US banks look beyond pandemic for growth

November 5, 2020

US Banks

The U.S. banking sector has been in the spotlight with better than expected third quarter results as the U.S. economy has slowly improved.

There are challenges ahead, but the latest three months, while categorized by uneven recovery, show signs of better things ahead. On one hand, the sector is seeing lower revenue as the Federal Reserve keeps interest rates low and signals rates will stay low. Loan growth has been weak as the economy struggles with the pandemic. On the other hand, a minimal rise in loan loss provisions and a strong quarter for investment banking has offset some of the weakness.

These trends have helped U.S. bank stocks rebound from their spring lows and the momentum should continue, says Paul MacDonald, Chief Investment Officer at Harvest Portfolios Group Inc..  In a Q&A, Mr. MacDonald and Harvest Senior Portfolio Manager James Learmonth talked about the challenges ahead, the sector’s long term energizers and the philosophy behind the Harvest US Bank Leaders Income ETF (HUBL: TSX, HUBL.U:TSX)

 

Paul MacDonald, CFA
Chief Investment Officer
Harvest Portfolios Group
James Learmonth, CFA
Senior Portfolio Manager
Harvest Portfolios Group

 

 

Q:  How have U.S. banks done this year?

Paul MacDonald (PM): They have lagged the broader market quite significantly and that makes sense. There are some headwinds in the near term, but some positives looking ahead 12 to 18 months.

Q: How were third quarter earnings?

Paul MacDonald (PM): Overall, a little better than expected. A lot came from lower loan losses, so the banks adjusted their reserves. This boosted their bottom lines. It indicates that the depth of the recession isn’t as bad as they thought.

Loan growth is still tepid, in part because many companies added to their credit lines earlier this year just in case.  Many have been paying back those lines since which is putting a little bit of pressure on growth.

Q: What are the near-term challenges?

Paul MacDonald (PM): Banks make money by borrowing short and lending long. The difference is their net interest margin. So longer term we need to have rate spreads widen.

The last thing are federal stress tests of the banks’ ability to withstand shocks. The implications of that are still unknown.

We’re also still very much in the throes of the pandemic and that adds uncertainty with regards to loan growth, the risk of loan losses and credit defaults.

But on the plus side, one of the biggest strengths is strong capital positions helped by changes in regulation made after the 2008 financial crisis. You’ve also got attractive valuations, solid balance sheets and good dividend yields.

So some headwinds, but great valuations, great yields, great balance sheets and our covered call strategy make a lot of sense.

Q: Can you explain your covered call strategy?

Paul MacDonald (PM): An important part of the Harvest model is the use of covered call options to generate extra income. We sell a portion of the potential rise in a stock price in exchange for a premium. In exchange for this  premium, we give up a bit of the gain. It also acts as a cushion if share prices fall but more importantly, it is cash flows that allow us to pay high distributions each month to investors. Covered call options are a Harvest specialty.  

Q: How do U.S. and Canadian banks compare?

Paul MacDonald (PM): In the U.S., you have kind of two levels of bank, mega cap and regional. Regional banks tend to have less regulatory overhead. At times, the two will perform differently. We own both the mega cap banks and regional banks. For now, the mega caps will have more headwinds, but longer term they have potential while our Fund is benefitting currently from the outperformance of Regional banks.

For banks, the U.S. market is significantly wider and deeper than in Canada. In Canada you have a little bit lower valuation and a little bit lower earnings but you have a higher yield. So Canadian banks are well positioned and adding US banks to a portfolio complements the Canadian position. It adds diversity.

Q: What would another U.S. stimulus deal do for the banks?

James Learmonth (JL) : It would likely mean lower default risk to some outstanding loans and we could see loan loss provisions shrink to some degree.

Looking at the longer term, all the stimulus that’s already in place, plus the potential for more, creates an opportunity for higher levels of growth as well as potential for higher levels of inflation.

The Fed has said that said they’re willing to accept higher levels of inflation to make sure that the economy returns to full employment, so we don’t expect them to raise rates for a while. However, it’s possible that we could see the long end of the interest rate curve rise in a higher growth environment which could lead to increasing net interest margins.

Q: Tell me about the Harvest US Bank Leaders Income ETF

Paul MacDonald (PM): It has 15 large cap banks and bank-like businesses, plus one insurance company. A bank-like business is an investment bank like a Goldman Sachs.

The ETF is equally weighted so it is a diversified way to play the US banking system. The covered call strategy enhances income, so the yield on the fund is very attractive.

Q: How would you sum things up?

Paul MacDonald (PM): We see things stabilizing early next year which sets the banks up for a pretty good 2021. But it may be the second or third quarter  before we start to see it.

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