Steady growth in consumer spending is the key to a robust US economy, and right now the outlook doesn’t look all that promising. We discussed in our June 18 Market Commentary how generous government stimulus payments and expanded unemployment benefits led to a spike in Personal Income beginning in April of this year. However, we also wrote that rather than spending those windfalls, consumers instead opted to sock away the payments due to fears of extended economic weakness. Consumers’ cautious response should not have been a surprise. Over 47 million Americans have applied for unemployment benefits since March of this year. Job insecurities and the temporary nature of government support payments caused a highly predictable consumer retrenchment. The more difficult question, then, is how long will this retrenchment last. The good news is that the savings rate (personal saving divided by disposable personal income) fell from its unprecedented April level of 32% to about 23% in May. The bad news is that that 23% is almost as unprecedented.
It’s good to know that consumers at least have the wherewithal, if not the willingness, to spend. The buildup in savings will be especially important given what is going on in the banking sector. Last week the Federal Reserve announced the results of its annual stress tests for 33 of the largest financial institutions in the US. The results of the stress tests should have been somewhat reassuring: the Fed determined that the banking system as a whole is adequately capitalized to withstand even the most adverse of stress-test scenarios. But the story doesn’t end there. The Fed also effectively acknowledged that its worst-case economic scenarios were not particularly “stressful” when it placed restrictions on bank capital returns (stock buybacks and dividends) and required that each of the 33 banks resubmit revised capital plans later this year to reflect the progression of coronavirus-related pressures.
Bank investors did not like what they heard from the Fed. The KBW Bank Index, which is an index of 24 large-cap banks, fell 6.4% on Friday in response. Investors fear what the Fed left unsaid. There is a non-trivial risk that credit losses will rise to a magnitude that leaves banks without an adequate capital buffer. Under that scenario, individual banks could be required to not only suspend stock buybacks (which have already been restricted) but also cut dividends. In an even worse-case scenario, banks could be required to raise more capital at extremely depressed valuations, in the process diluting the ownership interests of existing shareholders. This is what happened during the Global Financial Crisis. Could it happen again?
One implication of the Fed’s action is that it will force banks into capital preservation mode. Rather than helping the economic recovery by keeping the credit spigots wide open, banks will instead tighten their lending standards and make fewer loans. The Fed is well aware that its crackdown, however modest it may seem, has procyclical implications. It wants and needs the big banks to be out there helping businesses and consumers work through this intense recession. However, it’s primary obligation is the protection of the banking system and ensuring that banks operate in a “safe and sound manner.” To put it more succinctly, the Fed wants insurance against a disastrous collapse in the banking system, and that takes precedence over its stewardship of the economy.
There is another factor that is inhibiting the flow of credit to consumers. In response to widespread layoffs and furloughs related to the coronavirus outbreak, banks are allowing payment deferrals on a huge percentage of consumer loans. However, the federal government has stipulated that banks cannot penalize their customers for these deferrals by notifying the credit-reporting agencies about their delinquent payments. This rule is making it much harder for banks to make credit decisions on new loan applications. According to a recent article in The Wall Street Journal by AnnaMaria Andriotis, “From March 1 through the end of May, Americans deferred debt payments on more than 100 million accounts, according to credit-reporting firm TransUnion, a sign of widespread financial distress.” If banks can’t identify the borrowers that are having trouble making payments on existing loans, they are unable to assess the likelihood of default on new loans. Consequently, the banks are increasingly withholding offers of credit. The chart below, taken from Andriotis’ article, shows the effects.
The sudden drop in loan supply resulting from regulatory/capital concerns and a lack of data is concerning. It is true that job insecurities and waning consumer confidence are also causing a spike in savings rates and lowering the demand for loans. However, ready access to loans at very low interest rates has been the lifeblood of the economic recovery from the Great Recession. If access to cheap credit becomes impaired indefinitely it would be very hard to envision the V-shaped recovery that everyone is hoping for. A banking system that was considered very healthy and the envy of the world just a few months ago now seems decidedly less so. A resolution to the uncertainty does not seem forthcoming any time soon.
Despite seemingly attractive valuations, we believe bank stocks may be in for a rocky road in the months ahead. Our advice would be to stick with the highest-quality among them. Otherwise, the sector seems at best dead money for a while. Longer-term investors, on the other hand, could well be rewarded by owning positions in the highest-quality names which could benefit from market share gains over time.
Farr, Miller & Washington 