Bank Shares Exhibit Cyclical Tendencies?
Bank Shares Exhibit Cyclical Tendencies?
Cyclical corporations issue shares by companies whose businesses and share prices follow the economic cycle. They normally perform well during economic expansions but usually underperform during recessions as sales decrease.
Automakers serve as a suitable example of a cyclical enterprise. When a recession occurs, consumers may opt to delay buying new vehicles, resulting in declining sales. Similarly, airlines, hotels, restaurants, and major retail merchandisers, like clothing companies, are also cyclical businesses. When the economy thrives, more individuals can afford to travel, stay at hotels, dine out, and purchase luxury items.
Defensive stocks, on the other hand, are the opposite of cyclical stocks. Also known as recession-resistant stocks, these corporations maintain consistent sales and profits regardless of the economy's conditions.
In this article, we examine the banking sector to determine whether bank shares are cyclical investments.
Cyclicality
Are bank stocks cyclical?
The simple answer is yes. Banks are largely affected by recessions due to several factors.
First, interest rates tend to fall during recessions. As banks' primary business model revolves around lending money and generating profit, lower interest rates can lead to falling profits. For instance, if a bank's average auto loan interest rate is 8%, it would generate more income than if the average rate were five percent.
Second, and most notably, unemployment rises during recessions, which results in a significant increase in loan defaults for banks. Consumers often struggle to meet their financial obligations during recessions, causing a surge in loan losses for banks.
While this is generally true, it's essential to bear in mind that every bank is unique. Consumer banking (accepting deposits and lending money) is highly cyclical, especially for banks that focus on riskier forms of lending, such as credit cards. However, some aspects of investment banking, like equities trading, often perform better during difficult times. Consequently, banks with large investment banking operations usually experience profits that remain relatively stable.
Inflationary effect
Bank stocks in inflationary environments
It is crucial to address the impact of inflation and rising interest rates on bank shares, given that inflation reached a multi-decade high only a few years ago, and the Federal Reserve increased rates to combat it. Essentially, these economic factors can be both beneficial and detrimental.
On the positive side, high inflation means that goods and services become more expensive, so average loan amounts tend to increase. In this scenario, if vehicle prices rise by ten percent, a bank's auto loan volume should also increase by the same amount. Since banks earn income from interest on loans, rising interest rates usually translate to higher interest margins.
On the negative side, high inflation and increasing rates can lead to a slowdown in consumer spending. Consumers may be more cautious about purchasing homes when mortgage rates are at seven percent, compared to three percent, or when the average home price is thirty percent higher than five years ago.
Moreover, as interest rates and costs escalate, more individuals may struggle to meet their financial obligations, resulting in an increase in loan defaults. Ultimately, some inflation and rising interest rates can be beneficial for banks, but excessive inflation and interest rates can cause loan volumes to decrease and default rates to increase.
Cyclical stocks
3 cyclical bank stocks
Given this context, here are three cyclical bank stocks, meaning these banks are highly susceptible to recessions but also tend to perform well during prosperous times.
1. Capital One Financial
Capital One Financial (COF 0.22%) is a comprehensive regional consumer bank with a substantial branch network and various types of loan products. However, Capital One primarily focuses on credit card lending (approximately half of its loan portfolio), making its business highly cyclical.
In good times, substantial profit can be generated with credit card lending. As of 2024's late autumn, the average credit card interest rate is approximately 25%, offering significant revenue potential. However, credit cards have relatively high default rates (four to five percent charge-off rates are common, even in robust economies) that can escalate during challenging times.
2. Wells Fargo
*Wells Fargo (WFC -0.24%) is a member of the renowned "big four" U.S. banks. The other members are Bank of America (BAC 0.09%), JPMorgan Chase (JPM 0.16%), and Citigroup (C* 0.0%).
Of these, Wells Fargo is the only bank without a substantial investment banking business to maintain profits during periods of high unemployment and low interest rates. If the U.S. economy were to enter a recession, it wouldn't be surprising to see Wells Fargo perform worse than its major bank peers.
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Many people associate *American Express (AXP -0.18%) with credit card networks. However, unlike competitors such as Visa (V 0.23%) and Mastercard (MA 0.19%)*, American Express also operates as a bank.
While Visa and Mastercard work with banks (like Capital One) to provide loans to customers, American Express operates as a "closed loop" payment network. This means that not only does the company process payments, but it also extends credit to its customers.
American Express' cyclical nature is somewhat tempered by its clientele's affluence and smart lending practices, as well as its reliable revenue stream from the payment network. However, the company's heavy reliance on credit card lending makes American Express a highly cyclical bank stock.
FAQ
Cyclical Bank Stocks FAQ
Are bank stocks categorized as cyclical stocks?
In general, bank stocks are considered cyclical businesses. They tend to perform well during strong economic periods and poorly during recessions and other economic disruptions.
Are bank stocks safe during a recession?
Demand for loans tends to decrease during recessions, and default rates on existing loans tend to rise. However, each bank stock's safety level depends on the specific company and its business. It's generally a good idea to expect bank stocks to underperform during a recession. However, banks typically have more than enough capital reserves to weather the storm.
Is investment banking cyclical?
Certain aspects of investment banking, such as IPO and debt underwriting, can become scarce during difficult economic times. But other parts, such as equity and fixed-income trading, tend to thrive in volatile market environments.
Do bank stocks perform well when interest rates fall?
The impact on bank stocks can vary depending on factors such as deposit costs and consumer loan demand. In a falling-rate environment, online banks with high deposit costs may see greater benefits, while large banks may benefit from both lower deposit costs and increased loan demand.
Citigroup, JPMorgan Chase, Bank of America, and Wells Fargo are advertising partners of Our Website Money. Matt Frankel has positions in American Express, Bank of America, and Capital One Financial. Our Website has positions in and recommends Bank of America, Goldman Sachs Group, JPMorgan Chase, Mastercard, and Visa. Our Website recommends the following options: long January 2025 $370 calls on Mastercard and short January 2025 $380 calls on Mastercard. Our Website has a disclosure policy.
In the context of the text, here are two sentences that contain the words 'finance', 'investing', and 'money':
- Given the cyclical nature of bank stocks, investors might want to consider diversifying their portfolio to include defensive stocks during periods of economic uncertainty.
- If you're interested in investing in cyclical bank stocks, it's essential to research individual banks' business models and their resilience during economic downturns to make informed decisions.