Financials - Stress Tests Easily Pass

Federal Reserve, CPI and Prospective Rate Increases

A string of robust Consumer Price Index (CPI) readings spooked the markets as a harbinger for the inevitable rise in interest rates. Furthermore, Federal Reserve commentary also induced volatility in the markets when Jerome Powell spoke in early June. As investors grapple with the prospect of downstream rate increases, pockets of vulnerabilities throughout the market have been exposed. The overall markets have been on a blistering bull run since the November 2020 presidential election cycle. Year-to-date, the S&P is up over 16%, while all valuation metrics are misaligned with any historical comparator with heavily stretched valuations and record risk appetite. As real inflation enters the fray, these frothy markets will come under pressure and possibly derail this raging bull market. Although rising rates may introduce some systemic risk, the financial cohort is poised to go higher. The confluence of rising rates, post-pandemic economic rebound, financially strong balance sheets, a robust housing market, and the easy passage of annual stress tests will be tailwinds for the big banks.

2021 Financial Stress Tests

The recent stress tests were easily passed and indicated that the biggest U.S. banks could easily withstand a severe recession. In addition, all 23 institutions in the 2021 exam remained “well above” minimum required capital levels during a hypothetical economic downturn.

The central bank said that the scenario included a “severe global recession” that hits commercial real estate and corporate debt holders and peaks at 10.8% unemployment and a 55% drop in the stock market. While the industry would post $474 billion in losses, the Fed said that loss-cushioning capital would still be more than double the minimum required levels.

Pandemic-related restrictions hindered the banks’ ability to return capital to shareholders via dividends and buybacks. Those restrictions will now be removed based on the recent stress test results. So now, the banking industry can hike buybacks and dividends by billions of dollars starting in July 2021. Nearly all banks have since increased their payouts to shareholders.

Financials

The prospect of rising interest rates coupled with fantastic earnings has propelled bank stocks to all-high highs. Citigroup (C), JPMorgan (JPM), Bank of America (BAC), and Goldman Sachs (GS) had appreciated to all-time highs and sold-off when the Federal Reserve released its testimony on the economy and future actions. Rising interest rates in combination with the highly disruptive COVID-19 backdrop abating have served as the foundation for this move higher. The big banks responded and evolved in the face of COVID-19 to the real possibility of widespread loan defaults, liquidity issues, ballooning credit card debt, and stressed mortgages. To exacerbate these COVID-19 impacts, interest rates, Federal Reserve actions, yield curve inversion, and liquidity heavily weighed on the sector.

The big banks have demonstrated their ability to evolve in the face of COVID-19 and present compelling value. Now with the prospect of rising rates, this may serve as a long-term tailwind for banks to appreciate higher. This is especially true not that the banks have retreated from their highs.

COVID-19 and 2008 Financial Crisis

The big banks are far stronger and more prepared than they were during the 2008 Financial Crisis. Lessons learned from the Financial Crisis yielded rigorous annual stress tests that forced banks to maintain a slew of fiscal discipline measures. With the Federal Reserve working in hand with the banks, a financial bridge to those businesses and consumers negatively impacted by COVID-19 as a stop-gap measure has been afforded as this pandemic moves to the rearview and economic activity rebounds, the bank's present value even after these all-time highs. Add in the prospect of higher rates, and the banks are set up for long-term appreciation. Their strong cash positions and healthy balance sheets allow dividends to continue, and share buybacks will resume as the economy transitions through the damage of the pandemic.

Conclusion

The pandemic has undoubtedly had a negative impact on economic activity worldwide. COVID-19 has ushered in the real possibility of widespread loan defaults, liquidity issues, ballooning credit card debt, and stressed mortgages. Despite this overwhelmingly negative backdrop, the massive fiscal and monetary stimulus was adopted quickly to blunt this economic fallout that amounts to trillions in total stimulus. The banks are far stronger than they were during the 2008 Financial Crisis and have rigorous annual stress tests to show they can survive an economic downturn while maintaining the ability to make loans and continue paying out dividends. Dividends have been held steady, and share buybacks have resumed across the financial cohort. The banks are much more resilient and capitalized with unprecedented government stimulus coming into the fold. The big banks have demonstrated their ability to evolve in the face of COVID-19 and present compelling value, especially after the recent sell-off from all-time highs. Now with the prospect of rising rates, this may serve as a long-term tailwind for banks to appreciate higher.

Noah Kiedrowski
INO.com Contributor

Disclosure: The author holds shares in AAPL, AMZN, DIA, GOOGL, JPM, MSFT, QQQ, SPY and USO. He may engage in options trading in any of the underlying securities. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of www.stockoptionsdad.com where options are a bet on where stocks won’t go, not where they will. Where high probability options trading for consistent income and risk mitigation thrives in both bull and bear markets. For more engaging, short duration options based content, visit stockoptionsdad’s YouTube channel.