KBW raises investment rating for entire US banking sector

Keefe Bruyette & Woods' analysts are bullish on the future earnings power of U.S. banks.

Christopher McGratty, managing director and head of U.S. bank research for KBW, raised his investment rating for the entire U.S. banking sector to "overweight" in a Sept. 6 report, citing stronger loan growth, higher interest rates and increased opportunity for capital deployment. Half of KBW's bank research coverage is now rated "outperform" after the analysts upgraded seven banks. The analysts wrote that the second-quarter earnings season offered reasons for optimism, as management teams said they expect loan growth to return in the second half and banks' earnings results showed "green shoots for core loan growth."

"If you listen to what the banks have said, they've actually been increasingly more optimistic about a second half turn. Now, I don't think it's going to be a massive acceleration," McGratty said in an interview. "But I think we're calling it kind of an inflection point. And if that happens, all the factors ... work in concert to help support positive earnings revisions for the group."

The proportion of banks that posted negative year-over-year core loan growth — excluding the Small Business Administration's Paycheck Protection Program — was 39% in the second quarter, an improvement from a recent peak of 53% in the first quarter, according to the report. Additionally, 36% of banks posted at least 5% core loan growth year over year in the second quarter, up from 25% in the linked quarter.

The analysts model median 5% loan growth for banks in its coverage space for 2021, 2022 and 2023, compared to median growth of 2% in 2020.

The analysts tabbed several banks as top ideas for being "proven loan growers": First Republic Bank, East West Bancorp Inc., Pinnacle Financial Partners Inc., Signature Bank, Silvergate Capital Corp., SVB Financial Group, Western Alliance Bancorp., Cambridge Bancorp, FB Financial Corp., First Merchants Corp., Metropolitan Bank Holding Corp., United Community Banks Inc., Univest Financial Corp. and Wintrust Financial Corp.

For banks with the potential to benefit from the loan growth inflection point, the analysts highlighted Citizens Financial Group Inc., Comerica Inc., First Horizon Corp., Hancock Whitney Corp., Synovus Financial Corp. and Zions Bancorp. NA.

KBW upgraded its investment rating for the entire U.S. banking sector to "outperform" based on a number of positive catalysts.

Rising interest rates will also boost earnings, particularly for asset-sensitive banks, McGratty wrote. The analysts model the first 25 basis point increase in the federal funds rate to occur in December 2022 with another 25 basis point increase in mid-2023. The analysts expect the 10-year Treasury to end this year at 2.0% and increase to 2.8% by the end of 2023.

McGratty also pointed to capital redeployment as a "coiled EPS spring." As excess liquidity continues to stick around longer than expected, banks can be "more opportunistic" about liquidity deployment.

"What's been surprising is that the level of retention has been much greater than we thought," McGratty said in the interview. "If the banks have more confidence that the money is going to stick around, they're more likely to reinvest that money."

The analysts expect a median of 4% EPS growth for all banks in 2023 as a result of capital deployment in securities reinvestments and incremental loan growth.

As uncertainty surrounding loan growth and interest rates wanes and banks begin to deploy their excess liquidity to drive growth, the analysts expect bank stocks, particularly small- to mid-cap bank stocks, to play catch-up from recent underperformance.

"If the market can see, 'Hey, there's an inflection on the horizon,' they can start discounting the probability and the likelihood of that," McGratty said. "The market likes certainty, and that's becoming a little bit less cloudy."

The recent discounted valuations provide "an opportunity to add exposure to the sector (particularly spread lenders) given the potential for positive EPS revisions to occur," McGratty wrote.

For top picks based on value, the analysts named Amerant Bancorp Inc., Bankwell Financial Group Inc., Citigroup Inc., ConnectOne Bancorp Inc., Eastern Bankshares Inc., First Citizens BancShares Inc., Heartland Financial USA Inc., Morgan Stanley, M&T Bank Corp., New York Community Bancorp Inc., PacWest Bancorp, Peapack-Gladstone Financial Corp., State Street Corp., Texas Capital Bancshares Inc. and Wells Fargo & Co.

While the analysts were mostly constructive on the industry, they highlighted Commerce Bancshares Inc., KeyCorp, Regions Financial Corp. and Truist Financial Corp. as banks that may experience less upside due to a multitude of factors, including lower asset sensitivity, lower amounts of excess liquidity to deploy, a less-proven history of loan growth and revenue headwinds. The analysts have "market perform" ratings on Commerce and KeyCorp and "underperform" ratings on Regions and Truist.

The analysts upgraded the stock ratings for Comerica, East West Bancorp, Heartland Financial, Hancock Whitney, SVB Financial, Wintrust Financial and Zions Bancorp. to "outperform" based on their outlook for returned loan growth, higher interest rates and capital redeployment to drive earnings growth.