Charles Schwab (SCHW 0.13%) has had a difficult go of it in the higher interest rate environment. Since the Federal Reserve began raising rates amid inflationary pressures in March 2022, Schwab has seen significant deposit outflows, leading the company to tap the Federal Home Lending Bank (FHLB) and other resources to smooth outflows.
Over recent months, the deposit outflows at Schwab have slowed, and the fourth quarter showed more of the same. With the stock up 37% from its low last May and the prospect of interest rate cuts in 2024 on the table, is Schwab's stock still a buy?
Charles Schwab's strength leaves it vulnerable during rising interest rates
Charles Schwab has delivered solid returns for investors for decades thanks to its limited credit exposure and cost-efficient business model. The financial services company has historically relied on low-cost deposits that have led to a solid return on equity above its peer averages.
As a crucial component of its business model, Schwab relies heavily on deposits, most of which are in savings accounts that clients have yet to invest, to drive strong profit margins. While this has worked well for the company over the past decade, Charles Schwab has also struggled during periods of rising interest rates.
In 2017, the Federal Reserve began gradually increasing its federal funds rate, which eventually posed a problem for Charles Schwab called "client cash sorting." Rather than keep deposits in low-yielding accounts, many customers shifted funds to high-yield savings, CDs, or other relatively safe assets with appealing yields, which reduced its balance sheet and a sizable amount of those low-cost funds it relied on.
So when the Federal Reserve began raising interest rates in March 2022, Schwab faced client cash sorting problems again. The difference this time is that interest rates were rising in response to inflation, which was increasing year over year at its fastest rate in 40 years.
The pace of Schwab's deposit outflows has slowed down significantly
From August 2022 through March 2023, Charles Schwab lost deposits due to client cash sorting at a pace of $5.6 billion per month as yields on savings accounts or other safe short-term assets like certificates of deposits rose. These deposit outflow pressures slowed significantly following the regional banking crisis. From June through December last year, Schwab's deposits continued to decline, but at the pace of $1.1 billion monthly.
Chart by author.
The pace of Schwab's outflows is moderating, which is helped by the Federal Reserve's recent pause on its interest rate hiking campaign. With rates moderating and possibly coming down, Schwab could see those deposit pressures begin to diminish. That would be a welcome sign for the company, which will look to reduce higher-cost funding sources, like retail certificates of deposit and FHLB advances.
Is Charles Schwab stock a buy?
Charles Schwab is still managing its outflows, and the primary risk to the company is interest rates remaining higher for longer than anticipated. That could result in more outflows and put pressure on the share price. However, it seems more likely rates will go down. According to the CME FedWatch Tool, markets are pricing in five interest rate cuts by year-end.
SCHW PE Ratio data by YCharts
With the prospect of interest rate cuts, Charles Schwab's valuation is quite reasonable. The stock trades at a price-to-earnings ratio of 24.6, which is close to its 10-year average. However, based on one-year forward earnings, it trades at just 14.2.
Given its reasonable valuation, Charles Schwab looks like a good stock to buy today and add to through the year if interest rates do indeed fall, which would take significant pressure off its declining deposit base.
