skip navigation
Blog

Stay up to date on timely topics and market events. Subscribe to our Blog now.

MARKETS
26 September 2022
Banks Well Prepared for High Inflation and Recession
By Sebastian Angerer, Ivor Schucking, Daniel Alexander

Stay up to date on timely topics and market events. Subscribe to our Blog now.

We have outlined the banks’ bumpy, bondholder-friendly journey back to basics in the decade following the global financial crisis (GFC) in several blogs and papers in recent years. In 2017, we argued that the industry’s dramatic de-risking created a much simpler, safer and stronger business model that would be resilient in the next economic downturn. COVID-19 provided the first real-world test in 2020 and bank fundamentals surpassed even our contrarian, constructive expectations. Importantly, rather than being the key problem as they were during the GFC, banks were a key pillar of the economic solution following the pandemic-induced economic upheaval. Moreover, the negative direct impact of Russia’s invasion of Ukraine was limited to a few banks, and was actually much smaller than expected given both regulatory requirements around the resolution and the impact of prior sanctions following Russia’s takeover of Crimea. We believe that banks will similarly exceed market expectations in the current investment environment dominated by concerns around high inflation and economic contraction.

Exhibit 1 highlights key historical metrics of the US banking system since 2001. Our constructive secular view is that the risk profile of banks is much lower now given a new, strict rulebook with extreme fines, improved risk management and supervisory oversight. Our view that banks enter this period of heightened uncertainties with the strongest fundamentals in decades is not shared by sceptical rating agencies and investors, as seen in quite bearish credit ratings, equity valuations and credit spreads.

Exhibit 1: Key Financial Metrics, Ratings and Market Valuations of the US Banking System vs. Prior Recessions
Key Financial Metrics, Ratings and Market Valuations of the US Banking System vs. Prior Recessions
Source: FDIC, S&P, Moody’s, Bloomberg, Western Asset. As of 21 Sept 22. Select the image to expand the view.

Bank Fundamentals Remain Strong

The banking sector’s strong fundamentals, given its de-risked profile, support our constructive credit view. We believe market and ratings-agency scepticism create meaningful opportunities across the capital structure for top US banks. In the US, banks are well positioned for likely tougher economic times ahead given: (1) rising rates supporting higher net interest margins; (2) strong loan growth; (3) sound expense controls; (4) near-record-low credit losses (i.e., 23 bps versus a 19-bp all-time low and an 85-bp historical average), and; (5) extremely low-cost funding (average funding cost of 26 bps; 28% of deposits are zero cost). We believe that a near-record-low loan/deposit ratio of 60% (equal to $6.5 billion of excess deposits) will lead to much less deposit repricing versus prior Federal Reserve (Fed) rate-hiking cycles. Asset quality should remain strong and only deteriorate gradually given the combination of tight lending standards, low unemployment rates and high home equity, relatively subdued loan growth prior to 2022, a less risky loan mix since the GFC, and healthy balance sheets for most corporate and household customers.

Today’s less risky banking business model continues to remain out of favor historically in terms of credit ratings (ratings are four notches below their 2007 peak). Equity valuations remain below historical averages and credit spreads have underperformed the credit index in 2022 given misplaced fears related to the highly unusual GFC period and negative investor sentiment based on a potential near-term recession. For example, Bank of America 10-year senior debt (+202 bps) currently trades +70 bps wide of the Bloomberg US Credit Index (+131 bps), compared with +15 bps at the beginning of the year. Based on our fundamental sector view, we have high conviction that it can trade through the index in the future.

In Europe, we see similarly strong fundamental starting points against an arguably more difficult geopolitical and economic backdrop. Like their US bank peers, European banks should benefit from central bank rate hikes and asset quality should be supported by likely future fiscal support measures. European bank bondholders fared extremely well under very conservative stress test assumptions in the most recent test. For example, the banking system’s average Common Equity Tier-1 Capital Ratio would be sufficiently above the level where institutions’ most junior debt (AT1) would face coupon non-payments even with the modelled 500 bps capital drawdown in the latest stress test. For investors to suffer losses on the principal of these most junior securities the capital drawdown would have to double the stress test impact (close to €1 trillion, equivalent to 1.2x sector market capitalization).

