Why bank stocks are down when lending is up

Banks have collectively reported solid earnings growth so far this year, and many analysts expect the good times to extend through the third quarter as lenders benefit from rising interest rates.

Yet the KBW Nasdaq Bank Index is down more than 25% this year, reaching a fresh 2022 low on Monday.

How to reconcile this?

In short, the Federal Reserve's aggressive interest rate hikes — last week it boosted its benchmark rate for a third time this year by 75 basis points — have boosted lending profitability for banks, and should continue to do so. When rates jump, banks earn more in bread-and-butter interest income and often post stronger overall earnings. But customers also pull back on borrowing, or struggle to make payments, amid economic uncertainty.

Michael Nagle/Bloomberg

The Fed's efforts to combat surging inflation have had only modest success to date. The federal measure of consumer inflation hovered close to 9% over the summer months, roughly four times policymakers' preferred level.

Historically, the combination of rapidly rising rates and lingering high costs has tilted the U.S. economy into recession. 

Downturns, by extension, hinder loan demand and tend to diminish credit quality. Often, borrowers either pull back to avoid problems — slowing banks' growth — or they miss loan payments, resulting in credit losses for lenders.

Investors are now looking past the benefits of rising rates and are focusing more intently on threats to banks' financial health. The U.S. economy contracted modestly through the first two quarters of 2022, and if deeper contractions happen this year, recessionary challenges could emerge quickly, analysts say. This helps to explain the downward slide for banks stocks and equities broadly as a bear market's roots take hold. The Dow Jones Industrial Average is down about 20% this year.

It "seems unlikely that headwinds are likely to abate anytime soon," said Mark Dowding, chief investment officer at Royal Bank of Canada's BlueBay Asset Management.

More declines may lie ahead, he said.

"The climate of uncertainty shows little sign of lifting, and we may need to wait for data to show better outcomes on inflation before adding risk," Dowding said. "Generally speaking, in financial markets and in the economy at large, we have a feeling of wanting to hope for the best but being prepared for the worst. Were incremental news flow on inflation to disappoint at this juncture, then the outlook could be pretty bleak indeed, and should we see a bigger drop in equity prices, then there will be a point where flight to quality starts to support longer-dated bonds," further pressuring stocks.

Analysts at D.A. Davidson said in a report that "banks and investors have broadly been anticipating slower loan growth in the back half of the year." The analysts noted that some demand "was pulled forward" into the second quarter as borrowers tried to lock in interest rates before the Fed's latest hikes. They also cited "a presumed economic slowdown amid higher interest rates."

The Davidson team said many banks heading into the third quarter reported lighter loan pipelines. Quarter-to-date loan growth through the first seven days of September reflected this, the analysts added. Fed data over the stretch showed loan growth from the prior quarter's end at 1.9%, compared with 4% growth during the second quarter.

On the credit quality side, the Davidson analysts noted, investors also are concerned that banks may soon have to start bolstering provisions for possible loan losses. Accounting rules require banks to make adjustments when their economic outlooks dim. When banks set aside more to cover potential losses, it eats into their bottom lines. 

"The impact of higher rates could be felt more acutely on the provision line," the Davidson analysts said.

Piper Sandler recently surveyed 38 of its buyside investor clients and found that the majority of them (55%) view credit quality risk as their chief concern about banks. That was up from 5% in a 2021 survey. Another 21% this year cited fallout from higher interest rates as their top worry.

Piper Sandler analyst Brad Milsaps said he expects banks to report continued low loan losses and strong earnings for the third quarter. But futures market investors are looking ahead, bracing for potential pitfalls, he said.

"Everyone wants the forward look on credit," Milsaps said. "With rates up this much, the assumption is it's going to stress the economy and that stress will eventually show up with the banks. We aren't seeing it yet, but the generalist investor is not returning to the bank space. I think they are having a hard time getting comfortable with all the crosscurrents out there."