By Sinéad Carew
(Reuters) - While U.S. bank stocks had a rocky start to the year, investors and analysts see accelerating loan growth and Federal Reserve interest rate hikes boosting the sector.
The U.S. economic recovery has spurred consumer spending, which is encouraging companies to build inventories and in turn has increased demand for business loans.
And while net interest income, the difference between the rates banks charge for loans and what they pay out for deposits, weakened during the pandemic, this is expected to change in 2022 with interest rate increases, which the Fed is aiming to use to help tame runaway inflation.
After rallying in 2021 and early 2022, the S&P 500 bank index tumbled 15% from its record high last month as rising expenses and weak trading revenue at firms including JPMorgan (NYSE:JPM) sent investors fleeing.
Since bank lending profits depend on a steepening yield curve, recent flattening of the curve has added to investor worries, with the difference between U.S. 2-year Treasury yields and 10-year yields hitting it narrowest level since November 2020.
As inflation has surged, traders have been betting on an increasing number of rate hikes in 2021.
While higher rates favor banks, their share price declines reflect worries the Fed may "hit the brakes a lot harder" than originally expected and end up hurting the economy, according to Mike Cronin, investment director at asset manager abrdn in Boston. But he is bullish on banks.
"Expenses were an issue in the fourth quarter but we've set the bar on that," Cronin said. "Now it's a bit more about the economy and rates. If we continue to see modest economic growth and accelerating loan growth going forward that bodes well for the sector in 2022."
Compared with March 2020, when they traded at 6.8 times earnings expectations for the next 12 months, bank stocks have recovered dramatically. But the S&P bank index's current price/earnings ratio of 12.9 still lags the S&P's 19.5 multiple.
With the KBW regional bank index currently trading at around 70% of the S&P 500's multiple compared with its more typical 90% level, the sector looks cheap to KBW's director of research, Matthew Kelley.
"The fundamentals of the banks are actually strengthening," said Kelley, citing loan growth and rising rates. While higher expenses have hurt profits, he sees "more than enough positive things happening with the banks on the top line to offset this."
Kelley says recent selling in bank stocks has been exacerbated by a flattening yield curve, which was the result of fears about the economy that he expects will prove transitory.
As if on cue, bank stocks rose more than 2% on Friday, their biggest one-day gain since Jan. 6, after a stronger than expected jobs report provided some reassurance about the economy.
Wall Street analysts expect declines in quarterly earnings per share at the biggest U.S. banks in 2022, according to Refinitiv. After setting aside extra loan loss reserves in 2020, banks were able to release unused reserves last year, which artificially inflated earnings last year, making a tough comparison between 2021 and 2022 earnings.
While investors have been betting on Fed rate hikes for some time, analysts say bank stocks do not fully reflect these expectations. KBW's Kelley notes that in the 2016-2018 Fed tightening cycle bank stocks did not peak until 21 months after the policy maker started raising rates.
"Conceptually it's priced in but quantitatively there's potential for more upside," Piper Sandler analyst Jeffery Harte said.