What Not to Love About Bank Stocks Right Now

Bank stocks soared after firms handily passed the Federal Reserve's stress tests, but the upbeat finish to the second quarter belies a tough spell amid challenging lending and interest-rate conditions.

Those trends threaten to drag on banks' performance in coming months, a potential counterweight to the higher dividends and share buybacks many banks announced last week. In the second quarter, growth in business lending fell to its slowest pace since spring 2011. Long-term interest rates remain close to historically low levels, despite an uptick in the last week of June. And market volatility remains subdued, resulting in muted trading activity.

"As we head into the second half of the year, the question is how long can banks fight the fundamentals," said James Chappell, an analyst at banking group Berenberg. "Earnings expectations may be too high."

Worries about banks' underlying performance have weighed on bank stocks this year, even though first-quarter results were strong. Financial stocks in the S&P 500 have led all sectors since last November's election, but the bulk of the gains came in late 2016. In the first half of 2017, financial stocks trailed the broader market.

In the second quarter, the KBW Nasdaq Bank index, which tracks 24 of the U.S.'s biggest banks, lagged behind the S&P 500 until the stress-test results were announced on June 28. The end-of-quarter surge happened as banks announced shareholder payouts -- through dividends and share buybacks -- that are just shy of their highest level relative to earnings in nearly two decades, according to analysts at Barclays.

Regional banks didn't get the same bump. The KBW Regional Banking index was nearly unchanged in the second quarter, trailing the broader market. In the first half, it was down more than 4%.

Besides the immediate prospect of more cash in hand for shareholders, the stress tests also bolstered investor hopes that the Trump administration would usher in a period of less-stringent bank regulation. That approach could help bolster returns on equity, which have remained tepid.

Donald Trump's election spurred hopes for even broader changes from Washington, namely a tax-code overhaul and policies, such as major infrastructure spending, that would promote stronger economic growth. But these have yet to bear fruit.

That has led to a decline in confidence that growth will accelerate. As a result, long-term interest rates slid in the second quarter. After a sharp rise in yields following the election, the 10-year Treasury note topped out at 2.6% in mid-March. The 10-year yield rose in late June and recently hovered around 2.3%.

At the same time, short-term rates have marched higher thanks to continued increases in the Fed's rates. The Fed increased its short-term target in June to between 1% and 1.25%.

The result: The difference in yields between 10-year and two-year Treasurys, which is a proxy for the profits banks can make from borrowing and lending money, fell below 1 percentage point in mid-May. It has stayed there since and closed the quarter at 0.90 percentage point. In the wake of the election, the spread topped out at 1.35 percentage points in late December.

Bank of America Corp. Chief Executive Brian Moynihan told investors in May that the bank's potential net-interest income growth in the second quarter could be lower by tens of millions of dollars compared with the first quarter. "We always follow the [yield] curve, and it's been lower, " Mr. Moynihan said at an investor conference.

Investors have been following it, too. After starting the year with a relatively big allocation to banking, Jason Benowitz, a senior portfolio manager at Roosevelt Investments, said he has dialed back on banks over the course of the year. "Our forward concerns are around declines in long-term yields and slowing loan growth," Mr. Benowitz said.

That, he added, may now be of greater import than the stress-test outcome. "People have been gearing up for capital return for a few months, and it's in the market," Mr. Benowitz said.

The other point of concern, slowing lending activity, is a bit of a mystery. Bank executives have been at a loss to explain the decline, especially given the surge of optimism among business owners following the election.

Loans and leases in bank credit, which are counted on a weekly basis, were up 3.8% in late June compared with the same period in 2016, according to Fed data released on Friday. That was the slowest rate of growth in more than three years. The week before the presidential election, banks registered a 7.3% rate.

Meanwhile, trading activity has been held back as hopes for an uptick in inflation, which would lead long-term interest rates higher, have faded. Also, volatility levels during the quarter plumbed historic lows, which also suppressed trading.

Executives at J.P. Morgan Chase & Co. and Citigroup Inc. warned during the second quarter that trading revenues may be down by double-digit percentage points from those of the year-earlier period.

Reflecting such concerns, analyst estimates for second-quarter earnings per share at the six biggest U.S. banks have declined between March and June. The same day the stress-test capital returns were announced last week, Credit Suisse Group analysts reduced earnings estimates for Goldman Sachs Group Inc. and Morgan Stanley "to better reflect the current low volume, low volatility trading environment."

Write to Telis Demos at telis.demos@wsj.com

(END) Dow Jones Newswires

July 04, 2017 07:14 ET (11:14 GMT)