Financials - Soft-Landing and Net Interest Margin Tailwinds

The Soft-Landing Thesis:

Stock market despair culminated to close out 2022 as widespread fears of an economic recession became the overwhelming consensus from key economic opinion leaders. Meanwhile the Federal Reserve is attempting to thread the needle of slowing economic activity while simultaneously lowering inflation without pushing the economy into a recession, the so-called “soft-landing”.

The soft-landing narrative hit a bump in the road when above-average inflation as measured via the Consumer Price Index (CPI) continued to show resilient strength. The CPI figure came in at a 0.5% increase in January and rose 6.4% relative to a year ago. Both metrics were slightly higher than economists had forecasted. However, per Jerome Powell, the disinflation process has begun and lowering inflation doesn’t happen in a downward linear fashion. The Federal Reserve is at the tail end of its rate hike cycle and will likely trickle in 25 basis point rate hikes until inflation is curbed. It is widely expected that the Federal Reserve will hold rates higher for longer than previously predicted.

With unemployment at the lowest levels in over 50 years at 3.4% and a record number of job openings, this combination feeds into the soft-landing thesis. The strong labor market can likely absorb additional rate hikes without driving the economy into a recession. Outside of the tech-centric layoffs, if job openings are paused rather than an elimination of jobs via widespread layoffs then the soft-landing thesis is attainable.

Soft-Landing and Banks:

With a resilient labor market and the Federal Reserve at the latter stages of its rake hike cycle, banks are well positioned. With a strong labor market underpinning the rate hike cycle, a goldilocks scenario may be an outcome. On the loan front, banks’ underwriting standards have greatly been overhauled since the days of the Financial Crisis. Passage of annual stress tests are now mandatory and model a worst-case economic scenario. Despite the slowdown in housing, lack of total loan volume will be partially offset by loans at higher rates. Additionally, the consumer has been resilient and household spending has held up strongly, specifically in travel and leisure. Credit card spending continues at a robust clip while charge-offs remain at low levels. This economic backdrop does not present any systemic risk to the financial system.

Net Interest Margin Income:

Net interest margin income is an important financial measure that is essentially the difference between interest paid out on deposits and interest received via loans. This boils down to the revenue generated by its loans and interest paid out on its deposit base. As rates increase, net interest margin expansion disproportionality benefits the banks. The interest rate paid out to consumers’ savings accounts lags each interest rate increase by the Federal Reserve. With each step-function increase in rates, net interest margin income flows to bottom line profit.

Bank stocks perform well in a rising interest rate environment as the interest income earned from loans rises faster than what they pay for funding. Additionally, the banks’ deposit base can be invested in risk-free treasuries at a higher rate than what is paid out to their deposit base. The higher interest rates go, the greater the net interest income banks earn. Banks will generate billions in net interest margin income throughout 2023.

Conclusion:

The Federal Reserve is attempting to thread the needle of slowing economic activity while simultaneously lowering inflation without pushing the economy into a recession, the so-called “soft-landing”. The Federal Reserve is at the tail end of its rate hike cycle and will likely trickle in 25 basis point rate hikes until inflation is curbed. With unemployment at the lowest levels in over 50 years and a record number of job openings, this combination feeds into the soft-landing thesis. The strong labor market can likely absorb additional rate hikes without driving the economy into a recession.

Net interest margin expansion will continue with each step-function increase in rates, flowing to the bottom line. Rates will remain elevated for longer, benefiting the banks. The financial cohort is poised to benefit via a confluence of a possible soft-landing, net interest margin expansion, financially robust balance sheets and easy passage of annual stress tests to support expanded buybacks and increased dividends. Bank of America (BAC), JPMorgan Chase (JPM), Morgan Stanley (MS), Citigroup (C) and Goldman Sachs (GS) are well suited to ride this wave to higher stock prices.

Disclosure: Stock Options Dad LLC is a Registered Investment Adviser (RIA) firm specializing in options-based services and education. There are no business relationships with any companies mentioned in this article. This article reflects the opinions of the RIA. Any recommendation contained in this article is subject to change at any time. No recommendation is intended to constitute an entire portfolio. The author encourages all investors to conduct their own research and due diligence prior to investing or taking any actions in options trading. Please feel free to comment and provide feedback, the author values all responses. The author is the founder and Managing Member of Stock Options Dad LLC – A Registered Investment Adviser (RIA) firm www.stockoptionsdad.com defining risk, leveraging a minimal amount of capital and maximizing return on investment. For more engaging, short duration options-based content, visit Stock Options Dad LLC’s YouTube channel. Please direct all inquires to info@stockoptionsdad.com. The author holds shares of AAPL, ACN, ADBE, AMD, AMZN, ARKK, AXP, BA, BBY, C, CMG, COST, CRM, DIA, DIS, EW, FDX, FXI, GOOGL, GS, HD, INTC, IWM, JNJ, JPM, LULU, META, MS, MSFT, NKE, NVDA, PYPL, QCOM, QQQ, SBUX, SPY, SQ, TMO, UNH and V.

NOTE: This article and its content has been exclusively created and published by stockoptionsdad.com. This article may not be redistributed or published without consent by Stock Options Dad LLC.