Navigating U.S. Bank Investing Between Recession Fears And Rate Cut Fantasies

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In this article, I share how I navigate investing in the banking sector amid declining interest rate cuts and a potential recession.I discuss the key metrics that I look at from both a macro ...

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I explained in detail why I remain confident in building positions in a few select large regional banks — despite the (mostly sensationalized) headlines about hundreds of billions of unrealized losses on their balance sheets. Most bank stocks have recovered well from the sharp sell-off. However, with a few exceptions, they are still trading close to the level before the onset of the banking crisis. Banks in general — as measured by the SPDR S&P Bank ETF (NYSEARCA:KBE) — have underperformed the S&P 500 Index (SPY) by almost 8 percentage points so far this year. Regional banks (SPDR S&P Regional Banking ETF (KRE)) have underperformed significantly, with a year-to-date performance of only 4.4% (Figure 1). There is a significant valuation gap between SPY, which currently trades at nearly 24 times earnings, and KBE and KRE, which trade at about 12 times earnings.   Figure 1: Year-to-date performance of SPY, KBE, and KRE (ycharts via Seeking Alpha) Of course, one could argue — rightly in my opinion — that the performance of the S&P 500 is currently being driven by a few select fast-growing technology heavyweights, but the underperformance of regional banks in particular is still a reason to take a closer look. A key reason is the shift in workplace trends since the pandemic as well as the sharp rise in interest rates, which has significantly increased the credit risk of commercial real estate (CRE) loans, and regional banks in particular tend to have concentration risk in this sector. However, I think the market is also pricing in a headwind for bank earnings due to falling interest rates as well as the negative impact of a potential recession. This is certainly not a straight-forward environment for investing in banks. On the surface, it remains unclear whether the banking sector is rightly trading at a comparatively cheap valuation or whether it represents a value opportunity — especially for those who look a little closer and are willing to invest in individual banks. In this article, I share how I am personally navigating this environment and deciding whether it is a good idea to continue adding to my bank holdings. I discuss the key metrics that I look at from both a macro perspective and a bank-specific perspective that help me come to an informed conclusion. I will use the following four banks to illustrate my arguments: $Bank of America Corp(BAC-N)$. (BAC), a Category I (categorization here) and global systemically important bank (G-SIB), which is currently the number 2 in the U.S. based on consolidated assets of $2.6 trillion at the end of Q2.  U.S. Bancorp (USB), a Category III bank that is not subject to the same stringent regulations and capital requirements as larger G-SIBs. U.S. Bancorp ranked number 5 in terms of consolidated assets at the end of Q2, with $665 billion. Due to its broad footprint, I consider it a “super-regional” bank. Truist Financial Corp. (TFC), also a Category III bank, is quite a bit smaller than USB, with $512 billion in consolidated assets. It is still in the process of digesting the merger of BB&T and SunTrust in late 2019.  Bank OZK (OZK), a small and under-followed regional bank that is highly concentrated in CRE. At the end of Q2 2024, it ranked number 55 in the U.S., with consolidated assets of $36.8 billion. The Macro Indicators I Look At Before Investing In Banks The most obvious and easy to understand recession indicator is the unemployment rate (Figure 2). It is by no means an ideal indicator as it cannot “predict” a recession, thereby signaling rising defaults and thus loan loss provisions, which indirectly have a negative impact on bank earnings and therefore valuations. Figure 2: Monthly unemployment rate in the U.S. in percent, seasonally adjusted (U.S. Bureau of Labor Statistics, Unemployment Rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis) Due to the somewhat lagging nature of this indicator, as illustrated in Figure 3, I also like to look at the Sahm Rule Recession Indicator (Figure 3). This indicator considers the slope of the unemployment rate and is therefore more sensitive. As a side note, here is an interesting discussion on the pros and cons of this indicator, published on Substack by the inventor of the indicator, Dr. Claudia Sahm. Figure 3: Sahm Rule Recession Indicator, seasonally adjusted (Sahm, Claudia, Real-time Sahm Rule Recession Indicator [SAHMREALTIME], retrieved from FRED, Federal