XLF: All is not as it seems for the banking system (NYSEARCA: XLF)

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While 2020 has been dominated by high-growth tech giants, 2021 is turning out to be a “reflationary” year. Long-term interest rates are on a strong trend which is boosting bank profitability. However, it also generally lowers stock valuations. This market regime benefits banks, commodity producers and most capital-intensive companies while suppressing the value of high-value non-cyclical companies such as technology and “safe” sectors. Thus, energy, financials and industrials led the pack in the first quarter with double-digit returns, while technology, utilities, healthcare and consumer staples all rose by less than 5%.

Of all the sectors, financials are the most impacted by the steepening of the yield curve. This can be illustrated by the strong relationship between the 10-2 Treasury yield spread and the 1-year price returns of the popular financial ETF (XLF):

Graphic
Data by YCharts

As you can see, a steeper curve clearly indicates higher bank yields. The reason for this relationship is very simple. Banks borrow short-term from savers (and the Fed) and lend long-term. As the difference between the two increases, banks are able to earn better returns on capital (i.e. net interest margins).

To make matters better, financial companies have lower valuations than the market as a whole. The yield curve has been notoriously flat over the past decade, largely due to long-term quantitative easing activity in Treasury buying from the Fed. Until recently, this (along with the trauma of the 2008 crisis) discouraged many from investing in the financial sector. As such, XLF has a lower weighted average price to cash flow ratio of just 11.7X and a forward “P/E” of just 15X. Technically, this is the average valuation of the S&P 500 over a long-term period, but it still makes financials much cheaper than the S&P 500 today with a “P/E” of 30X+.

At first glance, financials appear to be a big opportunity today as the market regime has finally turned in their favour. However, given the many extreme changes in the global economic and monetary environment, we have to wonder whether or not the “reflationary” regime is here to stay. Overall, it seems clear that inflation will continue to rise, but banks need rising inflation with a strong economy to maintain their historically high debt levels. If the economy weakens and inflation stays where it is, banks could find themselves in a difficult “stagflationary” environment.

A Look at the Bank-Fed-Treasury Marriage

In my view, the past few decades have seen a clear trend toward growing dependence between banks, the Federal Reserve, and the US Treasury. Specifically, the growing amount of Treasury assets on commercial banks and Fed balance sheets. See below:

Graphic
Data by YCharts

As you can see, an increasing proportion of the total assets of the US Federal Reserve and commercial banks are on loan to the US government. This implies that private investors (individuals, hedge funds, foreign entities, etc.) are not buying Treasury debt at the same level as US banks and the Fed. This can be illustrated by looking at the proportion of the market value of Treasury debt held by the Fed and commercial banks. As you can see below, this has grown significantly over the past year:

Currently, the banks and the Fed now own almost half of the total public debt. More importantly, they were by far the biggest contributors to soaring 2020-21 deficits. Foreign entities that were previously major buyers such as China and Japan have not increased their holdings over the past year. Simply put, only those who are actually forced to buy US Treasuries are buying, everyone else is either holding or selling.

Banks actually cut Treasury assets early last year, but reversed after the Federal Reserve passed a temporary rule that allowed banks to buy Treasury debt and exclude those assets their leverage ratio (which cannot exceed a certain level). This was done in order to encourage US banks to help fund the current multi-trillion dollar budget deficit program.

Importantly, the Federal Reserve has decided not to extend this relief program past March 31, which means banks may need to offload some of their Treasury bond assets. This is likely a contributing factor to the continued decline in the bond market. Overall, we can see that the appetite for Treasuries is extremely low, which means that the US budget deficit may hinge on permanent QE In my opinion, this puts the banks in a weak position because the value of much of their balance sheet can be built on an artificial foundation.

The steep yield curve may not benefit banks

Normally, a steep yield curve increases the profitability of banks because it allows them to lend with higher net interest margins. However, we must consider Why the curve is up because the conditions today are not normal due to the extreme interdependence of the banks, the Treasury and the Fed.

