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Trade War Escalation Likely to Hurt Bank Stocks' Prospects

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On Friday, both the United States and China announced fresh round of tariffs, and President Donald Trump tweeted that the U.S. companies should “start looking for an alternative to China.” Less chance of any near-term end to the trade war sent investors scurrying from stock markets to safe havens like bonds and gold.

Therefore, stock markets fell sharply. All three major indices — the S&P 500, the Dow Jones and Nasdaq — tanked 2.6%, 2.4% and 3%, respectively.

Similarly, all the sectors including bank stocks didn’t remain untouched. Notably, KBW Nasdaq Bank Index declined 2.8% and SPDR S&P Bank ETF (KBE - Free Report) dipped 3%.

Big global banks — JPMorgan (JPM - Free Report) , Bank of America (BAC - Free Report) , Citigroup (C - Free Report) and Wells Fargo (WFC - Free Report) — lost 2.5%, 2.7%, 3.1% and 2.6%, respectively. Also, several smaller, domestic banks including Prosperity Bancshares (PB - Free Report) , Huntington Bancshares, Cullen/Frost Bankers (CFR - Free Report) and Zions Bancorporation declined more than 2.5%.

As the demand for bonds increased, the 10-year Treasury yields sank to its lowest level since August 2016. Also, earlier this month, for the first time since 2005, the yield on the 10-year Treasury note dipped below the yield on the two-year bill.

Yield curve has been inverting since December 2018, and the trend has gained strength in the recent months. Economists see this as an early indication of an impending recession.

For banks, which are already reeling under tough operating backdrop, this is bad news. Banks earn interest income by charging borrowers higher long-term interest rates while doling out smaller interest rates to depositors. This results in improvement in net interest margin (NIM).

As the yield curve inverts and the spreads between short-and long-term rates narrows down, growth in banks’ interest income will get hampered and lead to decline in NIM.

Further, escalating trade war and inversion of yield curve will put pressure on the Federal Reserve to cut rates aggressively (after having once cut the rates in July). Already, the CME FedWatch tool is predicting approximately 99% chance of interest rate cut happening in September. Also, analysts are expecting two more cuts before the year end.

Moreover, the ongoing uncertainty related to the trade war, Brexit and several other geopolitical matters have led to sluggish demand for loans for the past several quarters. The same has become more pronounced this year as these concerns have led corporates to delay capital investments.

Hence, all these factors are expected to hurt banks’ prospects in the near term. While banks are undertaking restructuring and streamlining initiatives against the impending downturn, investors must be cautious and invest in fundamentally sound banks to earn solid long-term returns.

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