Investors flock to bank stocks, anticipating higher interest rates

Bank stocks are booming, reflecting investors’ ambitious outlook for lenders.

The threat of inflation looms as the U.S. economy heats up amid the pandemic recovery. With that risk comes increased likelihood of higher interest rates in 2022 — to tamp down spending and curb price increases — and banks are uniquely positioned to benefit. When rates rise, most sectors primarily see only higher borrowing costs. For banks, however, higher rates make lending more profitable.

“Inflation could be a real issue — and the Fed may have to act sooner on rates than it currently signals,” said Robert Bolton, president of the bank investor Iron Bay Capital. “Plenty of investors clearly think that’s a strong possibility.”

Investors have pumped more than $30 billion into financial stocks this year. The prospect of higher rates comes on top of banks’ robust credit quality, higher first-quarter profits and broad expectations that banks will emerge from the pandemic in good financial health.

For now, Federal Reserve policymakers maintain a posture of keeping rates low through next year. Fed officials argue a rise in inflation will be temporary and prices will settle down after the economy absorbs a burst of demand that was pent up during the pandemic.

But inflationary pressures are mounting quickly. U.S. consumer prices in April were up by 3.6% from a year earlier. That was the biggest jump since 2008 and put inflation well above the Fed’s targeted 2% level, the federal Bureau of Economic Analysis said last week.

Anecdotally, executives at the national big-box chain Costco said they saw accelerating prices across a range of products in recent months, from shipping containers to food. “Inflationary factors abound,” CFO Richard Galanti said on the company’s earnings call last week. “These include higher labor costs, higher freight costs, higher transportation demand.”

Investors are betting that inflation will persist until the Fed lifts rates to prevent runaway price increases, said Michael Matousek, head trader at U.S. Global Investors. “Higher rates are inevitable,” feuling investor interest in banks, he said.

S&P Global’s index of small-cap banks was up 32% on the year through the end of May. Its large-cap banks index was ahead 36%. If sustained, both could post record years relative to the broad S&P 500 index, which was up 12% through the end of last month.

Banks stocks declined about 15% in 2020.

“Higher rates are good for banks overall,” said Chris Nichols, head of capital markets at the $37.8 billion-asset South State Bank in Winter Haven, Florida. “Bank stocks are on a tear as a result.”

Nichols said banks’ underlying fundamentals are solid, too. A feared wave of loan defaults amid the pandemic never materialized, enabling South State, a unit of South State Corp., and dozens of others to release loan-loss reserves. When banks do this, the money falls to their bottom lines.

Nichols also said loan demand is beginning to pick up, as consumers travel and borrow to make big-ticket purchases, and businesses draw on credit lines to invest in growth as the economy gains steam.

Those factors collectively create a sound foundation for earnings growth. With rising profits, banks could increase dividends or buy back shares, benefiting investors. “Things are setting up nicely,” Nichols said.

Analysts at Deutsche Bank said that while markets are forward-looking, investors have not yet priced in the potential for strong economic growth into 2023 and 2024. That could give banks and their clients another bump; analysts said bank stocks could rise another 25% to 50%.

Jerry Plush, CEO of Amerant Bancorp in Coral Gables, Florida, sees a long runway for earnings growth. The $7.7 billion-asset bank operates in both South Florida and the greater Houston area. Both areas were early to reopen businesses during the pandemic, and economic activity has surged. Loan demand is building. As other parts of the country catch up, demand could rise nationally, he said.

“We’re seeing the recovery in full force where we are,” Plush said.

He cautioned, however, that discussions among lawmakers in Washington about raising corporate taxes worry bankers.

Higher tax bills would eat into the profits of both banks and their commercial clients. President Biden, a Democrat, last week laid out a plan to raise the corporate tax rate to 28% from 21%. Wealthy Americans would also pay more in individual taxes.

Kevin Cummings, chairman and CEO of Investors Bancorp in Short Hills, New Jersey, agreed that the specter of higher taxes lurks as a serious potential headwind. The pandemic, too, remains a wild card. He is confident in the effectiveness of vaccines, but “we still don’t know for sure that this thing is behind us," he said.

Government stimulus and loan forbearance programs also are ending this year. This could shock individual households and some small businesses, and that could result in more missed loan payments. A choppy recovery could also curb loan demand.

Still, Cummings said, the outlook at the $25.8 billion-asset Investors is brightening. With credit quality solid, loan demand expected to rise this year and higher rates more likely to follow next year, momentum for banks is mounting.

“We’re going to have a strong third quarter and fourth quarter, and I think things will continue to improve,” Cummings said. “Higher rates, which I think is something that almost has to happen by next year, would add to gains we are already making this year.”