Normally, the yield curve steepens during a recession and acts as a signal that the recession is ending. As the economy weakens, default rates rise and investors buy fewer financial assets, which has a greater impact on riskier long-term bonds. In truth, a steep curve is a sign of a weak economy while a flat curve is a sign of a strong economy. However, a flat curve forecasts a weak economy as bank investment returns reach low levels and a steep curve forecasts a strong economy as it creates an attractive lending environment.

To illustrate, see the strong relationship between permanent unemployment and the curve:

Graphic
Data by YCharts

Unlike normal periods of steepening, there has not yet been a long and lasting devaluation of financial assets. There was also only a slight increase in delinquencies and bankruptcies due to government stimulus measures. In my view, this fiscal stimulus and QE has obscured the underlying reality which is an overall negative economy.

Permanent job losses remained high but did not continue to increase due to today’s extremely high job openings. Once again, we have a labor market situation that is far from normal. Many jobs are lost, many jobs are available, but few take them. The reason is that workers are demanding higher wages, as evidenced by the spike in wage inflation over the past year. This means that, as long as jobs are available, companies will face increased costs and therefore lower profits as they raise wages. This is a clear sign of wage inflation which is likely to prove negative for banks.

put it all together

In this article, I have covered many points that I believe are essential for the future of the financial sector. The key message is that traditional economic signals may not work because the current situation has no (modern) precedent. Yes, unemployment is falling and the curve is steepening, but unlike 2008, this may not be a sign that the banks are clear.

Based on the evidence, it seems that unemployment will only decrease if wages are higher and higher. Simply put, people’s appetite for work is down. This recession is one of the few that has seen job quits remain at record highs (and in fact have increased slightly). Personally, it seems that the meteoric rise in retail investment activity may be psychologically driven by the fact that many would rather try to “get rich quick” than keep working. It is important to note that higher wages do not translate into higher spending (as expected) and instead translate into higher savings.

Simply put, people earn more and spend less. While this may seem distant for the financial sector, it will put pressure on corporate earnings that are needed to pay off record levels of corporate debt. As has been the case, it also means that less government spending will come from taxes, making the government dependent on the Federal Reserve. American commercial banks have never held so much Treasury debt as they do today. If the curve rises due to the increase tax risk (suspected due to the absence of Treasury auction purchases from most entities), banks could suffer losses due to the ongoing devaluation. While many banks hedge some of this risk with derivative swaps, someone has that hot potato.

It is worth highlighting that the top five banks in XLF have seen their leverage return close to GFC levels since 2016:

Graphic
Data by YCharts

With this in mind, a small negative catalyst such as Treasury auction issues or an increase in corporate and household defaults could be deadly for the banking sector. With inflationary pressures rising sharply (since they are backed by wages), the Federal Reserve’s cards are limited without the risk of hyperinflation.

The essential

Overall, the financial sector today appears to be in a state that looks strong at first glance but perhaps incredibly weak in reality. The performance of their assets seems to rest on an increasingly fragile base that requires more and more newly created money to stay afloat. With rising inflationary pressures, the Federal Reserve’s ability to create new money is shrinking. While this is happening, I think we could see another meltdown in the banking sector.

Taking a closer look at XLF, it is worth pointing out that some of its holdings do not present these risks. XLF’s main holding, Berkshire Hathaway (BRK.B), as well as the fund’s holdings in financial services and consumer credit are only secondarily affected by these risks. However, as evidenced by its roughly 80% drop during the GFC, the fund’s value could see a steep decline given a financial crisis. Given that much of the data I’ve seen (including margin levels, valuations, and mortgage debt) is the same or worse than it was in 2008, I wouldn’t be surprised if the story goes say again.

Although XLF may continue to rise in the short term due to momentum, I am bearish on the ETF and the majority of its constituents. I can’t give an estimate of fair value given the immense uncertainty of this situation, but let’s just say that extreme leverage can result in extreme losses even with minor deterioration.

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