Ruth Saldanha: Inflation and interest rates continue to stay on the front burner for investors, and in this climate, banks come to mind as a potential place for us to make some money. We’ve already discussed Canadian banks. So, which U.S. banks are attractive right now and where could you get the most dividends? Eric Compton of Morningstar Research Services is here today to tell us what he thinks.
Eric, thanks so much for being here today.
Eric Compton: Yeah. Thanks for having me.
U.S. Banks Near Term Outlook: Net Interest Margins Will Peak, Fees Will Struggle
Saldanha: So, let me start off by asking what’s your near to mid-term outlook for the U.S. banks.
Compton: Yeah. So, for the U.S. banks, I think a couple of key themes are going to play out. One, we’re going to see net interest margins start to reach a peak. Funding costs have largely started to catch up with asset yields. So, I think banks are going to struggle to keep growing net interest income at the same rate they were in 2022. So, net interest income growth is going to start to slow down. So, that’s key point number one.
Key outlook item number two is that fees, I think, are going to struggle to grow in 2023. Fees were in a tough spot in 2022, and I think a lot of those headwinds are going to remain in place, whether it’s difficult environment for investment banking revenues just because of low volumes, difficult environment for mortgage fees as rates are high and people just aren’t refinancing and purchase volumes are down, difficult environment for wealth fees as markets struggle to move higher. So, I think a number of fee items will continue to face pressure. So, NII is going to grow at a slower rate. I think fees are going to be flat to down for most of the banks that we cover.
Then, expenses is a little more of a simpler story. Some inflationary pressures in there leading to roughly mid-single-digit growth for most of the banks I cover. And so, all of that leads to, call it, mid to high-single-digit to even maybe low-double-digit what we call PPNR growth or that’s essentially just revenues minus expenses for the banks. So, not too bad of a 2023, but definitely, I think a slowdown of what we saw in 2022. And then, the other thing I would add on top of that is we do expect credit costs to go up materially in 2023, as we expect a decent likelihood of a mild recession towards the end of 2023. So, provisioning is very likely going to up. We don’t think it will go high enough to completely eat up that PPNR growth. So, we still think net income and EPS growth will be decent in 2023. But like I said, higher credit costs and a slowdown in some of the other growth items that we saw compared to 2022.
Which U.S. Bank Stocks Will Pay High Dividends?
Saldanha: So, what does all of this mean for dividends? Is there any bank that you like from a dividend perspective?
Compton: Yeah. So, I would say that banks tend to be a place people look for dividends. At least in the past, some of them offered decent yields. I’d say maybe they’re a little less attractive now with treasuries yielding 4.5% to 5%. So, none of the banks I have are quite that high, but a couple are close.
So, the ones I would look at would be I would highlight KeyBank (KEY) and also Truist (TFC). Both have above 4% dividend yields, and both are decent operators, decent U.S. regional banks. Truist is a little bit bigger than KeyBank and one of the largest regionals in the U.S., whereas KeyBank is more, I would say, a mid-sized operator. And so, I think, no fundamental issues with their franchises. They offer decent dividend yields and on top of that, I think KeyCorp maybe has a little bit more room for dividend growth in the next couple of years. So, if I had to pick between the two of them, I would maybe look at them. But I think both, if you’re looking for decent dividend yields, would be good places to look.
Saldanha: What are some of the risks that you’re watching for the rest of 2023 for U.S. banks?
Compton: So, I’d say, there’s a lot of risks on the horizon, I think. This is definitely a period of heightened uncertainty just because we’re in a spot where we haven’t really been in recent memory in a long time for the banks. And so, what I mean by that is, where rates are potentially going to go above 5% in the U.S., that hasn’t happened for a long, long time. We’re at a weird kind of inflation spot where inflation was really high and now it’s starting to come down a little bit, but no one knows quite how fast it will come down. You’ve got the recession risks on the horizon. Net interest income for the banks is when you’re at peak rates tends to play out in sometimes unpredictable ways. So, I think there’s a lot of uncertainty. There’s a lot of difficulty in just forecasting what exactly is going to happen with net interest income, which leads to some risks on the forecasting side.
And then, just what happens with rates and the economy? Does the Fed have to keep hiking and cause a recession? Does the Fed, kind of, stay put and is the economy able to handle that? Or does the Fed eventually lower rates which could cause a decline in earnings for the banks? And so, I think those are a lot of the key risks we’re looking at now. The one point I would add on top of that is, even if a recession does happen, I do try to emphasize with investors, we think the banks are well-prepared for it. It’s likely to be a mild recession and we think it will be easily handled by the amount of capital and reserves the banks have built up over the years.
Top U.S. Bank Stock Pick for 2023
Saldanha: So, with all of these risks, which is your top U.S. bank pick right now?
Compton: So, I’d like to divide these up. Usually, investors tend to look at the – they like to look at the big four and then also regional banks. And so, among the big four, the most undervalued name for us is Citigroup (C). It’s the only 5-Star name on my list. They’re trading at over a 30% discount. Whereas a lot of the other banks aren’t trading at much of a discount at all. And so, to me, City shares look attractive on a valuation basis.
Now, that said, you could say there’s a reason for the discount. Citigroup has a lot of idiosyncratic issues going on that investors need to be aware of. This is definitely a more of a longer-term deep value turnaround play, and this comes with all of those unique risks. And so, I think over time it will work out in investors’ favor. I think there are some excess returns to be had there. But you have to be okay with investing in that type of situation. So, Citigroup would be my top pick.
If you want to stick to more of the established franchises in the big four, I like JPMorgan (JPM) a little bit over Bank of America (BAC) right now. They’re both technically fairly valued, but I think JPMorgan maybe has a little bit more of an idiosyncratic potential with just a lot of the investments it’s made over the last two years rolling off a little bit, and so, expenses slowed down, also a little bit less rate sensitive. So, if rates do get cut, a little bit less risk there. Among the regionals, I would just highlight again, KeyBank (KEY). Trading at a substantial discount, more so than most of the regionals under my coverage. And you get the decent dividend yields and I think catalysts for them are going to be – they have the highest exposure to investment banking revenue among the regionals. So, I think once that turns around, earnings are going to come back for them. And I think the market will appreciate them a little bit more.
Saldanha: Great. Thank you so much for joining us today with your perspectives, Eric.
Compton: Yeah. Thanks for having me.
Saldanha: For Morningstar, I’m Ruth Saldanha.