RealMoney

With the Federal Reserve's monetary-tightening cycle well under way, many investors are hoping the banking sector can shake off its reputation as the stock market's black sheep and return to its glory days of before the 2008 financial crisis. But while the financial sector does present more opportunities for growth now that Fed tightening has started in earnest, experts say that investors need to pick their plays carefully.

Here's what they told Real Money:

Is It Different This Time?

The main question about this cycle is this: Does it make sense to compare current conditions with past Fed tightening periods and assume that bank stocks will behave in relatively similar fashion? Answer: No. After all, at no time in recent history has the U.S. economy faced the challenges that it faces now.

"This time will be different only because it is different," said Richard Bove, currently with Vertical Group and long one of the most vocal banking analysts on Wall Street. "It's never happened before that the Fed shrank its balance sheet and increased its interest rate at the same time."

The Fed's "dot plots" -- its survey of Federal Open Market Committee participants regarding their assessments of appropriate monetary policy -- show that the midpoint of interest-rate expectations for 2018 is somewhere between 2% and 2.25% for the benchmark Federal Funds rate. That implies that the FOMC will approve around three 0.25 percentage points rate hikes this year to the Fed Funds rate, which is currently set at a range of 1.25% to 1.5%.

However, the Fed's tightening cycle has been so gradual so far that the markets have been more or less ignoring it. True, there was a brief exception this past Wednesday, when the bond market had a "tantrum" over reports that China was seeking to sell some of the U.S. government debt that it holds. But since the Fed started raising rates at 2015's end, a Bank for International Settlements indicator of financial conditions that combines information from various asset classes actually touched a 24-year low -- pointing to an overall easing of financial conditions.

This prompted Claudio Borio, head of the monetary and economic department at the BIS, to wonder: "If financial conditions are the main transmission channel for tighter policy, has policy in effect been tightened at all?" Borio believes the Fed's current tightening cycle is more like one in the early 2000s, when overall financial conditions "hardly budged and in some respects eased" as the Fed progressively raised rates:

Source: Board of Governors of the Federal Reserve System

The early 2000s tightening contrasted sharply with previous Fed tightening cycles, not least the one that began in 1994. That year, long-term rates soared, the yield curve steepened and asset prices fell. The big question for investors now is whether history will repeat itself -- and if so, whether the current Fed tightening cycle will look like 1994 or the early 2000s.

Banks had a particularly good run in the mid-2000s tightening. Consider this chart, which compares the performance of a FactSet index of major U.S. banks (the blue line below) vs. the S&P 500 (the green line) between 1998 and 2017:

Source: FactSet

FactSet's bank index is heavily weighted towards financial firms with large retail operations, with top holdings including Bank of America (BAC)  (a 33.11% weighting), Wells Fargo (WFC)  (32%), U.S. Bancorp (USB)  (10%) and PNC Financial Services Group (PNC)  (8%). As the chart above shows, this group performed relatively well during the mid-2000s Fed tightening (the red line above) -- even beating the S&P 500 at some points. However, the chart also shows that the index fell sharply during the 2008 financial crisis and has struggled to even come close to the S&P 500's performance ever since.

The Financial Select Sector SPDR ETF (XLF)   -- the most widely used ETF by investors who seek general exposure to the U.S. banking sector -- has had a similar performance. As this chart shows, XLF (the blue line below) beat the S&P 500 (the green line) at some points in the mid-2000s, but has badly trailed since the 2008 crisis:

Source: FactSet

However, a close look at the chart above shows that XLF didn't lag the S&P 500 quite as badly as FactSet's major-banks index did. Very possibly, this has to do with the fact that the XLF's main component is Warren Buffett's Berkshire Hathaway (BRK.B) , with an 11% weighting. It's followed by Action Alerts PLUS holding JP Morgan (JPM)  with an almost equal weighting of 11%, and then by Bank of America (8.3%), Wells Fargo (7.7%) and Citigroup (C)  (6.2%).

Why did banks' performance generally exceed the S&P 500's during the previous tightening cycle? Experts say it's because banks benefited from higher interest revenues at a time when the U.S. economy was growing robustly. So, there were plenty of opportunities to lend.

In fact, the opportunities were so plentiful that in some cases lenders threw caution to the wind. We all know how that ended.

