Michael Nagle/Bloomberg
Signs have been provided that interest rates could stabilize through 2024, easing pressure on both deposit costs and net interest margins. Substantial increases for community bank shares. sometimes in November. But the gains proved short-lived, and lender shares ended the month where they spent most of the year: depressed relative to the start of 2023 and compared to the broader market.
The S&P US BMI Banks Index, made up largely of community lenders, closed Thursday, the last trading day of November, down 6% from the beginning of the year. The S&P 500, on the other hand, rose 19%.
On the bull front, the S&P US BMI Banks Index posted its biggest gain of the year by far in the week ending November 3. The index recorded a gain of 9.4%. During that week, Federal Reserve authorities announced that they would leave their reference interest rate unchanged. After raise rates 11 times from March 2022 to cool inflationthe Federal Reserve has paused on that front for several months now.
The small bank index jumped another 6.9% during the week ending November 17. During that period, the Labor Department reported that the U.S. inflation rate slowed to 3.2% in October. That was substantially down from its peak 9.1% in June 2022. This indicated that the Federal Reserve's aggressive rate actions had largely worked. Futures markets began pricing in the end of the Federal Reserve's campaign and even the possibility of rate cuts next year.
"More and more people are beating the drum for a rate cut, maybe even a cut as soon as March," said Robert Bolton, president of investment bank Iron Bay Capital. "That's good news for community banks."
Investor response to interest rate and inflation news indicated bullish currents are brewing, with community banks and small-cap stocks generally favorably priced.
"We've seen a notable shift in underlying conditions: Investors have record levels of cash in money market funds, indices are consistently outperforming, and strong institutional conviction bodes well for markets," said Jeffrey O'Connor, head of of market structure of Liquidnet, a trading and liquidity network.
"As thoughts of rate pressure subside, the future outlook for small caps has improved while valuations are attractive, attracting investors looking for opportunities to put up working capital before the end of the year" , he added.
Lower rates could lead to lower deposit costs and stronger bank profits in the coming quarters after weaker results for the third quarter. With high rates, banks have had to pay more interest to depositors. This, by extension, has reduced NIMs, the profit margin between the amount banks pay for deposits and what they earn in interest on the loans they make. Interest income is key for community banks, in particular, because they rely primarily on core lending activity, unlike more diverse megabanks that derive income from a variety of business lines.
โWe think NIMs will bottom outโ in the first quarter of 2024, said Piper Sandler analyst Stephen Scouten.
And yet, despite the positives, confidence levels in small bank stocks remain tepid. Where is the problem? "We expect that investors will have to be able to protect the credit cycle before the group can rise consistently," Scouten added.
Analysts are focusing on the threats inherent to commercial real estate, given the dependence of many small banks on such loans. In particular, the office sector under siege remains a cause for concern. As leases expire, more companies are expected to further reduce office space, due to remote work trends and high costs in major cities. This could leave owners dealing with a drop in income; Many may have difficulty paying their debts.
The third-quarter CRE loan delinquency rate across the U.S. banking sector rose 21 basis points from the previous quarter to 1.03%, according to S&P Global Market Intelligence. That was the largest sequential increase in at least five years and pushed the delinquency rate above its initial pandemic high of 1.02% in the fourth quarter of 2020, the firm said.
There are other weaknesses, including areas of consumer credit such as auto loans. The delinquency rate for auto and truck loans reached 2.95% in the third quarter, an increase of 20 basis points from the previous quarter and a jump of 56 basis points from a year ago, according to show data from S&P Global.
But the potential for an improving rate environment could set the stage for strong credit quality and increased investor interest early next year, Bolton said. He said banks have strong reserves set aside to cover historically average credit losses, and many also have strong levels of excess capital that puts them in a position to increase dividends, initiate share buybacks and make acquisitions.
"We have a lot of advantages," Bolton said of community bank stocks.
Investors generally are eager to put their money to work in stocks, O'Connor said.
"The push and pull of narratives between bulls and bears that has persisted for much of 2023 looks better for bulls heading into the final month of the year, particularly on the inflation and rates front," he said.
