Despite a surge in new COVID-19 infections in broad swaths of the U.S., the stock market seems to take no notice.
The S&P 500 posted a modest gain of almost 2.0% for the month of June, leaving the index roughly where it was in late October 2019, well before the pandemic arrived. The tech-laden NASDAQ Index, on the other hand, posted a gain of almost 6.0% in June, exceeding its pre-COVID highs. While certain companies have actually benefitted from the COVID-19 shutdowns, those companies do not represent the bulk of the companies in the index. It seems obvious that there will be lasting negative economic impacts from the pandemic. It seems equally obvious that total employment, industrial production, and GNP, among many other economic indicators, will be weaker in 2020 and 2021 compared to 2019. How then can we explain stock market indices reaching to record highs? Is the outlook for corporate earnings better now than it was six months ago?
The performance of the stock market is not only disconnected from the outlook for the economy. It also seems to ignore the social and political upheaval affecting the country. The U.S. has been politically polarized for years, but the protests related to racial injustice and police use of force has broadened into a re-examination of our history. The coming presidential election is likely to bring out even more controversy and ill-will. Should Biden prevail, as currently seems like a good possibility, we will likely see increased tax rates. Whether this is good or bad depends largely on your view of the importance of deficits. However, increased taxes will not benefit corporate profits, which is another disconnect evident in the rising stock market.
The economic reports released in June provided some cause for optimism that the economy might bounce back from the COVID-19 shutdowns more quickly than anticipated. The U.S. manufacturing sector has been hit very hard. The ISM Manufacturing Index rose 1.6 points to 43.1 in May, posting its third consecutive month of contraction. The Empire State manufacturing index rebounded 48.3 points in June, but that still left the index at -0.2, a significant improvement, but still slightly negative.
Oil prices enjoyed a strong month in June, advancing on increased optimism that the end of lockdowns will help drive a strong rebound in demand. West Texas Intermediate crude prices jumped from around $35.00 per barrel at the end of May to more than $40.00 at month end. Brent crude followed a similar path. As a result, WTI futures posted a 91% rise in the three months ended June 30, while Brent Crude futures jumped 80% in 2Q20. This marked the best quarterly performance for oil prices in 30 years.
A look at the Fed’s H8 data for small domestically chartered banks through June 17, 2020 shows two significant spikes in loan originations in late March and late April-early May. These spikes coincided with the heavy activity in government emergency loan programs, particularly the Paycheck Protection Program (PPP) run by the SBA. Using the data for domestically chartered small US banks, we calculate loan growth for the first twenty five weeks of the year at 9.3%, which translates to a full year pace of 19.6%. Meanwhile, deposit growth was even stronger. The first twenty five weeks of 2020 exhibited deposit growth of 16.2% or 34.2% annualized. In recent weeks, as the Federal Governments programs have wound down, loan and deposit growth have shown a significant slowdown. In fact, loan growth over the past five weeks has been negative. Deposit growth, on the other hand, had one negative week (the week ending June 3, 2020), but has remained solidly positive overall.
We continue to project margin pressure for banks, low interest rates overall and a yield curve with only a slight upward slope presents a tough environment. However, the PPP program could provide some banks with a boost to net interest income, as the government provides loan forgiveness on many of these loans and the fee income is accelerated into NII. Those banks that originated a large amount of PPP loans relative to their outstanding loan portfolio are likely to see the biggest impact. Investors expect rates to stay at 0% for the rest of 2020, as the CME Group’s FedWatch tool currently shows a 100.0% probability that the Fed will leave rates unchanged at every scheduled meeting through March 2021.
Despite the fact that states began reopening their economies to varying degrees in May and a slightly upward sloping yield curve, bank stocks underperformed the broader markets in June. The SNL Bank and Thrift Index ended the month of June with a 0.6% decline, adding to the 4.0% drop recorded in May. The June performance was considerably worse than the 2.0% rise posted by the S&P 500 during the month.
Some of the economic data reported in June reflected early signs of the easing of COVID-19-related shutdowns. The May employment report released early in the month showed an unexpected rebound in jobs, logging a gain of 2.5 million jobs during the month compared to expectations for job losses of 7.5 million. Revisions to the prior two months subtracted a net 690,000 jobs. Meanwhile, the unemployment rate improved to 13.26% from 14.75% the prior month. The workforce participation rate declined to 60.9% from 60.2%. The year-over-year increase in average hourly earnings was 6.75% compared to the 8.02% figure in the prior month.
