Why the community bank stock rally stalled

Michael Nagle/Bloomberg

Signs that interest rates may level off into 2024 — and ease pressure on both deposit costs and net interest margins — provided substantial boosts for community bank stocks at times in November. But the gains proved short-lived, and lenders' shares finished the month where they've spent most of the year:depressed relative to the start of 2023 and compared to the market overall.

The S&P U.S. BMI Banks index, composed largely of community lenders, closed Thursday, the final trading day of November, down 6% from the beginning of the year. The S&P 500, in contrast, was up 19%. 

On the bullish front, the S&P U.S. BMI Banks index posted its biggest gain of the year by far in the week that ended Nov. 3. The index recorded a 9.4% gain. During that week, Federal Reserve policymakers announced they would leave their benchmark interest rate unchanged. After hiking rates 11 times since March 2022 to cool inflation, the Fed has paused on that front for several months now.

The small bank index jumped another 6.9% for the week ended Nov. 17. During that stretch, the Labor Department reported that the U.S. inflation rate slowed to 3.2% in October. That was down substantially from its peak of 9.1% in June 2022. This indicated that the Fed's aggressive rate actions had largely worked. Futures markets started to price in an end to the Fed's campaign and even the potential for rate cuts next year.

"More and more people are beating the rate-cut drum, maybe even a cut as soon as March," said Robert Bolton, president of bank investor Iron Bay Capital. "That's good news for community banks."

The response from investors on interest rate and inflation news signaled bullish undercurrents are simmering — for community banks and favorably priced small-cap stocks broadly.

"We have seen a notable shift in underlying conditions — investors are sitting on record cash levels in money market funds, indexes are steadily outperforming, and strong institutional conviction is boding well for markets," said Jeffrey O'Connor, head of market structure at Liquidnet, a trading and liquidity network.

"As thoughts of rate pressure subsides, the forward thinking prospects for small caps have improved while valuations are enticing, attracting investors searching for opportunities to put to work capital before year-end," he added.

Lower rates could lead to lower deposit costs and stronger bank earnings in coming quarters after softer results for the third quarter. With rates elevated, banks have had to pay more in interest to depositors. This, by extension, has cut into NIMs — the profitability margin between the amount banks pay for deposits and earn in interest on the loans they make. Interest income is key for community banks, in particular, because they mostly rely on bread-and-butter lending activity, unlike more diverse megabanks that draw income from an array of business lines.

"We do think NIMs bottom" out by the first quarter of 2024, Piper Sandler analyst Stephen Scouten said.

And yet, despite the positives, confidence levels in small bank stocks remain lukewarm. Where's the rub? "We expect that investors will need to be able to ring-fence the credit cycle before the group can move consistently higher," Scouten added.

Analysts are focusing on threats embedded in commercial real estate, given many small banks' dependence on such lending. In particular, the beleaguered office sector remains a source of concern. As lease agreements expire, more companies are expected to further scale back on office space, due to remote work trends and high costs in major cities. This could leave landlords grappling with falling revenue; many could struggle to service their debts.

The third-quarter CRE loan delinquency rate across the U.S. banking sector increased 21 basis points from the prior quarter to 1.03%, according to S&P Global Market Intelligence. That was the biggest sequential increase in at least five years and drove the delinquency rate above its early-pandemic high of 1.02% in the fourth quarter of 2020, the firm said.

There are other soft spots, including areas of consumer credit such as auto loans. The delinquency ratio for car and truck loans reached 2.95% in the third quarter, marking an increase of 20 basis points from the prior quarter and a jump of 56 basis points from a year earlier, the S&P Global data show.

But the potential for an improving rate environment could lay a foundation for sturdy credit quality and increased investor interest by early next year, Bolton said. He said that banks have robust reserves set aside to cover historically average loan losses, and many also have stout levels of excess capital that puts them in position to increase dividends, boot share buybacks and pursue acquisitions.

"We've got a lot of upside," Bolton said of community bank stocks.

Investors generally are eager to put money to work in stocks, O'Connor said.

"The tug of war of narratives between the bulls and bears that has persisted for much of 2023 looks better for the bulls heading into the final month of the year, particularly on the inflation and rates front," he said.