Higher interest rates are supposed to tame the market's animal spirits by putting pressure on corporate earnings. But that's not what U.S. Bancorp (NYSE:USB) CEO Richard Davis predicts will happen once corporations are convinced that the Federal Reserve will finally pull the trigger and increase the benchmark Fed Funds rate.
"As rates start to move up, I'm convinced of two things," Davis recently told analysts. "One will be that when there is a real sense that's about to happen there will be a tsunami effect, particularly on the corporate and wholesale side as people try to lock down low rates before they get stuck having missed that opportunity."
The ebb and flow of interest rates
We've heard this refrain before, but it's especially important to keep in mind now for two reasons.
First, it seems more and more likely with each passing day that the central bank will decide to ease short-term rates higher sooner rather than later. The Fed has intimated that it won't do so at its monetary policy meeting next week because of concerns about the impact on economic growth from a strong U.S. dollar and an unstable global economy. However, many analysts and commentators seem to be convinced that it will nevertheless happen by the end of the year (though I'm not as confident).
Secondly, given the comparatively dismal performance of traditional banks in the first quarter, it's important for investors to understand that the cause of their underperformance -- i.e., low interest rates -- is temporary.
For instance, last quarter was the first time since the beginning of 2010 -- a full 18 quarters ago -- that Wells Fargo's (NYSE:WFC) quarterly net income didn't grow on a year-over-year basis. Aside from higher loan loss provisions, low interest rates were the primary culprit behind its 1.5% decline in quarterly net income.
You can see this by looking at Wells Fargo's net interest margin, which measures the amount of net interest income a bank earns relative to the total value of its interest-earning assets. For the first time in well over a decade, the California-based bank's net interest margin dipped below 3%, settling at 2.95% compared to 3.2% in the year-ago period.
How much of an impact did this have on Wells Fargo's bottom line? It's impossible to say for sure, as other aspects of its operations benefit from low interest rates; but in terms of net interest income, which accounts for 52% of Wells Fargo's net revenue, the drop equated to $959 million in otherwise forgone net interest income. That alone would have boosted Wells Fargo's earnings last quarter by 16.5%.
It's for this reason that when an analyst asked about the direction of the U.S. economy during U.S. Bancorp's latest conference call, Davis answered, "I remain very optimistic for the economy and for the great citizens of America, a little less optimistic for the bankers until the interest rates start to move up."
Recency bias and regional banks
In instances like this, it's tempting for investors to make buy and sell decisions based upon what's happening now. There's even a name for this tendency: recency bias. "Because it's easier, we're inclined to use our recent experience as the baseline for what will happen in the future," author and certified financial planner Carl Richards wrote in 2012. "In many situations, this bias works just fine, but when it comes to investing and money it can cause problems."
My point is that, when it comes to bank stocks, it would be a mistake for investors to abandon traditional lenders like Wells Fargo and U.S. Bancorp based on their lackluster first-quarter earnings in favor of universal lenders such as JPMorgan Chase and Citigroup, both of which had much better quarters thanks to assists from their trading and investment banking operations. As I've discussed before, over the long run, the traditional banking business model has proved far superior in its ability to generate outsized shareholder returns.
In short, now isn't the time to sell your shares of traditional banks just because their earnings are suffering under the oppression of low interest rates. If anything, just the opposite is true. To Davis' original point, there will come a time in the not-too-distant future when the fortunes of U.S. Bancorp, Wells Fargo, and other commercial lenders turn around abruptly. You won't want to miss that.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, JPMorgan Chase, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.