Pub. 8 2020 Issue 1

www.uba.org 18 BANKS MUST PLAN, ADAPT AND OVERCOME IN 2020 W e’ve been arguing that the U.S. economy is at a cross- roads 10 years into the expansion. Bulls will tell you that economic expan- sions don’t die of old age. They’ll argue that the consumer, who accounts for two-thirds of our economy, is employed, confident, and spending money. They’ll also suggest that trade tensions, particu- larly those between the U.S. and China, have constrained economic growth. Now that the Phase One accord is signed, an- imal spirits could give the expansion an- other shot in the arm. The stock market, in testing new highs, is pricing according to this outcome, they’ll say. Bears will cite the law of gravity: what goes up must come down. Most likely, they’ll agree that trade is the gating issue. They’ll also concede that there has been momentary progress in U.S.-China relations, while noting that Phase One, by definition, necessitates a Phase Two or Phase Three, which could trigger renewed market volatility. This volatility could feed into the real economy through cuts in consumer spending or further reductions in capex. Subsequent trade spats, a conf lagration in the Middle East, or coronavirus, if uncontained, could chill global growth and dent confidence at home. At the bottom, bears are anxious about a self-fulfilling prophesy, of the same na- ture and scope that played out in 2018. It’s important to appreciate that the economic outlook can shift on a dime. For a recent example, let’s rewind to November 2018. At that time, Fed Funds futures priced in two rate hikes through December 2019. There was a 95% probability of a hike by Decem- ber 2019 and 0% probability of a cut. Federal Reserve Chairman Jerome Powell had suggested that Fed Funds were a long way from neutral, signaling that rate hikes would proceed unabated. Shortly after, the trade war stepped into high gear and global growth cooled, triggering a stampede to have safe assets. Within the next few months, the Federal Reserve monetary policy shift- ed 180-degrees. Instead of two hikes last year, there were three cuts. Some have praised us for anticipating lower rates, but the truth is far less glamorous. Our team noticed that, after a decade of historically low rates, a disproportionate number of bank balance sheets were asset-sensitive, many wildly so. Banks were exposed to lower rates. Additionally, because the market expected higher rates, down-rate protection was cheap. We encouraged banks to spend some asset sensitivi- ty — to prepare for lower rates — to remedy their exposure. Sound asset-li- ability management? Yes. A rate call? Absolutely not. The two are mutually exclusive in our minds. BANKS FACE GUSTY HEAD- WINDS IN 2020 We continue to marvel at the massive disconnect between market and bank management sentiment. Investors have been bidding up bank stocks, as part of a broader rotation into economically sensitive sectors, but the fact remains that banks face gusty earnings head- winds in 2020. Piper Sandler’s Equity Research De- partment recently updated its ag- gregate model, formally adjusting forward expectations for all of the banks and thrifts we cover. For 2020, Piper Sandler analysts expect median EPS growth of 1.5%, ref lecting NIM pressure, slowing balance sheet growth, tough fee comps, and potentially more volatile credit costs post-CECL. The key pressure point, as one might expect, is net interest income. Here, our analysts expect median NII growth of 2.8%, which would be the group’s weakest growth since 2013. NII growth is a function of 7.0% loan growth offset by 11 bps of NIM compression, with the latter representing the group’s weakest performance since 2007. Also, recall that over the past couple of years, lower-than-expected credit costs have offset thinner-than-anticipated top-lines, allowing for moderate earn- ings growth. Credit leverage seems to have run its course for most banks, with allowance-to-loans ratios well below pre-crisis levels. Additionally, most banks will have to absorb struc- turally higher provisioning expenses once CECL takes effect. The bottom line is this: if top-lines underwhelm, lower credit costs might not be able to save earnings. FACING SUCH UNCERTAIN- TY, STRENGTHEN YOUR CORE Specifically, we want banks to focus on strengthening core pretax, pre-provi- sion ROA (PTPP ROA). Core PTPP ROA excludes one-time accruals such as securities losses, debt extinguish- ment charges or lease termination ex- penses. It also isolates for credit and tax accruals, exposing a bank’s underlying earnings power and allowing for ap- ples-to-apples benchmarking to regional and highly valued peers. As shown below, the median PTPP ROA for banks with assets between $1 billion and $10 billion held pretty firm in 3Q19. While instructive, un- fortunately, such an analysis is back- ward-looking. The forward look is more challenging, with the f lat yield curve and structurally higher funding costs pressuring NIM. Still, there are numerous strategies to drive earnings, bolster relative returns, By Scott Hildenbrand and Matthew Forgotson