Reserve Bank of St. Louis) Since recessions are associated with higher loan defaults, a look at banks' overall charge-off rates can be very helpful in getting a rough idea of the credit quality of the industry as a whole and where we currently stand. To that end, the Federal Reserve Bank of St. Louis publishes the average charge-off rate on all business loans, net of recoveries. I would be wary of over-interpreting the chart (Figure 4), but sustained acceleration can be very helpful in assessing credit quality at the national level. The indicator can easily be used to get a quick idea of the relative credit quality of an individual bank — more on that later. Figure 4: Charge-off rates on business loans for all commercial banks in the U.S., seasonally adjusted (Board of Governors of the Federal Reserve System (US), Charge-Off Rate on Business Loans, All Commercial Banks [CORBLACBS], retrieved from FRED, Federal Reserve Bank of St. Louis) It is understandable that charge-offs have increased since the post-pandemic trough, which was due to loan moratoriums and especially the zero interest rate policy at the time. Admittedly, I had expected the pace of the Federal Reserve's latest rate hike cycle to have a greater impact on charge-offs. If interest rates are slow to decline from here on out, I would imagine that the rise in charge-offs will continue. While this would obviously have a negative impact on bank earnings, this “cleansing effect” should prove beneficial to the economy as a whole as unprofitable and debt-hungry companies are eventually removed from the system. I wrote an in-depth article here on Seeking Alpha some time ago on how to recognize and avoid these so-called zombie companies. However, given the increasingly weak debt servicing capacity of the U.S., as shown in Figure 5, I would not bet on interest rates being maintained at elevated levels and thus a sustained increase in charge-offs. Instead, I expect a gradual return to a very low interest rate environment over the course of a few years. In the context of GDP growth, I think it is also important to cautiously consider the aspect of ever-growing number of government employees. Figure 5: Interest payments by the federal government, divided by the gross domestic product (U.S. Bureau of Economic Analysis, interest payments [A091RC1Q027SBEA] and gross domestic product [GDP], retrieved from FRED, Federal Reserve Bank of St. Louis) To get a better idea of business sentiment, which ultimately influences bank earnings as well, I regularly check the U.S. Purchasing Managers' Index (PMI) for signs of improvement (or deterioration). The indicator was pointing to a recovery at the start of 2024, but has recently fallen back to a level that could indicate a mild recession (Figure 6).   Figure 6: U.S. ISM Manufacturing Purchasing Managers’ Index (ycharts via Seeking Alpha) The number of temporary workers as part of the private sector workforce can be a leading indicator of a recession. The continued decline, as shown in Figure 7, is not overly worrisome due to the still overall high level, and given the feeble sign of deceleration, I would definitely not read an expected severe recession from this indicator. This is confirmed by the stabilization of average weekly overtime hours worked, also published by the Federal Reserve Bank of St. Louis under AWOTMAN and CES3200000009, for example. Figure 7: Temporary workers divided by all employees in the private sector, seasonally adjusted (U.S. Bureau of Labor Statistics, All Employees, Temporary Help Services [TEMPHELPS] and All Employees, Total Private [USPRIV], retrieved from FRED, Federal Reserve Bank of St. Louis) Taken together, I don't think we are heading for a severe downturn — unless, of course, one that is triggered by an external event. A mild recession cannot be ruled out, but I would argue that the greatly increased capital requirements (and their regular re-evaluation) since the Great Recession have resulted in a banking system that has a reassuringly solid loss-absorbing capacity. So while bank stocks would certainly suffer in a downturn, long-term investors invested in well-capitalized banks can simply ride out the turmoil. Judging by the valuation of bank stocks, I feel that I have a slightly more positive view of the economy than the market. However, as mentioned above, the still fairly low valuations are also a result of the expected decline in earnings given lower interest rates and heightened risk in the CRE space. While the latter requires careful consideration on a case-by-case basis, several arguments can be made as to why banks do not necessarily suffer in a falling interest rate environment. For the sake of brevity, I refer you to my last article on U.S. Bancorp, where I discussed the positive