After falling by more than 20% in 2022, U.S. bank stocks have been making an effort to recover so far this year, spurred on by expectations that the Federal Reserve would be able to control inflation without triggering a financial crisis.

The S&P 500 bank subsector has increased by 4.9% so far in 2023, above the benchmark S&P 500’s increase of 3.3%.

But, some investors are being cautious because banks themselves issued a warning during the January earnings season that they anticipate increased loan losses and weaker borrowing demand.

These concerns result from economic uncertainty, potential loan losses, and a decline in loan demand brought on by higher borrowing costs following the Fed’s rapid interest rate hikes starting in March 2022.

Banks now have the green light to charge higher interest rates on loans because the rate increases have boosted their income. Yet, bank customers with savings accounts are looking for higher interest rates on deposits, counteracting lending benefits.

With U.S. data still showing a strong jobs market, this year’s equity market gains have been pinned on hopes that the Fed’s efforts to dampen inflation would not thrash the economy.

Despite the fact that its rate hikes have not yet reduced inflation as much as investors had hoped, the Fed is still trying to negotiate a soft landing, according to Rick Meckler, a partner at Cherry Lane Investments, a family investment office.

“For banks, that is a sweet spot, being able to gain from higher rates without having the economy stall so much that generates losses and puts a stop to investment banking activities,” said Meckler, a bank analyst based in New Jersey, who also notes that for banks, “the wind is really at their back right now.”

UNCERTAINITY

Mid-February conferences included upbeat updates from the heads of major US banks. David Solomon, CEO of Goldman Sachs (NYSE:GS), stated that although conditions are still “very, very unpredictable,” CEOs’ attitudes have improved due to expectations for a softer economic landing than six months ago.

Brian Moynihan, CEO of Bank of America (NYSE:BAC), also noted that consumers were in excellent shape, with good balances, readily available credit, and rising spending.

Additionally, on the business front, Sharon Yeshaya, the head of finance at Morgan Stanley (NYSE:MS), stated at the time that a cloud of uncertainty was “starting to lift” and that client CEOs were feeling more confident after reviving discussions about potential transactions.

But Aaron Dunn, portfolio manager and co-head of value equity at Eaton (NYSE:ETN) Vance, is keeping an eye on how much banks will raise the interest rates they provide on customers’ accounts.

According to Dunn, banks that offer a variety of services are less under pressure to raise rates if the Fed keeps rising and short rates remain high.

Banks must increase the rates on savings accounts in order to compete with the highest short-term Treasury rates in 15 years.

Dunn considered last year to be a “best case scenario,” with low credit costs and rising net interest margins due to rate increases, but he doesn’t anticipate a recurrence this year. He predicted that profitability will normalise this year as a result of declining net interest margins and increased credit expenses.

The money manager nonetheless advises maintaining “high quality exposure” to the banking industry. He points to strong deposit bases at Wells Fargo (NYSE:WFC) and M&T Bank (NYSE:MTB).

Barclay’s analyst Jason Goldberg sees economic strength as a bigger factor for U.S. bank stocks this year than the Fed hikes path.