A Four-Legged Stool

A mantra of portfolio managers is investing in themes supported by more than one factor. The image of a simple stool with three legs or more captures visually the notion that more support creates a sounder investment. Nobody wants to buy a one or two-legged stool.

The election of Donald Trump and Republican majorities in the House and Senate created a powerful, multi-legged thesis for investing in banks. Although current newspaper and internet articles refer to a potential repeal of Dodd-Frank as the catalyst for the bank equity move, we note four drivers in descending levels of importance:

A change in the corporate tax rate to the 15% to 20% level.
A 1% to 2% upward shift in long term interest rates.
A change in tenor of bank regulation.
The potential for an economic effect from fiscal stimulus.
We outlined the logic of a reduction to the corporate tax rate in our May 2016 blog, which reviewed the rival positions of then candidates Trump and Hillary Clinton.

“As a captive, transparent industry, banking is one of the biggest payers of corporate tax. Lowering the corporate tax rate would open up a cascade of benefits particularly powerful for banks and bank safety. Lower taxes could offset all of the increased costs of regulation added over the last several years. It would raise returns to investors offsetting the impact of higher capital requirements. It would decrease the attractiveness of interest-deductible debt in the bank capital structure and “behavior shaping” taxes like Ms. Clinton’s proposed non-deposit liability assessment could be introduced while still decreasing the overall tax burden. Lower corporate tax rates would be particularly powerful for community banks forced to compete with tax free credit unions. Higher returns would attract capital. For those banks that pay the full on rate, and most community banks do, it would be a 30% permanent upward shift in their earnings stream.”

Keeping a larger share of earnings would go a long way in addressing the grievances of banks with their government overseers.

Lower corporate taxes will further spur bank consolidation. Efficient, high ROE banks get the most benefit from lower tax and this will be reflected in their stock prices and ability to accumulate capital. All else being equal, a 14% ROE bank will see its ROE rise to 17%, while a 5% ROE bank will only rise to 6%. The opportunity cost of being an inefficient bank increases.

A reduction to corporate taxes is still prospective as there is a lot of political sausage left to make before it can happen. The second factor driving bank stocks, a rise in interest rates, has taken its first step. The ten year treasury rate rose from 1.7% to 2.2% over the last month. These 50 basis points may not seem much, but bank profitability is tied to deposits. Rates have been so low branch deposit gathering has been more expensive than wholesale money. Rising rates may put an end to the super low rate anomaly of the last several years and restore normality to bank liability rate relationships.

Most bank analysts boil this down to NIM, or net interest margin. The assumption is rising rates will cause NIM to widen for banks, thus improving profits. Bank of America has publicly forecast it can make as much as $5 billion more in pretax profit if rates move by 100 basis points. J.P. Morgan and Citigroup also expect margin expansion. For Bank of America, a wider margin could be $.30 to $.40 more per share earnings depending on the tax rate, a 25% improvement to earnings over the current run rate. This is in line with how far bank stocks have run since Trump was elected. Throw in tax rate adjustment and a benign regulatory outlook, and the bank move looks more like a first step.

The same analysis can be done on banks up and down the size spectrum. It is not universally positive. Some banks lack transaction account focused deposit bases, and their NIM may not expand at all. Others may be “too long” or “too fixed” or “too floored” to get much benefit. Even a modest rise in rates is going to stall real estate and mortgage activity. Bank of America has a mix of business that is particularly well suited for higher rates, but it isn’t correct to translate that into universal bullishness for the sector based on rising rates. The Nasdaq Bank Index, which is driven by performance of regional banks, has moved up more than 20% in the last two weeks. This is money flowing into index products, and is probably not justified by the fundamentals for a significant portion of the banks making up the index.

All banks are likely to benefit from a change in regulatory tenor. We know ideologically different people will soon take over the major regulatory agencies and even the insulated Federal Reserve will see change through appointments. Hopefully we will see an end to ivory tower reports like Neel Kashkari’s plan to end too big to fail with 25% capital ratios. Someone should explain to the chicken littles that sometimes it’s better to build your house on the flood plain near your daily work rather than in the mountains far away from your work. Your daily productivity will be so much higher that you can deal with the consequences of a thirty year flood.

In the same way bank regulation creates a lot of walking to and fro, but a lot less productivity and risk taking. If bank regulation can shift such that a banker’s first thought when trying something new isn’t what will a regulator think, then this will be more significant than any repeal and replace of Dodd Frank.

With this said, we are not early fans of a Republican idea to tie achieving a 10% leverage ratio with bank regulation lite. We have advocated in this blog and in prior writings that robust risk management systems are more effective than capital when it comes to heading off a new systemic crisis. Creating a new wild west where the only requirement is a balance sheet that says you have 10% capital, doesn’t seem prudent.

It is straightforward to look at our first three points – corporate tax reductions, interest rates rising and regulatory change – and expect some rapid change and benefit. These points are either already happening or they are early low hanging fruit for a Trump Administration. Expecting our fourth point – fiscal stimulus – to be the icing on the cake might be pollyannaish.

The Trump Administration appears to be ready to set in motion policy actions with highly uncertain outcomes. Re-writing trade deals, tariffs, an infrastructure bank, immigrant deportations and income tax code changes are supposedly all on the table. The United States is pretty close to full employment, growing GDP between 2% to 3% per year, and has the world’s strongest currency. We also have long term debt and pension problems, a Federal Reserve stuffed with trillions of government debt and a wealth gap caused mostly by the housing debacle before the Great Recession.

Trump’s policies and lifting the bond market off near zero rates will have unpredictable consequences with the most significant being the potential for inflation. Tax cuts mated to a major infrastructure program are a lot of fuel to add to a near full employment economy. A little bit of inflation wouldn’t be a bad thing. Let’s hope we can still say that in a few years.

Uncertainty is nothing new for markets or investing. For those of us focused in banking, we have a three-legged stool supporting investment in our sector. Corporate tax reform, modestly higher interest rates and a changing regulatory tenor are all market moving positives with the former the most significant. Whether our stool has a fourth leg, a quickening of economic growth, is a question unanswered. The policy adjustments being discussed are big enough to cause this economy to depart from trend. The amplitude and direction is still in the stars.