In contrast to the corporate bond market, bank lending standards are consistent with immediate recession. We believe regulatory constraints on banks – including capital uncertainty – is the most significant factor in both the long-term underperformance of their shares and even their cyclical decline this year.
US banks have been tightening lending standards for about five quarters now. The total return for the S&P Large Cap Bank Equities index has been about -7% this year and -19% for S&P Small Cap Bank index, both dramatically trailing the S&P 500’s 19% return in the year-to-date. An equally striking contrast is the performance of high yield credit markets, with a 6.4% gain year-to-date.
A sharp tightening of lending standards has been a traditional near-term leading indicator of US recession, but not in isolation. Current tight corporate bond spreads and other financial indicators show scant signs of stress. Profit declines have been minimal, and corporate debt servicing looks strong. The big expansion of debt in the past four years has been Federal borrowing, not private borrowing.
The commercial real estate sector is a standout potential source of weakness after a 40% surge in lending by small banks since end-2019. Office properties are a well-discounted secular loser from “work at home” flexibility. A record high level of multi-family residential properties will also be delivered in the coming year, with financing costs sharply higher.
We believe regulatory constraints on banks - including capital uncertainty - is the most significant factor in both the long-term underperformance of their shares and even their cyclical decline this year. Share price drops may prove exaggerated if credit markets are “right.” However, we prefer investments higher up in capital structure for financials. Investment grade bank preferreds yield near 7.5% and have gained 4.5% on a total return basis in the year-to-date, outperforming common.