Bank stocks struggle with high-rate headwinds

Manulife another non-bank alternative

The seemingly inexorable rise in interest rates in North America, Europe, and even recently in Japan, has resulted in yields hitting levels not seen for over 15 years. That’s bad news for banks, which recently reported quarterly earnings.

At the time of writing, the benchmark 10-year government bond yields in the U.S. and Canada were 4.3% and 3.7%, respectively. That’s up 1.3% and 0.8% over the last 12 months and 0.45% and 0.3% in the last month alone.

In Europe, German, and French 10-year yields are up 1.4% to 2.65% and 3.2%, respectively, over the last year. The 10-year gilt yield in the U.K. is up 2.25 points, to 4.65%.

In Asia, Japan’s central bank has finally relaxed its cap on the 10-year yield on the Japan Government Bond (JGB), with its new governor doubling the cap to 1% from 0.5%. The yield is up 0.45 points, to 0.64%, effectively a tripling of the interest rate. Meanwhile yields on Australia’s and South Korea’s 10-year bonds are up 0.85% and 0.7% over the last 12 months to 4.25% and 4%, respectively.

In short, it’s the same story everywhere you look. Rates continue to rise as central banks struggle to get a grip on inflation.

The recent surge in bond yields and the attendant fall in equity markets as the risk-free return on government debt becomes more attractive has several drivers. One of the least important on a fundamental basis is that the sharp moves in stock prices are due to low trading volumes during August, when many professionals take their vacations. This means any moves are exaggerated.

More important from an underlying perspective is that investors have finally given up hoping that central banks will start cutting interest rates by the end of this year. They now realize there may be more increases before the banks finally decide inflation is under control.

The U.S. Federal Reserve, Bank of Canada, European Central Bank (ECB), and Bank of England have all made it clear that they remain “data dependent.” That means they are waiting to see what monthly inflation, employment, and business confidence measures look like before making their decisions. Investors have to decide whether lagging indicators such as unemployment and rental increases, which are still showing strength, are more important to Fed Chair Jerome Powell and BoC Governor Tiff Macklem than weaker coincident indexes such as business sentiment, housing starts, and commodity prices.

The central bankers’ summer camp, as some irreverent commentators have described the Fed’s summer get together at Jackson Hole, Wyoming, gave some clues, as Mr. Powell adopted a hawkish tone and stressed that the Fed is not happy with the current inflation rate, although it is well down from last year.

In fact, CPI inflation has fallen sharply from over 9% at this time in 2022 to under 4% in the U.S. and Canada. It’s even down in such lagging economies as the U.K. But this has not been enough to convince policymakers to stop raising short-term interest rates.

While it’s true that core CPI (excluding volatile food and energy prices) has remained stronger than policymakers would like, it seems that the Fed is haunted by the fear of repeating the mistakes of the 1970s.

At that time, Fed chairmen such as Arthur Burns and G. William Miller relaxed policy too soon, reducing interest rates before inflation was thoroughly under control. The result was that inflation returned at a higher level than previously as inflationary expectations became embedded in popular psychology.

Higher for longer

The likely result this year seems to be that interest rates may be higher for longer than investors had anticipated. Until the signal given by the inverted yield curve (short-term rates higher than long-term) results in an economic slowdown, as has always been the case since World War II, then interest rate cuts are not on the agenda. At present, short-term interest rates such as the Fed funds rate or the BoC rate are over 5% while 10-year yields are only 4.3%, even after their rapid rise in the last month.

This presents problems for the banks. Rising interest rates widen their net interest margin (NIM), the difference between deposit and lending rates, thus helping their profits. But higher rates also lead to more bankruptcies and loan losses. Usually, the wider NIM more than offsets higher provisions for credit losses (PCLs), but the markets have been reluctant to accept this. As a result, bank share prices are all down over the last year.

