As the Democrats look almost certain to take the White House in 2020, PhillipCapital research analyst Yeap Jun Rong warns of a 6-8% drop in profits for US banks. A proposed corporate tax hike from 21% to 28% and possibly greater financial regulation, he argues, could hurt banks already suffering from low interest rates and weakened loan growth.
“Bloomberg estimates that major US banks’ earnings may fall by 30-40% in FY2020E from the Covid-19 fallout. A further hike in corporate tax rates may hinder their earnings recovery,” Yeap writes in a broker’s report on Oct 19.
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Small regional banks, Yeap adds, could be harder hit if Biden reinstates Dodd-Frank financial reforms repealed under Trump. He expects Biden to reinstate Dodd-Frank Act financial reforms repealed under Trump such as greater restrictions on asset thresholds for stress tests and the “Volcker Rule”. Larger banks are less affected since they are deemed “too big to fail” and are subject to Fed stress tests and tight capital requirements and shareholder payout restrictions.
A Trump upset on the other hand could favour the financial sector, says Yeap, anticipating an extension of his signature tax cuts. These cuts saw large US banks booking record profits in 2018 as corporate taxes fell from 35% to 21%, with tax savings for these banks made up 12-15% of full-year net income in those two years. Trump is also likely to keep to his agenda of financial deregulation, minimising compliance costs for financials.
That said, the worst could be over for US bank fundamentals, which have suffered under Covid-19. The Fed’s large-scale asset purchases and fiscal relief efforts, he says, have seen the Fed Stress Test Index improving significantly from its March 2020 peak to -0.36 as of October. A sub-zero score indicates below average financial market stress.
“We believe credit markets have largely stabilised and funding liquidity has improved,” cheers Yeap. He observes that most major banks will be able to adhere to the Fed’s new CET1 capital requirement of between 7-13%, suggesting relatively strong balance sheets.
But on the flipside, a surge in loan defaults could perhaps see banks having to cut their earning expectations. Fortunately, however, Yeap sees the lower earnings priced into bank valuations, with banks largely accounting for default risks. With allowances for loan and lease losses at US$221 billion ($300.1 billion) double pre-Covid-19 figures and just 5.6% off their financial crisis peak, any subsequent buildup of loan loss allowances should begin to ease, says the PhillipCapital analyst.
“Still, the recovery may be onerous. Despite economic reopening, the weekly economic index still falls below pre-Covid levels,” Yeap warns. Total loan growth has weakened of late, as borrowing under the government’s relief programme has begun to wind down and banks tightening underwriting. With interests rates also expected to stay near zero till 2023, banks could see pressure on core lending profitability, he remarks.
US financials have been lagging the overall market. While 70% of S&P 500 stocks are currently trading above their 200-day moving average, only about 52% of S&P 500 financial stocks are doing so. The sector is down 18.9% year-to-date relative to a gain of 7.8% on the S&P 500.
But US financials enjoy attractive valuations, as the sector’s price-to-earnings (P/E) ratio came in at 13.0 below its five-year historical average of 14.8. Dividends have also been strong at 2.47% vis-a-vis its five-year average of 1.90%, with major banks aside from Wells Fargo maintaining dividend payouts after their stress tests, though a Fed dividend cap means further increases are unlikely going forward.
Investors, therefore, will have to be patient before they realise the potential of US banks. “For positioning on a Biden win, we favour accumulating large U.S. banks on weakness, considering their attractive risk-to-reward proposition,” says Yeap, warning that whether corporate tax hikes come into fruition depends also on who controls congress and the pace of US economic recovery. A Trump win could see tax cuts that favour the industry as a whole, as well as deregulation measures that would favour small banks.
As of Oct 19, The Economist sees Joe Biden as very likely to defeat Donald Trump in the US Presidential elections, with a 91% chance of winning the electoral college. He is projected to win 341 votes against Trump’s 197. FiveThirtyEight gives Biden a 87 in 100 chance of winning the election, with a 10.6 point lead in national aggregate polls over Trump at 52.4% to 41.9%.
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