Steven Alexopoulos, JPMorgan's U.S. mid- and small-cap bank analyst, commented in a note on Tuesday that investors should trim their exposure to the sector.
Alexopoulos stated that he was previously bullish on the prospects for a Fed "lift-off." However, a slowdown in China and related "spillovers" proved to be a "game-changer" for the rate outlook in the United States. As such, the Fed demonstrated a "very dovish" tone during its most recent meeting where it left the Fed rates unchanged.
Alexopoulos continued that the September jobs report "introduced yet another uncertainty" on both the rate front and potentially for credit costs. The analyst added that he now sees the prospect of higher rates "continued to diminish."
'Baked In' Assumptions
Alexopoulos went on to note that he went through an exercise of trying to figure out what rate assumptions were "baked into" regional bank valuations. The analyst assumed zero rates and then looked at the trajectory needed to drive to the ROTEs (return on tangible equity) to support valuations.
"We essentially demonstrated (at least to ourselves) that the market is indeed efficient and that the path of fed fund futures was essentially what was being baked into regional bank valuations," Alexopoulos wrote. "In terms of investing in regional banks, what investors need to consider is the likely path for fed funds as what's currently implied by fed fund futures."
'Highly Unlikely For Banks To Be Market Performers'
The Fed has made it clear that it's not the timing of a rate hike that matters, rather the "pace of normalization," which will remain "highly accommodative." The analyst suggested that while for investors with exposure to banking stocks, the timing is indeed "very important."
The analyst expanded, "The implied likelihood of a hike at the October meeting is now down to 10 percent. While few appear to believe that rates will move up at the October meeting, it is implied that there is 10 percent likelihood of an increase that will come out of the names should the Fed not move.
"Assuming December odds held (which we think is unlikely) at current levels, there are currently 32 percent odds implied of the initial hike. If the Fed were to move in December, there are currently ~68 percent odds of no hike implied that would move into the valuations and if they did not hike there would be 32 percent odds that would come out.
"Consequently, we see no actual way for the path of fed fund futures to follow current expectations: it will either be above or below the line, in our view."
As such, the analyst sees downside risk in regional banks for the remainder of 2015 with "hopes for better days" in 2016. Nevertheless, if growth in the United States doesn't fully materialize, it's likely that the banks "might never see the more meaningful benefit" from higher rates with the growing risk that credit costs start to "normalize at a more rapid pace."
Comerica Downgraded: Stock Is ‘Dead Money' For Now
Alexopoulos downgraded shares of Comerica to Neutral from Overweight with a $45 price target.
According to the analyst, Comerica has been one of the worst performing banking stocks under his coverage since the Chinese yuan devaluation and the recent Fed meeting. As such, shares are now trading close to its TBV (tangible book value).
While some investors may view Comerica as a "bargain" stock, Alexopoulos thinks the stock is "likely dead money" until the prospects for higher rates "improve considerably." The analyst expanded that the downward pressure is likely to continue weighing on the company's below cost of capital ROTE. In fact, its ROTE was in the 8 percent range during the first half of 2015 and without any support from higher short-term rates, its ROTE is expected to "drift down under the weight of sustained NIM (net interest margin) pressures as well as provision expense continuing to increase on a year-over-year basis."
Finally, Alexopoulos also pointed out that the company's reduced run-rate of share buybacks over the past two quarters is likely to continue.
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