Why we haven't dumped our bank stocks despite growing recession fears

Published Tue, Aug 2 20223:43 PM EDT

Kevin Stankiewicz @in/kevinstankiewicz @kevin_stank

Recession fears have been a major drag on bank stocks in recent months, but Bank of America analysts haven't turned against the entire group. We also see reasons to stay invested in certain names in the sector. In a note to clients Tuesday, the BofA analysts included the Club's two financials — Wells Fargo (WFC) and Morgan Stanley (MS) — on their list of nine stocks to own despite all the uncertainty hanging over the industry. Large-cap peers Goldman Sachs (GS) and Citigroup (C) also made the cut. BofA's price target for Wells Fargo is $50 per share, implying a nearly 15% upside from the stock's Monday close. The firm has a $98 price target on Morgan Stanley, representing a 16.5% increase from its Monday close. Both targets incorporate recession risk, according to the analysts. "We believe it is conceivable that certain stocks may have already bottomed, especially if a mild recession and easing inflationary pressures are what comes next," BofA analysts wrote. "Worth noting that bank stocks did rebound in 2000 despite the rise in the unemployment rate ... However, the late cycle investor mindset will be hard to dispel and is likely to weigh on valuation multiples. A deeper recession and/or stickier inflation remain the key risks." Club take Morgan Stanley and Wells Fargo shares have slightly outperformed the S & P 500 since its closing low on June 16, rising nearly 14% and 16%, respectively, compared with the index's 12.3% advance. However, we're fully aware the stocks' recent strength can reverse in the near term. It's impossible to predict exactly how the market will treat the banks in the coming moths, especially one like Wells Fargo that benefits tremendously from the higher interest rates the Federal Reserve is implementing but also is hurt by the slowing housing market. The trajectory of the economy factors heavily into investor sentiment. The tension between bears and bull right now is something like this: It is generally true that a recession is bad for banks' underlying businesses. Loan growth slows and more existing borrowers struggle to repay their debts. So, bears who believe that's where the U.S. economy is headed – or worse yet, believe we're already in a recession – think it's a mistake to own the financials now. They might argue there are better opportunities elsewhere. On the other hand, some bank bulls see a group of stocks that have already been punished and now trade at very reasonable valuations based on historic averages — a point BofA analysts emphasized in Tuesday's note — with noteworthy tailwinds like expanding net interest margin. They acknowledge the U.S. economy is slowing as the Fed's tightening regime works its way through the system, but say a deep recession like Great Financial Crisis of 2007-2008 is unlikely. They say banks are in very sound financial shape and can weather some normalization in the credit environment while still growing earnings. When we look at Morgan Stanley and Wells Fargo, we're doing it with a time horizon that stretches out past the end of the month and even the end of the year. We don't ignore near-term sentiment shifts — Club members may recall our decision to not fight the Fed in April , where we trimmed some tech and positioned the portfolio more defensively — but we also aren't day traders. We study Morgan Stanley and see a financial firm in the midst of a transformation that's good for investors over the long term. With the acquisitions of brokerage firm E-Trade and asset manager Eaton Vance, the Wall Street bank is leaning into fee-based, recurring revenue streams. The shift doesn't happen with the flip of a switch, to be clear, but we expect it to be reflected in the stock over time. In the interim, we're willing to stay invested as the stock carries a dividend yield firmly above the 10-year Treasury and management executes a massive share repurchase program. The Bank of America analysts hold a similar view. Their $98 price target on Morgan Stanley shares is based, in part, on applying a 15 multiple to expected 2023 earnings. The analysts place a higher P/E ratio on MS shares than most others in their coverage universe "given a more recurring revenue mix and rising [return on equity] due to strategic shift in business which correlates to our [return on tangible equity]/ROE estimates." For reference, the analysts' price target on Wells Fargo shares incorporates a 10 multiple on expected 2023 earnings. Our thesis for Wells Fargo also remains intact for now. Management continues to work on reducing expenses, and the Fed just raised interest rates by 75 basis points for the second straight meeting, and multiple central bank officials have recently stressed more work needs to be done to bring inflation under control . Put another way, more rate hikes from the Fed are likely on the way if the data calls for it. While higher interest rates raises the cost of money and therefore can tamp down on economic activity, they benefit Wells Fargo in other ways. Specifically, we're talking about net interest income. The higher interest rates go, the more money banks can make on the difference between what they pay customers for their deposits and what they charge on loans. As that margin between the two expands, banks like Wells Fargo make more money. In the second quarter, Wells Fargo's net interest margin of 2.39% exceeded analyst expectations and net interest income jumped 16% year over year to $10.2 billion. On the firm's July 15 earnings call, CEO Charlie Scharf said he expected the increases to persist. "Despite the economic environment, I remain optimistic about our future," he said. "Credit quality remains strong, and we expect net interest income growth to continue, given rising interest rates, which should more than offset any further near-term pressure on non-interest income." With Wells Fargo, there is also the potential for regulators to lift the asset cap imposed on the bank after a series of scandals. Of course, we cannot predict when that will happen, and our investment isn't solely a bet on that occurring. Some think it could be a late 2023 story, but it would not surprise us if the timeline was pushed out further. In any case, it would be a significant positive development for the company and its shareholders. (Jim Cramer's Charitable Trust is long WFC and MS. See here for a full list of the stocks.) 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James Gorman, chairman and chief executive officer of Morgan Stanley, speaks during a Bloomberg Television interview in Beijing, China, on Thursday, May 30, 2019.

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