When meeting with different clients we often have similar questions come up surrounding current market events. Lately we have been getting a lot of questions on oil and some of the potential repercussions that the rapid decline could have. Specifically, clients have asked about the impact on banks given outstanding loans to energy related companies. Below takes a look at what has been happening with banks in the markets and summaries their overall energy exposure.
It’s pretty clear that falling oil prices are not good for the energy sector. Lots of oil and gas companies have been downgraded. Some have become “fallen angels” after losing their investment grade ratings and are now considered “high yield” or “junk.” Defaults and bankruptcies are starting to accumulate. No surprise there.
Early in the year investors began fretting about energy related loan losses in the banking system. Bank stocks lost ground and yield spreads on bank bonds widened out reflecting a bigger risk premium (i.e. prices fell relative to the Treasury market).
Chart 1 shows the KBW Bank Index compared to the S&P 500, assuming you invested $100 at the beginning of the year. Chart 2 is the spread on bank bonds vs. other corporate bonds. Both depict underperformance in the banking sector in the first quarter.
APCM believes this is an overreaction and have added banks selectively to fixed income portfolios. In general, bank bonds have gotten pretty “cheap”, bond talk for attractively priced.
CreditSights, an independent bond rating service that APCM subscribes to, weighs in with, “we strongly believe that large bank energy exposure is mostly an earnings headwind and should not result in a meaningful deterioration of bank credit profiles.” They note that exposure varies widely among regional banks and that this exposure is more heavily weighted to non-investment grade names compared to large banks. They point to Regions, Comerica and Zions as having heavier exposures, but “do not believe any of the three companies overall credit profiles are threatened by potential losses.” Still, APCM does not own these three names.
J.P. Morgan opines that reserves taken against energy exposures at the end of Q4 were “fairly robust” and that the large money center banks have modest exposure at 2 to 3% of total loans outstanding, whereas some of the regional players have energy exposure in the 6 to 7% range.
Perhaps a bigger concern is the impact of “lower rates for longer” on bank earnings. Recall the Federal Reserve just dialed back expectations for interest rate increases this year from four to two. The net interest margin (what it costs banks to borrow versus what they earn on loans) has been narrowing. That has crimped profits, in addition to a drop in trading revenue and lower M&A fees at the big banks. First quarter earnings at the banks will be out soon and they are expected to be lackluster.
APCM Portfolio Manager Jason Roth notes that the U.S. banking system is much stronger than it was eight years ago before the financial crisis. Banks are more conservatively capitalized as equity cushions on their balance sheets (to absorb losses) have doubled as a percent of assets since 2007. The banks have much less leverage and their funding is more secure. There is considerably more regulatory oversight. In fact, the banks submitted data this week to the Federal Reserve for their annual “stress tests” with the results expected by June.
By the way, the European banks are not in as good of shape with capital ratios about half that of U.S. banks. Their energy exposure is on par with the big U.S. banks, but they are also grappling with negative interest rates and sovereign debt exposures.
We have been saying for a while now that one consequence of the financial crisis is that U.S. banks are looking more and more like a regulated utility. That’s good for bonds, but not for stocks. That beat goes on.
As for the markets, here are some headlines/comments from last week:
The major U.S. stock averages declined more than 1% last week with the S&P 500 closing at 2,048. Most international indices were down a similar amount except for the Nikkei which dropped 2% in yen, but gained 1% in dollars. The yen surged from 121 yen to the dollar in early February to 108 at the end of last week. The 10 year Treasury yield dropped a nickel to 1.72%.
(Bloomberg) Oil climbed the most in almost two months as U.S. crude output continued to slide. Oil was up $3 last week closing near $40 a barrel. The number of active oil rigs in the U.S. dropped to the lowest level since 2009 this week. OPEC and Russia meet April 17 and most analysts expect no consensus on production cuts or a freeze.
(WSJ) Earnings forecasts cast shadow on stock market (Alcoa begins the first quarter earnings season this Monday. S&P 500 corporate earnings are seen falling 8% YoY in Q1. It’s closer to -4% Ex-Energy. Actual earnings usually beat estimates by 3 or 4%. Still, earnings are not likely to turn positive until the third quarter.
Jeff Pantages, CFA®
Chief Investment Officer