December was a huge month for major bank stocks, with Bank of America (BAC -0.21%) and Wells Fargo (WFC -0.03%) both gaining 10.4%, and PNC (PNC -0.12%) charging 15.6% higher, according to data provided by S&P Global Market Intelligence.
The banking sector was lifted by the Federal Reserve's commentary following its Open Market Committee meeting on Dec. 13. The central bank had a more dovish tone than anticipated, openly suggesting that a shift away from restrictive monetary policy could be around the corner. The commentary fueled optimism that interest rates will be cut next year.
The banks' big price moves were rapid and highly correlated with one another, so it's clear that the stocks were responding to the same macroeconomic news rather than anything company specific.
Why were investors so excited about the Fed news?
At times in the past, bank stocks have performed poorly when interest rates were too low, so the December rally might seem strange at first glance. Lenders can struggle in excessively low interest rate environments, because their interest income declines while many of their fixed costs remain the same. This drives profit margins lower and threatens the cash flows that can be distributed to the banks' shareholders.
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This situation is a bit different. Investors have been concerned about a potential recession triggered by high interest rates. A variety of macroeconomic factors combined to fuel high inflation around the world, and the Fed aggressively hiked rates over the past two years in an effort to control inflation.
While it was important to combat inflation, the interest rate hikes come with an important trade-off. High rates discourage risk, impact consumer spending, and cause businesses to stop hiring and investing in growth -- in general, they slow the economy down. Both businesses and consumers are simultaneously dealing with high inflation, slowing economic growth, tighter lending standards, and higher borrowing costs.
The recent rate hikes are not only crushing demand for bank lending products, they are potentially threatening existing customers' ability to service their loans. With a large amount of corporate debt set to come due next year, high rates extending into 2024 would exacerbate the situation if corporations are unable to refinance at a manageable cost. That's all bad news for banks and their shareholders.
The major banks are also suffering from weak capital markets impacting their other divisions. High rates are discouraging activity in the acquisitions and initial public offering markets. This hurts the investment banking segments of the major banks.
The outlook for Bank of America, PNC, and Wells Fargo
The banking sector is full of bellwethers that reflect broader economic health. There's a growing set of evidence that interest rate relief is around the corner and a soft landing will be achieved without a major recession. That would be great news for the banks, but it's hard to feel completely confident about the next few quarters. Central banks around the world are still highly active in response to inflation, and there could be delayed effects to extended high rates that cause unemployment to spike. Recent signals have been bullish, but we aren't out of the woods yet.
As it stands, the major banks' Tier 1 capital ratios indicate relatively strong health right now. This is always subject to change, and an unexpected global slowdown could send bank stocks tumbling. Bank of America and Wells Fargo are similar in terms of balance sheet size, health, and valuation. PNC has a somewhat smaller buffer if the economy turns sour. PNC's 3.9% dividend ratio is 130 basis points higher than its peers as a result. All three stocks have a beta around 1.2, so they're likely to be more volatile than the market in general if we hit a rough patch.
