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Bank ETFs: Value Play of Value Trap?

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Wall Street has been witnessing excessive gyrations for the past few days, thanks to the coronavirus pandemic. The S&P 500 has seen 9% swings in three consecutive trading days for the first time since 1929. Goldman Sachs’ chief U.S. equity strategist David Kostin cautioned that the benchmark index may not bottom until 2,000, as quoted on Bloomberg. Recession fears are also full-blown.

In such a trying situation, global central banks are coming to the rescue of economies and markets. The Fed has cut interest rates this month by 1.5% to zero (for the first time since the 2008 financial crisis) and has also started QE policy of purchasing at least $700 billion worth of Treasury bonds and mortgage-backed securities over the next few months. The Fed stated, “The effects of the coronavirus will weigh on economic activity in the near term and pose risks to the economic outlook.”

Are Banks in Trouble?

Banks underperform in a low-rate environment. Since banks borrow money at short-term rates and lend capital at long-term rates, steepening of the yield curve bodes well for bank stocks and ETFs.

The Fed action has dragged down short-term bond yields this month. If risk-on sentiments improve in the market, long-term bond yields would rise, resulting in a steeper yield curve, which is a positive for banks.

But if there is more fear in the market, safe-haven trade may keep the long-term yields extremely low, resulting in a flattening yield curve and hurting banks further. The restart of QE measure is also likely to keep long-term bond yields in check.

But there is one clear worry – amid economic slowdown, there could be a rise in delinquency rates, affecting banks’ asset quality. Global companies are drawing down their line of credit, forcing banks to disburse large sums of money, per an article published on Wall Street Journal. With expectations of economic depression doing the rounds, default of a line of credit is possible.

The growing risk of a global recession owing to the rising coronavirus fears will likely hurt demand for high-quality loans too, which will cause trouble for the sector. With cities on quarantine and activities coming to a standstill, demand for loans from household and corporations is likely to drop. The biggest American banks — known for shareholder value maximization — announced a suspension of buybacks.

No wonder, lower net interest income and suspended buybacks will drag down earnings of financial companies this quarter and the next. U.S. banks may be downgraded by Moody’s Investors Service amid the Federal Reserve’s rate cut and the global pandemic.

Any Silver Lining?

“The quantitative easing will support banks’ already strong liquidity,” per Moody’s. Amid a QE scenario, a central bank buys financial assets from commercial banks and other financial institutions, thus raising prices of those financial assets (read: Must-Watch ETF Areas on 2nd Fed Rate Cut of 2020 & QE Launch).

ETFs in Focus

Having said all, we would like to note that banks still have cheaper valuation. If there is any improvement in the reporting of coronavirus cases and risk-on sentiments, banks are likely to bounce back sharply. Till then, keep a close tab on SPDR S&P Bank ETF (KBE - Free Report) , Financial Select Sector SPDR ETF (XLF - Free Report) and iShares U.S. Financials ETF (IYF - Free Report) (read: Banking Earnings Mixed, ETFs Gain Moderately).

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