impacts of lower interest rates on bank earnings in a dedicated section. Now let's look at the indicators I regularly review on a bank-specific basis to assess the quality and attractiveness of each institution. What I Look For When Analyzing Banks Net Charge-Offs And Commercial Real Estate Exposure I have already explained why I am generally quite positive about the economy and only expect a mild recession. In addition, it is worth noting that the Federal Reserve will eventually expand its balance sheet again, which will have a positive impact on liquidity and therefore asset prices. After all, open market operations have been declining since the banking crisis was contained in mid-2023 (mainly thanks to the Bank Term Funding program, see this article). I have recently increased my position in U.S. Bancorp and opened a position in Bank OZK. Depending on how valuations develop in the coming weeks and months, I will add more shares here and there. Bank OZK seems like a very counterintuitive stock due to its focus on commercial real estate, so I think it's a good example to start the discussion. The bank is known for its unique and conservative approach to lending, which I discussed in another article. However, Bank OZK's conservative approach is hard to miss, even with just a brief look at the fundamentals. Figure 8 compares OZK's net charge-offs as a percentage of total loans to the much larger institutions listed in the introduction, but also to the national average. The bank has outperformed the index every year since its IPO in 1997, and the difference of 30 to 50 basis points in recent quarters already says a lot about the quality of its CRE portfolio without having to dig deeper. Figure 8: Net charge-offs in percent of total loans and leases - BAC, USB, TFC, and OZK, compared to the domestic average on a quarterly basis (own work, based on data from company filings and CORBLACBS from FRED, Federal Reserve Bank of St. Louis) Taking a closer look, more than 60% of OZK's loans are either in the non-farm/non-residential loan segment or the construction and land development loan segment (see p. 40, OZK 2024 10-Q2), but the bank had an overall net charge-off ratio of just 0.17% in the second quarter of 2024. In comparison, Truist's CRE exposure amounts to only around 10% of total loans and leases, and BAC only had 6.8% of its total loan base exposed to this sector in the second quarter. USB had the highest exposure at around 14%. However, net charge-offs in this segment were by far the lowest at U.S. Bancorp — which, like OZK, is known for its conservative lending practices — at just 0.28% in the second quarter. CRE-related charge-offs at Truist and Bank of America were similar, but significantly higher at 1.6% and 1.5%, respectively. Taken together, I think it's easy to see why I sleep very well with OZK despite its high CRE exposure and have decided to increase my position in USB above my minimum portfolio allocation of 0.5%. I wouldn't over-interpret BAC's CRE exposure despite the somewhat elevated charge-offs, and indeed Truist looks the riskiest of the group. However, if we dig deeper, it becomes clear that Truist's exposure to the riskiest CRE segments, such as offices, is minimal, so I wouldn't over-interpret the higher — but still very manageable — charge-offs. At Truist (and also at U.S. Bancorp and Bank of America), it was the unrealized losses in the held-to-maturity portfolio that were considered the biggest risk last year. Unrealized Losses In The Held-To-Maturity Portfolio And Why Lower Interest Rates Should Benefit BAC, TFC, And USB Going Forward Truist is the first bank I bought when the crisis hit in 2023, mainly because of what, I thought, were exaggerated fears related to the unrealized losses in the bank's held-to-maturity portfolio. In fact, I have always considered this risk to be more or less theoretical, although if triggered it would have quickly led to a self-reinforcing vicious circle. In this context, I think larger banks with a high proportion of insured deposits benefited from the perceived higher level of security, so I felt quite confident with my newly opened positions in TFC and USB. The issue of unrealized losses is now well understood, and I don't believe there is any significant risk associated with this balance sheet item anymore — the Bank Term Funding Program has served its purpose very well, and it makes sense that the Fed has seized making new loans as planned. Figure 9 shows that BAC's unrealized HTM portfolio losses in particular had already reached a worrying level in the second quarter of 2022 — almost a year before Silicon Valley Bank made headlines. Had BAC had to sell all of its HTM assets at that time, its tangible equity would have fallen by more than 40%. I think this