In simple terms, banks earn more when interest rates are high. They can offer loans on bigger margins. When interest rates are tight, margins become squeezed. Also, when rates are as low as they are, the demand for loans decreases, putting more pressure on bank profitability.
But all is not doom and gloom, however. The last rate movement in the US was upward and the probability of another rate rise in the US before the end of the year is a distinct possibility.
When interest rates rise, people save more, meaning it costs banks less to make loans because they can use their low-cost depositors as their funding source.
But when individuals and corporates feel more secure in their standing they interact more freely with the economy as opposed to being austere, and the economic multiplier effect boosts the use of bank services accordingly, which could mean loans, capital expenditure, overdrafts and so on.
For rising profits, banks need economies to feel good, consumers to spend and purchasing manager indices to be positive.
The past eight years have not been much fun for individuals or corporates. Sure, the Brexit vote was a shock, putting the brakes on the economy, and there is talk of a recession around the corner.
However, Bank of England governor Mark Carney has dismissed this suggesting “a number of indicators of near-term economic activity have been somewhat stronger than expected”.
Capital discipline
The search for income continues unabated and banks could be considered a great source of dividends. With neater, stronger balance sheets and greater regulation forcing greater capital discipline, there is a strong argument from investors for return of capital in the form of dividends, special dividends or buybacks.
Operating in a highly regulated environment will stifle the speculative element banks previously enjoyed, and it might not be a surprise to see some sell non-essential business lines.
Not only will dividends pay a greater role in the total return from the banking industry over the next five to 10 years, but companies may also up the payout ratio due to the utility-like nature of the sector. Richard Buxton, CEO at Old Mutual, has long suggested looking at banking stocks for both capital and income appreciation, and he is not alone.
Banking stocks are not a sleep-easy investment in the short term, and there is likely to be a high degree of sentiment contagion – if bank ‘A’ comes under certain pressures, the odds are Bank ‘B’ will suffer, too.
Remember, not all banks are the same and as both returns and correlations of individual stocks differ, so do their opportunities.