This time around, it looks like things are better for banks. Despite various commentators worrying about rising debt, U.S. banks have by some measures plenty of room to lend even more. The U.S. credit-to-GDP gap -- an indicator that shows the difference between the current credit-to-gross-domestic-product ratio and its long-term trend -- was at -7.4% in the second quarter, according to the most recent BIS data. It's true that this gap is shrinking -- it was -8% in 2017's first quarter and -9.6% in 2016's second quarter -- but it still indicates that the ratio of credit to GDP is below trend.

One Tailwind: Deregulation 

Regulation was a headwind for banks until not long ago, but deregulation is turning into a bit of a tailwind now.

At an international level, the Basel Committee's oversight body finally agreed on completing Basel III reforms on Dec. 7, 2017. Informally known as "Basel IV" because they're so complex, these reforms are considered by markets to be a new set of rules -- and they put U.S. banks at an advantage over European ones.

After all, U.S. banks rely much less on internal ratings-based models to calculate the riskiness of their assets than European banks. Reliance on internal models is being constrained under the new Basel rules, which favor standardization of calculation methods.

That's not the only good regulatory news for banks, as the Trump administration and its appointees at banking regulators are basically talking like they plan to make a bonfire out of current banking regulations. "To my knowledge, nothing like this has ever happened before in the banking sector," Bove said. "New people are in or about to take all of the key positions."

The Federal Reserve has a new chairman and new vice-chairman in charge of banking regulation, while the Securities and Exchange Commission has a new head. So does the Office of the Comptroller of the Currency. These changes bode well for the financial sector, so much so that Jim Cramer called banks a "fabulous buy" for 2018.

Bove thinks regulators are likely to ease capital and liquidity requirements, as well as eliminate or weaken numerous rules. This includes  the "Systemically Important Financial Institution" designation (or "SIFI"), the "net stable funding ratio" rule and the requirement for banks to establish "living wills."

Other possible reforms include making reporting rules less onerous. The size of banks is also important. Minnesota Fed chief Neel Kashkari told The Street in a recent interview that he favored relaxing legislation on small- and medium-sized banks, as they aren't systemically risky. At the same time, he believes capital requirements for systemically important banks should be raised.

Mergers & Acquisitions

Another key change that's now before Congress would boost the size of banks subject to tighter regulatory constraints to $250 billion in assets vs. the current $50 billion rule.

Bove predicts that if this passes, the measure could unleash a wave of mergers and acquisitions among smaller-size banks. He said that currently, "if your bank goes [to] $50 billion in asset size, there's a staggering increase in regulations. It requires the bank to redo its systems, set up risk mechanisms, hold more capital. The last thing you're going to do when you're going through this process is go and make an acquisition."

But lift the cap to $250 billion and institutions below the increased threshold would be free to merge to grow earnings faster, invest more in new technologies and increase the scale of their operations. Bove said that bank CEOs will think: "I can't cut prices or do stuff like that because the guy across the street will cut his, but I can buy the guy across the street."

The Midwest, where the financial industry tends to be more fragmented, is the area where most mergers and acquisitions could take place. Among banks that Bove thinks could be on the lookout to acquire others are BB&T Corp.  (BBT) , Citizens Financial Group (CFG) , Fifth Third Bancorp (FITB) , M&T Bank (MTB) , PNC Financial (PNC) , Regions Financial (RF) , SunTrust Bank (SNI)  , U.S. Bancorp. and Key Corp (KEY)  (another holding of Jim Cramer's Action Alerts PLUS charity portfolio).

Should You Buy Small Banks or Large Ones?

As for banks below $50 billion in assets, even those that don't get involved in M&A could benefit the most from increasing interest rates. Data from the New York Fed show that these banks have much a higher net interest margin (annualized net interest revenue as a percentage of interest-earning assets) than both medium- and large-sized banks do:

Of course, that's due to the fact that smaller banks don't have other revenue-generating products such as trading activity, wealth management or Treasury services. But that could be just as well in the current environment. After all, trading is stagnating and rich clients are more cost-conscious, so larger banks haven't really had a great deal of success generating those revenues lately.

All told, smaller banks should benefit nicely from rising interest rates as long as they can avoid boosting what they pay depositors for cash. Bove said how long that happens will depend on how long consumer inertia lasts. "I haven't gone to my bank asking them to raise the rate for deposits," he said. "[Such] inertia in the system is benefiting the banks."

