Our portfolio set a new all-time high last week, but the investment case for banks remains strong from these levels.
Bank stocks underperformed the market by a wide margin over the past five years.
Banks had a terrible 2018 when the economy slowed down, a disappointing 2020 due to the pandemic, and a tough 2023 because of the failure of Silicon Valley Bank.
As a consequence, banks are cheap. Some banks in our portfolio, such as Santander, NatWest and BNP, trade at 5-6 times 2024 earnings. The historical average is closer to 9 times, suggesting 50% upside may be available if valuations normalise.
Historically, higher interest rates helped banks make more money. This indeed happened during the 2022-23 interest rate hike cycle: banks became more profitable. Bank stocks, however, failed to keep pace with earnings, and their valuation multiples compressed.
Why did this happen? Fundamentally, higher interest rates did not benefit all banks. Some banks bought too many long-dated bonds and lost money. Others saw their deposit costs increase rapidly with interest rates. Finally, investors became wary about credit losses banks might experience, as higher interest rates might tip the economy into recession and put pressure on borrowers.
For these reasons, the market now unusually appears to treat lower interest rates as good for banks, because lower rates improve financial stability.
Inflation is coming down, so perhaps interest rates can stabilise at current levels. Falling inflation and interest rates have been the story of the past month, which has helped bank stocks recover.
“If there is not a recession next year, bank stocks are too cheap,” concludes Robert Armstrong in the Financial Times.