Macro Wrap – Long Live Bailey Savings and Loan, $KRE, $WFC, $C, $GS

by Enis July 9, 2013 8:01 am • Commentary

There has been a major dichotomy within the financials sector in the past couple months.  International investment banks have struggled, while U.S.-centric commercial and regional banks have been strong market leaders.  To illustrate, here is the chart of the year-to-date performance of WFC (black) and KRE (orange), to represent the large commercial and small regional banks, vs. C (red) and GS (green), to represent the internationally-exposed investment banks:

Year-to-date performance chart of WFC, KRE, C, and GS, Courtesy of Bloomberg
Year-to-date performance chart of WFC, KRE, C, and GS, Courtesy of Bloomberg

At the market peak in mid-May, C and GS were major outperformers relative to their commercial and regional bank peers.  At the time, international equity markets were generally rising in unison.  Interest rates were still near all-time lows, and fears of tapering were non-existent.

Since mid-May though, global equity markets have drastically underperformed U.S. markets.  Interest rates have risen rapidly around the world, and tapering is a legitimate concern for the second half of 2013.  Against that backdrop, C and GS are still substantially lower compared to their mid-May highs, while WFC and KRE have broken out to new 2013 (and multiyear) highs.

Here is what Dan wrote in his Name That Trade post from yesterday:

For the moment it appears the “investment banks” like GS & MS as opposed to the “money-center banks” like JPM & WFC have underperformed off of the June 24th lows in the SPX, and frankly act very tired in front of their July 16th & 19th respective Q2 earnings releases.

Meanwhile, the regional banks have been much stronger, with KRE making a new bull market high last week.  They are in the bread and butter business of boring banking, where they borrow short and lend long.  In that sense, investors are getting optimistic that the rise in interest rates might finally give their earnings power a boost in the quarters to come.

There are 2 main forces at work in this dichotomy.  First, as international markets become more volatile, the investment banking stocks generally underperform.  Capital markets activity (such as IPOs and M&A) become more subdued, and investors simply assign a lower market multiple to the more volatile profits in the trading businesses.  Second, higher interest rates are more beneficial in the long run for the commercial and regional banks, who have much less flexibility than the investment banks in generating alternative revenue streams.  That simplicity can serve as a benefit when rates move rapidly higher.

Finally, the risks within the European banking system remain elevated.  The SX7E European banking index is still near 10 month lows, even after last week’s ECB bounce.  Within that context, investors are going to continue to prefer American banks with no European exposure.  Long live Bailey Savings and Loan.