How the Fed’s Gloomy Outlook Could Boost Bank Stocks

• Bank stocks could be one of the few pockets of value in today’s stock market.
• While they’re suffering from near-term risk, they could offer a considerable reward once the economy picks up.
• Investors don’t appear convinced about a financial-sector recovery, so bank stocks are still cheap.

U.S. banks are about to face another round of stress tests, and the scenario they’re based on is dire.

Last week, the Federal Reserve revealed that the economic scenarios it concocted to test whether America’s banks can withstand economic uncertainty are “significantly more severe” than most predictions about the nation’s recovery. The results of these tests will have a significant impact on bank stocks, which have yet to make a full recovery from their March drop.

The Fed plans to evaluate U.S. banks in a ‘severely adverse’ scenario in which unemployment rises to 12.5%. The results of these rigorous tests are due to become available by the end of the year. Also, U.S. banks will find out whether the Fed will continue its ban on buybacks and cap on dividend payments.

These significant developments have sent bank stocks lower as investors worry about the future of the financial sector while the pandemic rages on. 

Bank stocks haven’t recovered from the March dip, offering investors a compelling value proposition. | Source: Yahoo Finance

But this could be a great buying opportunity for long-term investors that can wait out some volatility. The stock market sell-off has seen investors rotate from the tech mega-caps that were supporting the impressive rally to cyclical stocks that tend to perform well when the economy enters an expansion cycle—financials fall firmly into that category.

Dan Skelly, head of Morgan Stanley’s wealth management strategy and research team, says taking a long-term approach is a great strategy for investors looking to capitalize on the market’s uncertainty: 

The idea is if we do get positive developments, positive catalysts — stimulus, vaccine, recovery in 2021, a benign election outcome for markets — I think the outcome of that particular aggregated recipe is probably driving higher rates and higher inflation over the next 12 months.

Banks, in particular, will benefit from rising rates over the next year. 

Risks for Bank Stocks

Loan loss provisions are soaring as banks prepare for a wave of defaults. | Source: WSJ

Bank stocks aren’t exactly a haven right now—there’s a real element of risk in the sector. A rise in loan defaults is likely to create significant loan-losses for most big banks, and low interest rates mean net-interest income is likely to remain low for the foreseeable future.

Still, many analysts believe those risks are worth taking. Jason Goldberg, a managing director at Barclays, says a portfolio devoid of bank stocks could be the wrong way to play the pandemic:

We wonder if the risk of not owning U.S. bank stocks is greater than owning them

Big Gains When the Risk Dissipates

So far, the credit crunch man feared would hit U.S. banks hasn’t materialized. After a meeting with JPMorgan CEO Jamie Dimon, analysts at Keefe, Brunette & Woods believe the bank could be ready to release its reserve cash before year’s end:

If projections do not change and come in as expected, Jamie noted it would not be unreasonable to expect reserve releases in the fourth quarter.

While the KBW projection is certainly lofty, reserve releases in 2021 aren’t a pipe dream as long as positive catalysts like a vaccine and upbeat economic data present themselves. Investors who can wait out some near-term uncertainty are likely to see an impressive earnings boost on the back of a reserve release. 

Timing Is Everything

Bank stocks could offer huge gains when the pandemic has been contained, and the economy is firmly on a path to recovery. In the meantime, though, the sector faces significant volatility as uncertainty weighs on investor sentiment.

There’s no telling exactly how long near-term volatility will persist, but investors who are willing to take a risk on improving conditions in 2021 may want to start adding bank stocks to their portfolios now. 

Disclaimer: This article represents the author’s opinion and should not be considered investment or trading advice from CCN.com. Unless otherwise noted, the author has no position in any of the securities mentioned.

Sam Bourgi edited this article for CCN.com. If you see a breach of our Code of Ethics or find a factual, spelling, or grammar error, please contact us.

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