Any worries about inflation seem to be unwarranted at least in the near-term. The core PPI rose to 0.34% on a year-over-year basis, compared to up (1.18)% the prior month. Meanwhile the core CPI slipped to up 1.2% YoY from 1.4% in the previous month. Both of these measures fell well below the Fed’s stated target of 2.0% inflation. The Fed’s preferred inflation measure, the core PCE Price Index, held steady, as the May report showed the core PCE deflator up 1.0% year-over-year, unchanged from up 1.0% YoY a month ago. Mortgage rates declined slightly in June with the 30 year fixed rate falling 2 bps from the prior month according to Freddie Mac data. Existing home sales in May were down 26.6% year-over- year compared to down 17.2% in the prior month. New home sales are now up 12.7% YoY, a significant rebound compared to being down 6.2% YoY in the prior month. Meanwhile, mortgage applications decreased 1.8% Wk/Wk in the latest weekly report, with purchase applications up 15% yr/yr.
Most major economic indicators (labor market, GDP, consumer sentiment) reported in June showed considerable weakness, reflecting the ongoing impact of the shutdowns that started in mid-March. Unemployment claims have fallen sharply from their peak, but they continue to show massive job losses in recent weeks. While the pace of new claims has slowed, with the most recent report showing 1.48 million new claims, down 60k from the prior week, this remains far above historical norms. The 2nd revision of the 1Q20 GDP estimate was released last Thursday, and it showed a 5.09% decline on an annualized basis, up slightly from the 1st revised estimate of a 5.15% decline. We will remind you that 1Q20 only included two weeks of the shutdowns. GDP is likely to take a much bigger hit in 2Q20. Loan growth was very good in the May, largely due to some of the Government programs to alleviate the impact of the COVID-19 shutdowns, such as the PPP program, but growth has come to a standstill over the last several weeks. The yield curve has moved to a slightly upward slope in the last three months, but with short-term rates near zero, this is a mixed blessing at best for banks. Though reported results from 1Q20 only showed the first hints of asset quality deterioration, it seems certain that the temporary shutdown of many businesses will lead to increased loan defaults, despite government efforts to offset the impact of the shutdown of some sectors of the economy. For at least the rest of 2020, there appears to be little chance that the Fed will move interest rates. Inexplicably investors seem to be expecting an throughout the country. Though economic activity is improving as stay-at-home restrictions are lifted, it appears unlikely that economic activity will return to its pre-pandemic state anytime soon. Re-opening international supply chains or forging new ones will take time, as will consumer comfort with going out in crowded public places.
Performance & Valuations
- The COVID-19 pandemic remains the most important factor in driving the economy, bank results, and stock valuations. Other factors that usually take center stage -interest rates, CECL implementation, unemployment, and GDP – all depend on the state of the pandemic. Even disputes and tensions with other countries and internal political squabbles take a back seat to the pandemic, though the tensions with China remain significant enough to warrant concern. Bank stocks continue to underperform the broader markets and are still showing substantial year-to-date losses for the year. Larger-cap banks declined slightly during the month, while smaller-cap banks recorded small gains in June, but both segments are down more than 30% year-to-date while broader markets are down 15% or less. On a year-to-date basis, bank indices are substantially underperforming the larger cap broad-market indices. Though smaller cap broad market indices gained some ground in June, they remain well behind the larger cap indices on a year-to-date basis. Bank indices still performed significantly worse than either. We believe that elevated unemployment and a sharp decline in 2Q20 GDP will be a challenge for bank balance sheets and earnings. Low interest rates and the yield curve also remain a hindrance to bank earnings. Bank stock valuations deteriorated slightly in June to a range of 11.5x-15.1x expected 2020 EPS from around 12.0x-16.2x a month ago, a range we feel is appropriate given the poor economic environment and the uncertain but certainly higher level of loan losses that is likely coming over the next year or so.