Exhibit 2: Significant Level of Bondholder Protection for Even the Most Junior Instruments
Significant Level of Bondholder Protection for Even the Most Junior Instruments
Source: EBA, Western Asset. As of 30 Jun 22. Select the image to expand the view.

De-Risked Banks Should Remain Resilient

We are constructive on the banking sector due to its fundamental resilience against economic and geopolitical uncertainties. In our view,valuations have moved from “reasonable” to “attractive” in 2022. It’s important to note that “de-risked” does not mean “no-risk,” and we continue to view unexpected economic recessions as the biggest risk to banks. Our highly selective and conservative bank investment thesis focuses on only 75 banks across the 20 lowest-risk countries. We are constructive on the highest quality US and European banks across the capital structure given our healthy fundamental assessment of the sector combined with attractive valuations and generally benign technicals.

© Western Asset Management Company, LLC 2024. The information contained in these materials ("the materials") is intended for the exclusive use of the designated recipient ("the recipient"). This information is proprietary and confidential and may contain commercially sensitive information, and may not be copied, reproduced or republished, in whole or in part, without the prior written consent of Western Asset Management Company ("Western Asset").
Past performance does not predict future returns. These materials should not be deemed to be a prediction or projection of future performance. These materials are intended for investment professionals including professional clients, eligible counterparties, and qualified investors only.
These materials have been produced for illustrative and informational purposes only. These materials contain Western Asset's opinions and beliefs as of the date designated on the materials; these views are subject to change and may not reflect real-time market developments and investment views.
Third party data may be used throughout the materials, and this data is believed to be accurate to the best of Western Asset's knowledge at the time of publication, but cannot be guaranteed. These materials may also contain strategy or product awards or rankings from independent third parties or industry publications which are based on unbiased quantitative and/or qualitative information determined independently by each third party or publication. In some cases, Western Asset may subscribe to these third party's standard industry services or publications. These standard subscriptions and services are available to all asset managers and do not influence rankings or awards in any way.
Investment strategies or products discussed herein may involve a high degree of risk, including the loss of some or all capital. Investments in any products or strategies described in these materials may be volatile, and investors should have the financial ability and willingness to accept such risks.
Unless otherwise noted, investment performance contained in these materials is reflective of a strategy composite. All other strategy data and information included in these materials reflects a representative portfolio which is an account in the composite that Western Asset believes most closely reflects the current portfolio management style of the strategy. Performance is not a consideration in the selection of the representative portfolio. The characteristics of the representative portfolio shown may differ from other accounts in the composite. Information regarding the representative portfolio and the other accounts in the composite are available upon request. Statements in these materials should not be considered investment advice. References, either general or specific, to securities and/or issuers in the materials are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendation to purchase or sell such securities. Employees and/or clients of Western Asset may have a position in the securities or issuers mentioned.
These materials are not intended to provide, and should not be relied on for, accounting, legal, tax, investment or other advice. The recipient should consult its own counsel, accountant, investment, tax, and any other advisers for this advice, including economic risks and merits, related to making an investment with Western Asset. The recipient is responsible for observing the applicable laws and regulations of their country of residence.
Founded in 1971, Western Asset Management Company is a global fixed-income investment manager with offices in Pasadena, New York, London, Singapore, Tokyo, Melbourne, São Paulo, Hong Kong, and Zürich. Western Asset is a wholly owned subsidiary of Franklin Resources, Inc. but operates autonomously. Western Asset is comprised of six legal entities across the globe, each with distinct regional registrations: Western Asset Management Company, LLC, a registered Investment Adviser with the Securities and Exchange Commission; Western Asset Management Company Distribuidora de Títulos e Valores Mobiliários Limitada is authorized and regulated by Comissão de Valores Mobiliários and Brazilian Central Bank; Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services License 303160; Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services License for fund management and regulated by the Monetary Authority of Singapore; Western Asset Management Company Ltd, a registered Financial Instruments Business Operator and regulated by the Financial Services Agency of Japan; and Western Asset Management Company Limited is authorised and regulated by the Financial Conduct Authority ("FCA") (FRN 145930). This communication is intended for distribution to Professional Clients only if deemed to be a financial promotion in the UK as defined by the FCA. This communication may also be intended for certain EEA countries where Western Asset has been granted permission to do so. For the current list of the approved EEA countries please contact Western Asset at +44 (0)20 7422 3000.