Finally, new housing supply could be constrained by several dynamics. Delinquencies appear to have peaked, so if prices eventually stabilize, the pace of new foreclosures and added future inventory should slow. This will allow the market to clear over time as new households form, the population grows and rising demand absorbs today’s inventories. These diminishing inventories would help ease the current supply/demand imbalance in U.S. housing. Also, home builders are not making the same mistakes they did in 2005 and 2006, when they overcommitted to new homes starts and future land development. Part of this is by choice, and part is due to a lack of credit availability. As a result, outside of trends in the shadow inventory, we should see relatively limited new inventory entering the market.
Over time, the combination of all the above factors should provide support for U.S. housing and thus add momentum to the current trend of gradual improvement in banks’ balance sheets.
Technicals Supportive for U.S. Banks
In addition to gradually improving fundamental trends, we expect positive technicals to support investors in U.S. banks. Despite refinancing needs under the FDIC’s Temporary Liquidity Guarantee Program (TLGP), U.S. banks have relatively limited issuance needs, particularly relative to European banks (chart 8). This is because U.S. banks have less need to grow their balance sheets given the weak economic recovery and uncertainty surrounding regulations under Dodd-Frank legislation. Given this environment, banks are shrinking their balance sheets, deleveraging and maintaining abundant liquidity through large deposit bases and liquid securities portfolios.
The government also appears willing to establish a regulatory framework for a covered bond market in the U.S., which would help to lower U.S. banks’ funding costs. Instead of funding through banks, U.S. covered bonds could be allowed to pool residential and commercial mortgages into debt securities. And unlike in Europe, U.S. covered bonds would include the ability to fund auto loans, credit cards, student loans and government-guaranteed small business loans as well.
The U.S. banking system’s abundant liquidity is shown in recent trends in the differential between three-month U.S. dollar LIBOR overnight index spread over the federal funds rate (chart 9). U.S. banks show few signs of stress as concerns over credit extension and liquidity have abated. Today’s environment of relatively solid confidence in the banking system stands in sharp contrast to the financial crisis in 2008 after the failure of Lehman. During that period, banks hoarded cash and investors were unwilling to lend to banks, pushing liquidity stress indicators to historically wide levels. However, in the years since and with the assistance of quantitative easing, banks have increased their excess (cash) reserves on hand and have increased their utilization of bank deposits as a preferred funding mechanism vs. commercial paper issuance. These improved funding tactics, in addition to enhanced regulations and capital requirements, should continue to improve transparency and confidence within the banking system, and should support U.S. banks going forward.
Valuations Attractive for U.S. Banks and Financials
With gradually improving fundamentals and supportive credit market technicals, U.S. banks and select specialty financials will likely outperform the broad credit market. This is particularly the case today given the attractive valuations in the financial sector. Bank and financial credit spreads remain attractive relative to industrial credit spreads (chart 10). While the U.S. industrial sector could be more vulnerable to a below-trend economic environment and may also entertain more shareholder-friendly activities, U.S. banks remain focused on a longer-term, secular deleveraging trend and are set to continue to strengthen balance sheets due to heightened regulations.
Sunlight on U.S. Banks
We believe stronger global banking regulations are critical for the safety of banks. The global financial crisis highlighted not only the need for improved regulatory oversight but also the need for strong bank balance sheets given the importance of healthy banks to the global economy. Fortunately, in the U.S., policymakers proactively supported the recapitalization of U.S. banks at a time when they needed it most. As a result, most U.S. banks have turned the corner and over time appear well-positioned to be able to meet the higher capital requirements under Basel III due to healthier balance sheets, solid retained earnings and gradually improving asset quality.
Over the past several years we have seen regulators both punish banks and try to make them safer. My hope is that global banking regulators can begin to transition into a new era of working effectively with governments and banks, particularly with those financial institutions most in need of capital, to help promote equity infusions and assist in providing more stability to both financial markets and the global banking system. Higher capital requirements and re-regulation are expected to be positive for bondholders because they improve transparency and should help make banks safer.
Although the global economy faces uncertain times, U.S. banks and select financials stand out within the global credit markets by offering gradually improving fundamentals, supportive technicals and attractive valuations. Given these positives, we believe select credit investments in U.S. banks and financials offer the opportunity for attractive risk-adjusted returns as today’s economic dark clouds gradually give way to more sunlight.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
Barclays Capital U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis.
LIBOR (London Interbank Offered Rate) is the rate banks charge each other for short-term Eurodollar loans. It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
