Tussle between rate benefits and recession worries
Following the higher tail risks flagged in our 1Q22 United States (US) banks results analysis (1Q22 results highlights, watchful for higher tail risks) and subsequent downgrade of the global financials sector last quarter (Global Financials – Higher growth risks ahead) on a deteriorating risk-reward outlook driven by increased growth risks which outweighed higher rate benefits, sector returns have softened further as recessionary expectations and investors’ risk-off sentiment intensified over the past few months.
The 2Y-10Y US Treasury yield curve has inverted for a second time this year reflecting increased recessionary worries by the bond markets. Looking ahead, we believe the narrative around inflation, implications of a hawkish Federal Reserve (Fed) and worries over an eventual rise in credit losses (if a recession does materialize) would persist as continued headwinds for the financials sector. With the latest US headline inflation print remaining uncomfortably elevated at 9.1%, our economist expects the Federal Open Market Committee (FOMC) to raise the Fed funds rate by another 75 basis points (bps) this week to 2.25-2.5%, with further hikes expected in 2H22 that should bring the Fed funds rate to 4% by early 2023 (Fed Preview: Another 75bps hike).
Overall, we maintain a defensive stance on financials given the sector’s sensitivity to macro uncertainties and scope for valuations to retrace further if a recession scenario materialize (not our base case although risks have increased). The MSCI World Financials Index last traded at 1.1x price-to-book (P/B), still above historical recession troughs below 1x book value, and with consensus forecasts still expecting +12.5% FY23E earnings growth (vs +7.1% forecasted for world equities), we believe sector share prices are reflecting some level of recession risks, but not fully pricing this scenario in. This points to further potential underperformance should a recession occur – not our base case, although we see the risks for a recession have increased towards a more material 50-50 probability (Macroeconomics: Fed hikes & recession risks). On the other hand, should global growth navigate a soft landing or inflation expectations moderate, there is potential for a rerating in sector share prices.
In this report, we provide 2Q22 results highlights of large US banks which recently reported mixed results although key takeaways included the continued health of the US consumer. We also assess the results of the Fed’s latest stress tests for large banks which included various severe recession assumptions and concluded that while large banks would see credit losses and earnings contraction in a severe recession scenario, they should still maintain capital ratios above minimum risk-based requirements. (Research Team)