Almost everything seems to be going U.S. banks’ way: The yield curve is steepening, expectations for multiple interest-rate hikes in 2022 have solidified, initial fourth-quarter investment banking numbers appear to be strong, fourth-quarter loan growth numbers are likely to be solid, credit losses are likely to remain cyclically low, and omicron seems unlikely to throw the economy back into a tailspin. Also, we will be updating our tax rate assumptions, as we no longer anticipate a corporate tax hike.
From a tax rate update alone, we expect increases to our fair value estimates for the U.S. traditional banks of roughly 7% on average. We expect Wells Fargo (WFC), Zions (ZION), and M&T (MTB) to be the bigger winners here, with expected fair value estimate increases of 10%-11%. We expect less of an effect on U.S. Bancorp (USB), KeyCorp (KEY), Huntington (HBAN), Cullen/Frost (CFR), and Regions Financial (RF) (expected increases of 3%-5%), while we anticipate increases of 6%-9% for the rest of our coverage.
We could see additional increases to our fair value estimates of a low-single-digit percentage on top of this as we bring forward our rate hike assumptions. Even anticipating all of this, we estimate that the banks would be trading at roughly 1 times fair value on average–in other words, we think the market is already discounting all of this positive news. Taking a through-the-cycle perspective, valuations appear closer to a cyclical peak to us, but there is no telling how long this can persist over the short to medium term. Earnings momentum is likely to persist in 2022, driven by rates.
During the fourth-quarter earnings calls, watch for a focus on the investment banking pipeline, commentary related to economic growth and loan growth, further refinements to rate sensitivities, and robust discussions about how much higher inflation will feed into expense growth.
We think the banks are in a very interesting spot, and some caution and awareness of what earnings power is already priced in is paramount. There is a lot of earnings momentum with the rate thesis picking up more than ever; this is juxtaposed against sectors like technology, where higher rates are viewed as a negative for valuations by many investors. We agree that the banks are in a good position and their earnings should see unique growth compared with most sectors for the time being, driven by rising rates. However, most bank sector theses we see are simply “higher rates equals good earnings momentum, which means you should buy banks.” Eventually, we think investors will have to move beyond this. We agree that momentum for banks is likely to continue, even though we see valuations as relatively full for the sector. We would probably need some sort of negative economic catalyst to start to see an unwind, and this is difficult to time. For now, valuations appear closer to a cyclical peak to us, and this could persist throughout 2022. Against this backdrop, remember that essentially all of the banking sector’s outperformance came in the first several months (late 2016) of the last rate hike cycle.
What We Like Now
We currently see Citigroup (C) as the most undervalued bank, and we expect this will still be the case after fourth-quarter results, making the bank the likely top pick for our 2022 full-year outlook. The bank is more in the value category now, as it has been left behind because of its regulatory issues and lack of rate sensitivity. The upcoming investor day in March, a resumption of card loan growth, further progress on the Asia consumer restructuring, and any additional clarity on the regulatory and expense outlook could all serve as catalysts to help the name rebound from its low valuation (under 1 times tangible book value).
Our top pick in 2021 was Wells Fargo, and the bank did have the best one-year total return among our coverage. We think there could be some additional momentum in 2022 from its leverage to higher rates, but we don’t think a lifting of the asset cap will be in play for 2022, and we expect the turnaround will still be years in the making. As such, we have a hard time seeing similar performance this year, although we still don’t see the valuation as overly demanding.
We think Bank of America (BAC) appears pricey, as the bank nicely fits today’s growth narrative (higher leverage to rates and no asset cap like Wells Fargo), and it is the top pick at a number of other research shops. From our perspective, of the biggest two U.S. banks, JPMorgan (JPM) looks more attractive on a relative basis over the long term.
Source: morningstar.com