shows very well how quickly and irrationally the market can react to headlines by suddenly discounting facts that were already available a year earlier. Figure 9: Potential mark-to-market losses in the held-to-maturity assets portfolio of BAC, USB, and TFC, in percent of tangible equity (own work, based on information from company filings) It is theoretically possible that the concerns about these still very high potential mark-to-market losses will resurface, especially with another trigger. However, in such a case, I would expect a quick resumption of lending under the Bank Term Funding program. More importantly, falling interest rates are a (psychological) tailwind here, as they will lead to a gradual decline in these unrealized losses, which will benefit banks' comprehensive income statements. It is also important to note that the HTM securities purchased in the current environment will result in unrealized gains in the coming years if interest rates are lowered as expected. If interest rates are very slow to fall, the “issue” of underwater HTM assets will be resolved over time by reinvesting the proceeds from the bonds as they mature off the balance sheet. Loan And Deposit Growth – Feeble Signs Of Stabilization The most fundamental way in which banks make profits is by taking deposits and making loans, and pocketing the spread. Consequently, sustainable growth in deposits and loans is one of the most important aspects to consider when investing in banks. Let's start with deposits: all four banks discussed in this article experienced strong deposit growth at the beginning of the pandemic (Figure 10). Churn among banks increased as interest rates began to rise in early 2022, and it is clear that larger and therefore perceived safer institutions could afford to offer comparatively lower rates on deposits. Smaller banks have to offer a better deal, mainly to compensate for the higher risk associated with their smaller (and oftentimes concentrated) balance sheets. Figure 10: Sequential change in total deposits of BAC, USB, TFC, and OZK (own work, based on information from company filings) Interestingly, however, in the midst of the 2023 banking crisis, Bank OZK experienced strong deposit growth, which it has sustained to this day. This is quite counterintuitive at first glance, but actually makes a lot of sense due to the bank's unique lending practices, which allow it to offer favorable terms on deposits and still turn a good profit. OZK's efficiency ratio is strong, around 33%, which is significantly better than U.S. Bancorp, which is already very efficient — especially for its size — at around 60%. However, I do not see BAC's efficiency ratio of 64% (Q1 and Q2 2024) as negative, considering the significantly higher regulatory burden of a Category I bank. Against this backdrop and considering management's promises immediately after the merger, I remain disappointed with Truist's efficiency ratio (Figure 11). In my previous articles, I have outlined why I continue to hold the stock despite these issues, but over time it has certainly become one of my lower-conviction investments. Figure 11: Truist Financial Corp. (TFC): GAAP and non-GAAP efficiency ratio, the yellow and blue areas indicate the pre- and post-merger period, respectively (own work, based on information from company filings) Returning to OZK: The secret of its excellent growth is not that depositors are risk-tolerant “high-yield savers.” The bank did not have to fear a deposit flight in the midst of the crisis, partly due to its excellent track record and healthy credit quality metrics, but mainly because about two-thirds of deposits are insured and another 16% are collateralized (p. 67, OZK 2023 10-K). Quite smartly, the bank is also placing increasing emphasis on term deposits — an “insurance premium” well spent, in my view. Looking at the assets side of the balance sheet (Figure 12), a similar trend can be observed. To a certain extent, it is only normal that lending at the larger banks is stagnating in the current environment, which is why I also welcome the diversification via smaller, specialized banks such as Bank OZK. To diversify further, I also own a position in Houlihan Lokey, Inc. (HLI), which is a leader in restructuring and M&A. My first article and the follow-up article are quite dated already, but the fundamental conclusions are still valid today. Figure 12: Sequential change in total loans of BAC, USB, TFC, and OZK (own work, based on information from company filings) As interest rates fall, new loans will become more affordable, and for businesses and individuals with floating rate debt exposure, the cost of servicing that debt will decline. These are two tailwinds that should increase demand for loan growth, and I expect this fundamental