How are US finances doing as rates rise? Key indicators that could provide clues

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Aggressive rate hikes by the US Federal Reserve have fueled speculation of a possible recession. Greg Bonnell talks with Stephen Biggar, Director of Financial Institutions Research at Argus Research, about the potential impact on financial stocks and their perspective for the future.

Transcription

Greg Bonnell: Well, the pace of rate hikes has many discussing the possibility of a recession on the horizon. And that has some investors wondering how financial stocks could hold up in an economic downturn. Well, our guest today says that there are three items that he is keeping an eye on when it comes to finances. Joining us now with more is Stephen Biggar, Director of Financial Institutions Research at Argus Research. Esteban, welcome to the show.

Stephen Biggar: Hi, Greg, I’m glad to be here.

Greg Bonnell: All right, so this one is interesting, obviously, with all this Fed market action, all these concerns about a recession. Let’s talk about sound financials. You have three things to look at. So let’s take them one at a time. One of them is a kind of loan book: the loan perspective, what are you seeing here?

Stephen Biggar: Yeah, well, the lending side of the business has actually been pretty strong for the banks here. We had that calm during the pandemic. A lot of people were shying away from borrowing, obviously. There was high unemployment and a lot of uncertainty. Therefore, the loans were not made at that time in any important way. But then a year or so later we have people going back to the banks for loans. Housing was very strong for a while, cars, pent up demand for other housing related items, everything from vacations to you name it.

So the Federal Reserve data that we get once a week on credit activity, and it’s been up 10% year over year until very recently. So that’s been a good part of the story of the consumer feeling pretty good, despite what some of the consumer opinion polls have said. There has been a lot of activity with the exception of a more recent real drop in housing, of course. Mortgage lending activity with rates rising as high as they are has been much lower. So we expect a bit of a slowdown here as rates go up. That is the intended shock that the Fed is trying to convey to slow things down.

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And, but the other, a good part of the history of the lending business for banks has been spread expansion based on the Fed rate hike. So we’ve had this universal improvement in the yield curve, rates short-term and long-term have risen dramatically over the last year. And that’s good for banks, and you’re seeing it in that interest margin expansion that they reported this most recent quarter.

Greg Bonnell: Very well, that is very interesting, not only has the loan portfolio been maintained, but of course the interest margins, which are so key to the banking business, have also been enriched a little, considering the movements that we have Seen from the Federal Reserve. So let’s talk about the Federal Reserve. All of these rate increases that we’ve seen, we’ve seen here in Canada, these very large increases. Of course, that raises fears of a recession. What should we think about in that part when we think about finances?

Stephen Biggar: Well, that’s the big risk that we think right now and why some of these (stocks of some of the major banks are trading at some of these lower levels) has been that the Fed is going to have to go too far, basically, to control inflation. And what happens is that when the cost of borrowing goes up, you obviously increase the chance of default in your attempt to slow down the economy. You will disturb the good image of employment. There will be fewer jobs available, more layoffs. And I would say that in the banking world, there is probably no better correlation between unemployment and net charge-offs or bank delinquencies. So if you lose a job and it’s hard to find a replacement job, you’ll often fall behind on your bills and payments. So the banks look at that, and they have to, depending on how long you haven’t paid, usually like three months, they’ll set it aside as delinquent and eventually they’ll have to write off that loan.

That means loss provisions are up, and we saw that in the third quarter results. We saw banks become a little more cautious, not because charge-offs have increased yet, but because they haven’t, but they are being more cautious going forward. And that’s what loss provisions are actually designed to do. You’re adding to your reserve for credit losses in anticipation of some looming weakness next year. And I think that’s where we are today, that there is still concern that the Fed is moving too far too fast here, and by the middle of next year, they may even be in a period of having to cut rates if they have gone. Very far.

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So really, it’s the employment situation that we’re watching closely here to the extent that that doesn’t get resolved. Ultimately, two months ago, we had about twice as many job openings relative to the number of unemployed, so it gives you an awfully big buffer to bring unemployment down a little bit. Of course, there is always a discrepancy between skill sets and between job offers and the job – the people who are eligible or able to take them.

But, that’s what I think, really the biggest risk here at this point is that the economy starts to loosen up a little bit. Credit costs for banks will rise, and that’s a big game changer for banks when things aren’t going well. And they have to add a lot in terms of loss provisions which will eat into their profits pretty quickly.

Greg Bonnell: Stephen, we have part 3 here, when it comes to the big money focused banks, I think some of the biggest names on Wall Street, we’ve already seen that downturn in the capital markets business. The deal was pretty… not as solid as you might expect. Well, what are we seeing in that space? What do we think we could be seeing in the future?

Stephen Biggar: Absolutely. It’s been a lousy year, Greg, and particularly in equity underwriting, but also in fixed income underwriting and a bit of M&A activity. The only thing that has really held up well has been the trading volumes of the banks, and that’s because of the huge volatility in the markets, and that’s in equities and fixed income currencies, commodities. There has simply been such massive volatility, which is why trading has held up well.

But it’s typical, I mean, there are two things going on, the comparisons are terrible because the 21st was a very good year for the capital markets, underwriting. We had kind of record years, or 20 or more peak 20 years in terms of stock underwriting activity, a lot of IPOs came out, secondary rates were low. So he still had a good fixed income issue. And that basically completely unwound this year.

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So usually when you have these downturns or downdrafts in the stock market, when you have some IPOs that don’t do well, then you have some doubts about public companies. There just isn’t enough liquidity, and of course the Fed flooded the market with liquidity and made a lot of money available, some of which went into IPOs. So that’s been winding down for much of this year. And again, the stock market downdraft was in a bear market after a 20% drop, so there aren’t many private company owners who are willing to go to the public markets now and convert their stocks. over there.

So that’s going to take probably a couple of quarters to improve. I think we need to see something better, some support and filling of the equity markets, and not just for a week like we’ve had, or even a month. I think we need to see a sustained move up. There have been some decent subscriptions popping up lately, such as Mobileye (MBLY), the spin-off from Intel (INTC), did well in its IPO debut. So there are certainly some encouraging signs out there and — but I think we need to lay some more groundwork here and get better on that front.

M&A activity as well, usually when funding costs go up, we have — there are a number of leveraged transactions, obviously, that would take a backseat in anticipation of better funding rates. So M&A activity hasn’t gone off a cliff like we’ve seen with IPOs, but it’s been softer, and we’ve seen some strength in Europe and some specialty areas, and healthcare remains a hot spot. sparkly. Some of the energy transition areas have been bright spots. But in general, the big tech names, the consumer-type names just haven’t been very active, and I think it’s going to take, again, at least a couple more quarters for that to show some signs of recovery.

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