After some years of lackluster returns, we believe the outlook for bank stocks is brightening. Broadly speaking, we can divide the reasons for this into two categories: interest rate movements and the anticipated regulatory changes stemming from the Trump presidential victory and Republican control of both the House and Senate from January 2025.

In recent weeks, the Treasury yield curve has “normalized” (i.e., is upward sloping again) for the first time in a few years. Since September, the Federal Reserve has trimmed the Fed Funds by 100 basis points in response to a decline in the rate of inflation. To the surprise of some observers, the rate on 10-year Treasuries has shot up nearly 100 basis points on the back of resilient economic growth, some inflation stickiness, and fears of a wider budget deficit (e.g., through more tax cuts) and perhaps higher inflation under a Trump presidency.

Banks benefit from a steeping yield curve because they tend to borrow short (e.g., savings accounts or by issuing CDs) and lend long to commercial, industrial and consumer borrowers. A widening spread between the cost of banks’ borrowing and lending rates widens their net interest margins, which is favorable for bank profitability. In addition, banks can park their own assets in fixed-income securities with higher yields, which also helps to boost earnings.

A Lighter Touch

The Republican election sweep may also benefit the banking sector through reduced regulation. For example, we think the environment for mergers and acquisitions (M&A) should improve, and the Trump Administration will likely water down the Basel III increased capital requirements for large banks, thus freeing up more bank capital to be deployed in the business. Overall, we anticipate that bank and financial regulators will adopt a lighter, more business-friendly touch in regulation and supervision of the banking sector. In fact, we have evidence of the difference an administration transition can make: During the first Trump presidency, the number and total value of bank M&A deals rose and then slumped during the Biden Administration’s years, according to data from S&P Capital IQ.*

With more than 4,000 independent, FDIC-insured banks with branches in this country—and given the secular growth in digital banking—the industry seems ripe for consolidation. “We believe there’s pent-up demand for deal making, which could result in a wave of industry consolidation in the next couple of years,” says Steven Labbe, a co-manager of LS Opportunity Fund (LSOFX). Unlike in some industries, acquisitions can enhance the valuations of both the acquirer (for instance, through increased scale and lower funding costs) and the acquired, whose share price is typically bid up by the takeover premium offer.

LS Opportunity, which is able both to hold long positions in companies it favors and short positions in businesses it perceives are troubled, is particularly drawn to regional banks in favorable geographies with strong in-migration and economies. “We like banks with enviable deposit franchises, since the cost of funds can be a true differentiator,” says Labbe. “A growing economic region is a tailwind to loan growth and credit experience.” Also, in our view smaller regional banks tend to have less exposure to market-making activities, derivatives and other esoteric assets, and systemic risk than do money-center banks.

Conclusion

The same deep financial-sector research process that uncovers attractively priced bank stocks can simultaneously identify weaker players that may provide lucrative short positions in the same portfolio. For example, in analyzing banks, LS Opportunity analysts and managers evaluate management quality and the quality of credit underwriting, loan growth and deposit costs, and the extent of exposure to assets like speculative construction and development loans and retail commercial real estate. In short, in an environment of deregulation and change, bank stocks may provide ample opportunities for astute investors on both the long and short sides of the ledger.

*Source: https://blog.longshortadvisors.com/news-insights/lsofx-q2-2024-shareholder-letter