as the ISM Manufacturing Index and at least two regional Federal Reserve manufacturing indices (Richmond, Dallas) deteriorated. However, consumer spending remains strong, as retail sales showed continued growth. Broad market indices, such as the S&P 500 recorded gains of 2.9% for the month, and bank stocks performed slightly better.
Just before Christmas, the BEA reported its third estimate of 3Q19 GDP, which showed growth of 2.1%, unchanged from the second estimate, but up from the original estimate of 1.9%. GDP growth was reported at 2.0% in 2Q19. In terms of stock prices, the broader markets posted solid gains in the month of December, as noted above. The same concerns we have voiced for months regarding tariffs and trade, international tensions, and an unfavorable yield curve remain, though recent developments regarding trade disputes and the yield curve provide reason for cautious optimism. We maintain our expectations of modest overall loan growth for banks in the coming year, though we remain concerned about continued margin pressures.
A look at the Fed’s H8 data through December 18, 2019 shows that loan growth remains slow. Using the data for domestically chartered small US banks, we calculate loan growth for the first fifty weeks of the year at 4.9%, which translates to a full year pace of 5.1%. This is up modestly from the 4.6% pace we calculated a month ago, but well below the 6.1% figure from six months ago. Meanwhile, deposit growth remains strong. The first twelve weeks of 4Q19 exhibited deposit growth of 2.9% (12.5% annualized). Year-to-date deposit growth is 6.7%, which annualizes to 7.0%. 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 a 9.2% annualized year-to-date pace, but this is down from a 10.7% pace as measured a month ago and 12.4% pace recorded three months ago, indicating that large time deposits were a smaller component of total deposit growth in December. 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 continued to move toward a slightly upward slope, but we are still far from a normal yield curve.
Fed policy actions have had a significant impact on bank performance and stock market valuations for the past year, and that is unlikely to change anytime soon. After the December FOMC meeting left rates unchanged, investors expect more of the same in January, as the CME Group’s FedWatch tool currently shows a 93.9% probability that the Fed will leave rates unchanged at the January FOMC meeting. The remaining 6.1% odds are pointing to a 25 bps increase. The majority of investors see rates remining at current levels through the March, April, and June FOMC meetings, with 82.7% projecting no change, while 12.0% anticipate rate cuts of 25 bps or more, and 5.3% projecting a 25 bps increase according to
FedWatch. Bank stocks enjoyed another strong performance in December, as anxiety about trade frictions eased during the month. The SNL Bank and Thrift Index ended the month of December with a 3.7 gain, a larger gain than the 3.3% posted in November. This performance was better than the 2.9% rise in the S&P 500 during the month.
In regard to economic statistics, the November employment report released early in the month showed surprisingly strong job gains of 266,000 in the month, surpassing the consensus estimate of 183,000. Revisions to the prior two months added a net 41,000 jobs, though this still resulted in the three month moving average declining 3,000 to 205,000. Meanwhile, the unemployment rate edged down to 3.53% from 3.56% the prior month. The workforce participation rate held steady at 63.23%, down slightly from 63.25% in the prior month. The year-over-year increase in average hourly earnings was 3.14% compared to the 3.18% figure in the prior month.
On the inflation front, the core PPI decelerated while the core CPI accelerated in November. The core PPI decreased to up 1.29% on a year-over-year basis, compared to up 1.63% the prior month. Meanwhile the core CPI rose to up 2.32% YoY from 2.31% 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, fell again, as the November report showed the core PCE deflator up 1.61% year-over-year compared to up 1.66% YoY a month ago. Mortgage rates advanced modestly in November with the 30 year fixed rate rising 6 bps from the prior month according to Freddie Mac data. Existing home sales in November were up 2.7% year-over-year compared to up 4.2% in the prior month. New home sales were up 16.9% YoY compared to up 27.5% YoY in the prior month. Meanwhile, mortgage applications decreased 5.3% Wk/Wk in the latest weekly report but they are currently up 49.0% yr/yr.
We maintain our view that the economy will generate modest or slow growth in 2020, though continued weakness in manufacturing and ongoing trade disputes present some dangers to this projected growth. Coupled with some recent minor improvements in the yield curve, the outlook for the banking industry is not great, but it is improving. Should trade negotiations produce lower tensions with China and Brexit finally reach a conclusion, the reduced uncertainty could provide a lift to business investment that would help the banking industry. Our current outlook suggests restrained bank earnings growth in 2020.
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 fell in November, and it remains in contractionary territory. Meanwhile, construction spending fell for the second month in a row, dropping 0.8% in October, though it is now up 1.1% on a year-to-date basis. Furthermore, the U.S. leading indicators for November was unchanged from the prior month at 111.6, following three consecutive monthly declines. Durable goods orders fell 2.0% in November and are down 5.75% YoY. Transportation equipment spending led the decrease, driven by 72.7% plunge in defense aircraft spending. Retail sales, which has been one of the bright spots for the economy this year, increased 0.19% from the prior month, while industrial production advanced for the first time in three months, rising 1.1%. Loan growth remains modest at best, and despite some improved investor sentiment and a slightly improved yield curve, we are not expecting any significant near-term 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. For at least the next six months, investors appear to believe that the Fed will keep interest rates unchanged. This suggests that the investors expect slow, but steady economic growth to continue. It still seems unlikely that we can expect our international trading partners to 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.