turnaround to be most visible on the balance sheets of larger institutions where credit growth is not distorted by specialized businesses as in the case of OZK. While falling interest rates will eventually lead to a narrowing of the spread between deposits and loans, I expect this to be a very slow process. In addition, the past zero interest rate environment has prompted banks to adjust their operations to become more efficient and diversified, which should benefit them going forward. Here I see banks like U.S. Bancorp and Bank OZK advantaged - the latter because of its excellent efficiency ratio and the former mainly because of its scale, diversified earnings streams, but also because of its - for its size - good efficiency, and both because of their demographically favorable regional focus. Conclusion: Why I Remain Constructive About The Banking Industry As A Whole At first glance, the current environment is not really positive for banks. The sharp rise in interest rates has led to an increase in charge-offs, demand for new loans is still subdued, and as the Fed has started cutting interest rates again, banks' net income is likely to fall from this perspective too. With a recession potentially around the corner, banks would face additional pressure on their earnings and capital ratios. As a result, banks as a whole are cheaply valued compared to the market as a whole. Personally, I feel much more comfortable investing in stocks of select banks where the risks are reasonably priced into the stock, instead of buying a highly valued index fund like SPY or even recession-resistant but heavily overvalued consumer staples companies like The Procter & Gamble Company (PG, see my last article). By highlighting several macro indicators that I regularly monitor, I hope I have made it clear why I do not expect a deep recession. Rather, I think a “soft landing” is very likely. The larger and thus more or less systemically important banks have, in my view, behaved prudently and strengthened their capital ratios (see the results of the Fed's latest stress test) by slowing down their share buybacks and dividend growth (USB dividend growth has averaged just 2% since 2022). The still significant unrealized losses on the balance sheets of several banks are not (and have never been) an issue in my opinion, and I only expect them to decline further going forward. Cash on banks' balance sheets is much higher than before the Great Recession (largely due to higher regulatory standards), which is very reassuring for an investor like myself, who is mainly invested in large banks (Figure 13). Figure 13: Cash position of large banks, divided by total assets (Board of Governors of the Federal Reserve System (U.S.), Cash Assets, Large Domestically Chartered Commercial Banks [CASLCBW027SBOG] and Total Assets, Large Domestically Chartered Commercial Banks [TLALCBW027SBOG], retrieved from FRED, Federal Reserve Bank of St. Louis) Taken together, I think the industry as a whole is well positioned, even if we are heading into a recession. I'm confident that investors in well-capitalized banks can easily ride out such an environment, but of course, it's always possible that regulators will order a temporary suspension of dividend payments to bolster capital ratios. Small banks, especially those with concentrated exposure to a riskier segment like CRE, are a minefield, but I think this particular situation offers potentially rewarding situations for investors willing to do thorough due diligence. Although it is of course impossible to predict the future, I do not believe that bank earnings will come under pressure in 2025. Lower interest rates should boost demand for loans and lead to fewer write-offs, and it would take a return to very low interest rates before the spread between loans and deposits puts renewed pressure on bank earnings. During the past zero interest rate environment, well-managed banks like U.S. Bancorp and Bank OZK have adjusted their operations, which should benefit them greatly going forward. While the market is pricing in significant rate cuts going forward, banks' earnings estimates remain very solid (Figure 14). These are the main reasons why I remain confident with my (modest) exposure to selected banks such as USB, TFC, HLI, and OZK and even expect to add a few shares here and there. Figure 14: Adjusted earnings per share estimates for 2024 – 2026 for BAC, USB, TFC, and OZK (own work, based on data from Seeking Alpha)  Thank you very much for reading my latest article. Whether you agree or disagree with my conclusions, I always welcome your opinion and feedback in the comments below. And if there's anything I should improve or expand on in future articles, drop me a line as well. 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