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Aggressive rate hikes by the U.S. Federal Reserve have fueled speculation about a possible recession. Greg Bonnell speaks with Stephen Biggar, Director of Financial Institutions Research at Argus Research, about the potential impact on financial stocks and their outlook going forward.
Transcript
Greg Bonnell: Well, the pace of rate hikes has many discussing the possibility of a recession on the horizon. And that has some investors wondering how financial stocks might hold up in an economic downturn. Well, our guest today says there are three items he’s keeping an eye on when it comes to those financials. Joining us now with more, Stephen Biggar, Director of Financial Institutions Research at Argus Research. Stephen, welcome to the program.
Stephen Biggar: Hi, Greg, good to be here.
Greg Bonnell: All right, so this is an interesting one, obviously, with all this Fed market action, all these concerns about a recession. Let’s talk about the strength of financials. You have three things to look at. So we’re going to take them one at a time. One of them is sort of the loan book — the lending outlook, what are you seeing here?
Stephen Biggar: Yeah, well, the lending side of the business has actually been pretty strong for banks here. We had that lull during the pandemic. A lot of people shied away from borrowing, obviously. There was high unemployment and a lot of uncertainty. So borrowing was not done at that time in any big way. But then roughly a year later or so, we have people going back to banks for lending. Housing was very strong for a while, autos, pent-up demand for other housing-related items, everything from vacations to you name it.
So the Federal Reserve data we get once a week on lending activity, and it’s up 10% year over year through very recently. So that’s been a good part of the story that the consumer is feeling pretty good, despite what some of the consumer sentiment surveys have said. There’s been a lot of activity with the exception of a real downtick more recently in housing, of course. Mortgage lending activity with rates going up as high as they are has been much lower. So we do expect a bit of a slowdown here as rates move up. That’s the intended impact that the Fed’s trying to get across to slow things down.
And– but the other– a good part of the lending business story for banks has been that margin expansion based on the Fed rate hike. So we’ve had just this universal uplift in the yield curve, short and long-term rates have moved up dramatically over the past year. And that is favorable for banks, and you’re seeing that in that interest margin expansion that they reported this most recent quarter.
Greg Bonnell: All right, so that’s very interesting, not only has the loan book held up, but of course, that interest margins, which is so key to the banking business, have gotten a little richer as well, considering the moves we’ve seen from the Fed. So let’s talk about the Fed. All these rate hikes we’ve seen, we’ve seen them here in Canada, these super-sized increases. Of course, that raises the fears of a recession. What do we need to think about in that part when we think about the financials?
Stephen Biggar: Well, that is the big risk we think right now is that and why some of these– the stocks of some of the major banks are trading at some of these lower levels– has been that the Fed will have to go too far, basically, to rein in inflation. And what happens is when you raise the cost of borrowing, obviously, you raise the chance of default in their attempt to slow the economy. You’re going to sort of disrupt the good employment picture. There’ll be fewer jobs available, more layoffs. And I would say in the banking world, there’s probably no better correlation between unemployment and net charge-offs or delinquencies for banks. So if you lose a job, and it’s difficult to find a replacement job, you will often get behind on your bills and on your payments. So banks look at that, and have to, depending on how long you’ve not paid, generally like three months, they’ll set it aside as delinquent and eventually have to charge off that loan.
So that means loss provisions move up, and we did see that in the third quarter results. We saw banks getting a bit more cautious about– not because charge-offs had increased yet because they hadn’t, but they’re being more cautious in the forward outlook. And that’s what loss provisions are designed to do, really. You’re adding to your allowance for loan losses in anticipation of some weakness coming up next year. And I think that’s where we’re at today that there’s still concern that the Fed will move too far and too fast here, and by the middle of next year, they may even be in a period of having to reduce rates if they have gone too far.
So really, it’s the employment situation we’re looking at closely here to the extent that that does not unwind. At last look two months ago, we had about twice the number of job openings relative to the number of unemployed, so that gives you an awful large buffer for unemployment to move down a little bit. Of course, there’s always a mismatch between skill sets and between the job openings and job– people that are eligible or able to take them.
But– so that’s I think, really the major risk here at this point is that the economy starts to unwind a little bit. Credit costs for banks will move up, and that is a big swing factor for banks when things are not going well. And they have to add heavily to in terms of loss provisions that will unwind your earnings pretty quickly.
Greg Bonnell: Stephen, we got part 3 here, is when it comes to the big money-centered banks, I think some of the biggest names on Wall Street, we have already seen that slow down in the capital markets business. The deal making quite– not quite as robust as one might hope. Well, what are we seeing in that space? What do we think we might be seeing going forward?
Stephen Biggar: Absolutely. It’s been a dismal year, Greg, and particularly in the equity underwriting, but also fixed income underwriting, and a bit of M&A activity. The only thing that’s held up well really has been trading volumes for banks, and that’s because of the lots of volatility in the markets, and that’s across equities and fixed income currencies, commodities. There’s just been such massive volatility, so trading has held up well.
But it has typical– I mean, there’s two things going on– the comparisons are awful because ’21 was such a good year for capital markets, underwriting. We had just kind of record years, or 20– 20-plus-year highs in terms of equity underwriting activity, lots of IPOs coming out, secondaries rates were low. So you still had good fixed income issuance. And that is basically completely unwound this year.
So, typically, when you have these downturns or downdrafts in the equity market, when you have a few IPOs that don’t do well, then you have some hesitation on companies coming public. There’s just not enough liquidity, and of course, the Fed had flooded the market with liquidity and made a lot of money available, some of which found its way into IPOs. So that has been unwinding for much of this year. And, again, the equity market downdraft where in a bear market after 20% down, so you just don’t have a lot of owners of private companies that are willing to go to the public markets now and convert their shares there.
So that’s going to take probably a couple of quarters to improve. I think we need to see just some better– some backing and filling of the equity markets, and not just for a week like we’ve had, or even a month. I think we need to see some sustained move upward. There have been some decent underwritings that have come through lately, like Mobileye (MBLY), the Intel (INTC) spinoff, did well on its debut IPO debut. So there are certainly some encouraging signs out there and– but I think we need to lay some more groundwork here, and improve on that front.
M&A activity as well, typically, when financing costs go up, we get– there’s a number of levered transactions, obviously, that would move to the back burner in anticipation of just better financing rates. So M&A activity has not quite fallen off a cliff like we’ve seen with IPOs, but it has been softer, and we’ve seen some strength in Europe and some specialty areas, and health care is still a bit of a bright spot. Some of the energy transition areas have been bright spots. But by and large, the big tech names, the consumer-type names have just not been very active, and I think it’s going to take, again, another at least a couple of quarters for that to show some signs of rebound.
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