The problems of regional U.S. banks like Silicon Valley Bank, Signature Bank, and First Republic were with mismatched loan books. These banks suffered losses on their holdings of long dated government bonds as rates rose. The bankruptcies that resulted in the first quarter further dampened sentiment towards banks in general, even though the enormously profitable and conservatively managed Canadian banks have not had any such issues.

Banks’ lacklustre performance

It’s remarkable to see how lacklustre the banks’ performance has been over the last five years. This period includes two episodes of rising interest rates (2018-19 and the last 18 months) and a period of effectively zero interest rates and massive monetary expansion during the Covid pandemic from 2020-2021. A few banks that are well regarded by the market have posted gains, such as a remarkable 52% for National Bank. But most banks have been treading water. RBC is up 16%, TD has gained 7%, and BMO has added 5%. The others have seen share prices drop. CIBC is off 12%, Scotiabank 17%, and Canadian Western Bank is down 30%. All these returns are before taking dividends into account.

It’s not just Canadian banks. There are some positive stories among major U.S. and European players, but not many. Investment banks like Morgan Stanley, Jefferies, and JPMorgan Chase are up 73%, 48%, and 30% before dividends. But Bank of America, Fifth Third, PNC, US Bancorp, and Wells Fargo are down between 5% and 35%. In Europe, Deutsche Bank and HSBC are off 5% and 15%, respectively, over the last five years.

While price/earnings ratios are not regarded as the best way of valuing financial stocks, all the Canadian banks and most of the U.S. majors are selling for less than 12 times last year’s earnings.

You can buy the two biggest and most successful banks in Canada (RBC and TD) with dividend yields of 4.5%. This situation has only occurred once before in this century, during the Great Financial Crisis in 2008-09. BMO offers a yield of 5.2%, while CIBC and Scotiabank are offering remarkable yields of 6.5% and 6.8%. It’s a case of “don’t put your money in the bank, put your money in bank stocks.” The dividend yield on the banks is equal to or better than you will receive on deposits. You also receive the dividend tax credit, which means the after-tax yield is substantially higher.

The non-bank alternative

All the banks except National are down over the last year. While concerns over rising loan losses are understandable, they seem already reflected in share performance. Investors looking for a way to get exposure to the financial sector without adding to bank holdings, might want to consider the insurance sector, as I discussed in my previous article.

Another solid choice is Canada’s largest life insurer, Manulife Financial Corp. (TSX: MFC), which is as close as you can get to a bank without actually being one. In fact, Manulife does have a banking subsidiary called Manulife Bank, which has no branches and operates online and through a network of ATMs.

But insurance is still Manulife’s main business. It is the largest Canadian life insurance company by market capitalization. It has extensive operations in Asia, where it has offices in 13 countries. The stock has been trading in a narrow range of $23-$28 a share for most of the past year,

Manulife reported a 4% increase in core earnings, to $1.6 billion ($0.83 pr share), in the second quarter (to June 30). That was up 9.2% from $1.5 billion ($0.76 a share) in the same quarter of the previous year. Growth was driven by a double-digit increase in sales in several areas, especially in Asia, following the reopening of the border between Hong Kong and mainland China at the beginning of the year.

Manulife's global wealth and asset management unit recorded sales of $2.2 billion in the second quarter compared with $0.7 billion in the previous year. Assets under management grew 1%, to $819 billion, despite the bear market in bonds and equities, helped by the acquisition of full ownership of Manulife Fund Management in China.

The release of $5 billion in capital three years ahead of schedule in 2020 was a key contributor to Manulife’s ability to withstand prolonged lockdowns in Asia.

In summary, the company enjoys a strong capital position, growing earnings, and the benefits of the reopening of the Asia economies.The stock sells at less than 10 times earnings and offers a 6% dividend yield, making it attractive for income-oriented investors.

Gavin Graham is a veteran financial analyst, money manager, and a specialist in international investing, with over 35 years’ experience in global investment management.

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