The volatility sweeping financial markets in the last quarter of 2018 slammed U.S. banking stocks. Though many sectors that fueled the bull market are in the red, banks would be first in the line of fire if the recession hits the economy.
Even as most economists see little risk of a near-term recession, investors are spooked by the yield curve inversion, a development in the bond market in which long-term rates are lower than short-term rates.
This is considered an ominous sign for banks, which pay less to short-term depositors and charge more on their long-term lending. When the yield curve steepens, banks can take advantage of a bigger spread between the rate at which they borrow money and the rate at which they lend.
SPDR S&P Bank ETF Daily Chart
This has hit hard the U.S. banking stocks, pushing them into the bear market. The SPDR S&P Bank ETF was down about 15% from its 52-week high.
Some of the nation’s largest lenders, including Morgan Stanley (NYSE:MS), Goldman Sachs (NYSE:GS) and Citigroup (NYSE:NYSE:C) were trading at their lowest levels since early 2017 on Thursday, giving back the gains they made during the past two years, fueled by President Donald Trump’s election and his tax cuts.
A possibility of a prolonged U.S.-China trade war is another factor that’s triggering a sharp selloff in the banking stocks. Though Asia doesn’t make a big portion of banks’ revenue, these companies are usually the first to suffer from slowing economic growth, credit contraction and companies going under.
In this uncertain global environment, it’s better for investors to avoid banking stocks for the next 3 to 6 months. In our view, the top U.S. banks have reached the peak in the current economic cycle and it’s going to be a bumpy ride going forward.
Beyond macro risks, some banking stocks are under pressure due to their company-specific risks.
Goldman Sachs, for example, has tumbled about 30% from a record high in mid-March. About half of the decline occurred in the past month, as investors worried about the costs and reputational damage the investment bank may incur over its involvement in Malaysia’s corruption scandal.
Once the dust has settled and the global economic picture becomes clear, we like Citi and JPMorgan (NYSE:JPM).
Citi’s financial metrics have improved a lot under the CEO Michael Corbat. His sustained cost cutting during the past six years have begun to reflect in the lender’s rapidly improving efficiency ratio, or expenses as a percentage of revenue. This metric has come in at less than 60% for the past three years, making it the only major bank able to maintain such a winning streak.
For investors who are keen to buy some quality banks once the bottom is reached, Canadian top lenders also have a great long-term appeal.
The nation’s top lenders, such as Royal Bank Of Canada (NYSE:RY) and Toronto Dominion Bank (TO:TD), are better positioned than their U.S. counterparts to weather any storm due to their balance-sheet strength and the country’s better risk management controls.
That strength was displayed during the 2008 financial crisis when Canadian lenders emerged largely unscathed. In the current downturn, too, Canadian lenders are outperforming their U.S. peers with much smaller losses.
Investors should avoid buying banking stocks in the current market downturn as we see further losses amid a worsening macro environment. Citibank, JPMorgan and top Canadian lenders are our favorite picks once the long end of the yield curve steepens, clearing the way for a rebound in the banking stocks.