For larger banks, revenues and earnings are likely to "rise moderately on the back of likely further increases in market interest rates," according to an "industry report card" issued by rating agency Standard & Poor's. S&P predicted that as the Fed's tightening cycle continues, all large banks will see additional improvements in net interest income. The rating agency also expects the Fed to hike rates three times this year, as the risk of falling behind the curve will outweigh currently soft inflation.

S&P found that net interest margins at JP Morgan, Bank of America and Wells Fargo have already expanded as a result of recent rate hikes. The large U.S. trust banks -- Bank of New York Mellon (BK) , State Street Corp.  (STT) and Northern Trust Corp.  (NTRS) -- also saw their net interest margins increase in 2017's third quarter vs. 2017's second quarter and 2016's third quarter, according to the study, which added that higher interest rates should boost trust banks' profitability. That said, S&P found that net interest margins have fallen at Citigroup as that firm continued to wind down higher-yielding legacy assets. 

The banks above are all institutions that investors should take a look at when researching buying opportunities from the Fed's tightening cycle. As for smaller regional banks, investors might consider the iShares US Regional Banks ETF (IAT) in addition to firms that Bove mentioned above.

What About the Fed's Balance Sheet?

Beyond rising interest rates, banks could also benefit from the Fed's ongoing efforts to shrink its balance sheet.

Bove said the central bank will probably seek to eliminate bank reserves -- that is, give deposits that commercial banks have built at the Fed back to the banks. He noted that bank reserves were an insignificant portion of Federal Reserve funding at the beginning of the financial crisis, but have risen steadily to represent around 54% of Fed funding at present.

As banks can in theory withdraw these deposits any time, the Fed would be only too happy to be rid of such an unreliable source of funding. The banks, in turn, could use the money they get back to lend more, pay down debt or to increase stock buybacks.

Many will probably do some stock buybacks, which should be good for investors over the short term -- but bad over the longer term. Bove believes that buybacks "harm the bank to benefit the stock," as they reduce the amount that banks can lend to customers. This cuts into firms' ability to grow earnings.

"Exxon (XOM) doesn't give away oil," he said -- and "oil" for a bank "is money -- is capital. If you give away capital, you're reducing your company's ability to grow."

Long-Term Risks

Of course, investors should be aware that over the longer term, there are plenty of clouds on the banking horizon.

For instance, S&P analysts expect credit quality to worsen from "benign" current levels as interest rates increase, and this will lead to a need for higher reserves. The areas they monitor are commercial real estate, leveraged loans, credit cards, auto loans and exposure to energy.

Additionally, big banks' non-interest income has been weak and is likely to remain so unless trading and other activities pick up substantially. In fact, Societe Generale recently downgraded its recommendations on Bank of America, JP Morgan and Morgan Stanley (MS) to "Hold" from "Buy" as part of what the firm called a "counter-consensual" move taken in the context of "euphoric" markets after the Trump administration's tax cuts.

SocGen also has "Sell" recommendations on Citi and Goldman Sachs (GS) . "We think tax cuts are priced in, and that the market is underestimating the risk of a turn in the cycle for corporate loans and credit cards," the bank's strategists wrote in a Jan. 9 research note.

Faster interest-rate hikes are also in the cards -- and even though they hardly seem likely now, they could scupper banks' good run in the future. That's because banks will eventually have to increase the rates they pay depositors for money or customers' cash will go elsewhere. "If money-market funds increase rates they're paying, money would move from banks to money-market funds," Bove said. "I think that when the Fed Funds rate closes in on 3%, you'll start to see things happen. The bond markets can't ignore a 3% rate; you'll see rates adjusting there."

The BIS's Borio added that "there is a sense in which the tightening has not really begun." He warned that the past decade's unprecedented period of low interest rates and quantitative easing has built up vulnerabilities around the globe. The biggest ones are high debt levels in some countries (in both domestic and foreign currency), plus "frothy" stock-market valuations underpinned by low government yields.

What's more, Borio warned, "the longer the risk-taking continues, the higher the underlying balance-sheet exposures may become. Short-run calm comes at the expense of possible long-run turbulence."

Investors in banks should keep an eye on the horizon for signs of that turbulence.