- The past month has seen divergent paths for different sectors of the market. The S&P 500 saw big gains early in the month followed by equally big losses, resulting in a slight gain for the period. The NASDAQ followed a similar up-then-down path, but showed enough positive momentum in the latter part of the month to drive a 5.99% rise for the month. The banking industry was not so fortunate. Continuing worries about asset quality deterioration due to COVID-19 drove the SNL Bank & Thrift index to a 0.6% loss for the month. While the yield curve remains an important determinant of bank earnings, the level interest rates seems destined to remain in a very narrow range near zero for the foreseeable future. Among the broader market indices, the S&P 500 Total Return Index and the Russell 1000 continued their rebounds, rising 1.99% and 2.21%, respectively in June, while the Russell 2000 recorded a gain of 3.53%. Meanwhile, the large-cap weighted S&P Bank Index declined (0.76)%, while the smaller-cap weighted NASDAQ Bank Index posted a 1.07% increase.
- For much of 2020, bank stock movement has been heavily weighted to one side or the other, with almost all issues moving in the same direction. June was a bit more even-handed. During the month, advancing bank stocks outnumbered decliners by a roughly 1.6:1 margin, 248 to 151. We should note, however, that there are still only two banks with assets over $1 billion and a market capitalization greater than $25 million (CIZN & CNUN) that have posted year-to-date gains in their stock price and only four others (THVB, FSMK, BAFI, & FBLV) that have held onto their stock price from the beginning of the year. All other banks in this category have posted year-to-date stock price declines. The greatest changes in common stock price witnessed among U.S. bank stocks during the month of May were in shares of Fidelity D&D Bancorp Inc. (FDBC, 27%), Peoples Bancorp (PPBB, -26%), MetroCity Bankshares Inc. (MCBS, 24%), Stock Yards Bancorp Inc. (SYBT, 18%), and First Choice Bancorp (FCBP, 17%). Roughly 60% of banks with assets above $1.0 billion and a market cap above $25 million saw price gains during the month of June, while 37% saw price declines.
- The U.S. bank market ($500M+ Assets) trades at a median 2020 Forward P/E ratio of 12.3x (down from 12.7x at a month ago), a 2021 forward P/E of 11.1x, and a Price-to-TBV ratio of 111.3% (up from 109.4% a month ago). Despite loosening of COVID-19 restrictions in June, the trend for infections nationwide has taken a turn for the worse, leading to downward pressure on bank stock prices. Meanwhile, many banks reported higher-than-expected loan loss provisions due to the pandemic in 1Q20, leading to lower-than-anticipated tangible book values. Valuations are now close to where they stood a year ago in terms of the current year forward P/E which stood at 12.0x at the end of June 2019, but far lower than the prior year’s P/TBV ratio, which was 163.1%. Though the early part of the month, but ended June in the red. The markets are anticipating substantially reduced bank earnings for at least the next year. At present, the median 2020 EPS growth estimate for banks with assets greater than $500 million stands at (27.8)%, down from (26.3)% a month ago, 1.9% at year-end 2019, and below the 7.1% growth in 2020 that was projected at the end of June 2019. We are concerned about slower loan growth, continued margin compression, and asset quality deterioration.
- Nothing during the past month has caused us to change our view on interest rates. We still think the odds are low that the Fed will change interest rate policy over the next year. The Fed is likely to continue trying to assure there is sufficient liquidity in the markets, but the target Fed Funds rate is unlikely to change. The yield curve now retains a more positive upward slope than it has in quite some time. There were some increases in yield on the short and the long end of the curve in June, while the intermediate maturities saw modest yield declines. The 3-month T-Bill rate rose 2 bps in June while the 1-yr maturity decreased 1 bps. Meanwhile, the 3-yr, and 5-yr rates both also decreased 1 bps, while the 10-yr rose 1 bps and the 30-yr bond yield remained unchanged. This movement resulted in little change to the overall slope of the yield curve. The spread between the 1-year and 10-year rates expanded to 50 bps from 48 bps at the end of May. This spread is above the 8 bps recorded twelve months ago at the end of June 2019. Spreads between the 10-year and 3-month treasuries slipped to 50 bps from 51 bps as of May 29, 2020. The conforming 30-year fixed rate mortgage rate decreased, falling to 3.13% from 3.15% at the end of May and stood 60 bps lower than at the end of June 2019.