How inflation, falling peso affect bank stocks?

Bank stocks are known to thrive in a rising interest rate environment because of the perception that higher interest rates will lead to greater earnings growth.

But ever since uncertainties over rising inflation and falling peso began early this year, bank stocks as represented by the financial sector index have lost as much as 32 percent from its peak, more than the 24 percent loss of the PSE index.

Rising interest rates as a result of increased inflationary expectations raises the risk of higher funding costs among banks, which in turn lower their profitability.

Banks, in general, are sensitive to interest rate volatility because they rely primarily on their nominal assets for cash flows, which are fixed in nominal terms, such as debt, cash and accounts receivables.

A weakening peso, on the other hand, exposes a bank to changes in exchange rate risks. Banks may be affected from short-run exposure that arises from foreign exchange trading.

Banks’ net foreign positions can also be affected by mismatches between the currencies in which their assets and liabilities are denominated, resulting in translation gains or losses.

Historically, bank stocks are negatively correlated with interest rate and the peso. Based on statistical data for the last 22 years since 1996, changes in interest rates and peso-dollar movement have negatively affected the returns of the financial sector index in 47 percent of the time.

This negative correlation became even stronger in the last 10 years where the returns of bank stocks since 2008 were influenced by volatility in interest and exchange rates in 67 percent of the time.

Interestingly, between the two risk factors, bank stocks are more vulnerable to changes in interest rates with negative correlation of 38 percent compared to peso correlation of only 6 percent.

With the market expecting interest rate to go up some more coupled with further weakness in the peso before the end of the year, there is a strong likelihood based on historical behavior that bank stocks will continue to fall.

Same time last year, the median hurdle rate of bank stocks was 7.2 percent. This was when the 10-year Philippine bond yield was only at 4.6 percent. Today, with inflation and the peso reaching multi-year record high, the median hurdle rate has increased to 9.4 percent.

The increase in hurdle rate has caused the implied value of expected growth embedded in bank stocks’ prices, on average, to shrink from 46 percent to a negative 2 percent.

The rise in hurdle rate also narrows its margin with the banking sector’s historical median return on equity of 9.6 percent from 2017 to only 0.2 percent.

Early indicator based on first half earnings this year already points to a declining return on equity with a trailing 12-month rate of 9 percent.

Falling returns on equity against an increasing cost of equity, that is, the hurdle rate, will result in rising negative residual returns, which will affect stock valuations in the long-term.

The median price-to-book value ratios have already declined to 1.02 times with some bank stocks already trading at below their book values.

Despite the risks of higher interest rates, it may be worth noting that there are some bank stocks that may be potentially underestimated by the market with negative growth values despite positive residual returns.

These bank stocks may be worth a second look for further research: Asia United Bank, which is trading at 49 percent discount to its minimum value per share at today’s risk; China Bank, 18.3 percent; East West Bank, 93 percent and Union Bank, 46 percent.

Interest rate increases may be good for banks because they indeed raise revenues and possibly earnings, but they may be bad because they also raise the minimum return that banks should earn, triggered by higher risks.

While the market may be pessimistic on the growth outlook of the banking sector as a whole for now, market perception will always change in the future once interest and the exchange rates stabilize.