The results of the Federal Reserve's annual stress tests are in and the good news is that the Fed views the largest U.S. banks as well-capitalized, but there are still some ominous signs to consider.
Proving that markets remain leery of the dividend outlook for the big banks, the Direxion Daily Financial Bear 3X Shares (NYSE:FAZ) surged almost 10% last Friday on above-average volume. FAZ attempts to deliver triple the daily inverse returns of the Russell 1000 Financial Services Index, which includes more than just banks.
“However, the newly introduced stress capital buffer (SCB), as well as the novel approach of limiting dividends based on recent earnings, will likely force some U.S. banks to reduce dividends in the near term, which would be prudent given the still significant economic uncertainty,” said Fitch Ratings in a note out last Friday.
Why It's Important
While the bank-specific directives from the Fed are still to come, the fact of the matter is the central bank is telling banks that they can't engage in buybacks and dividends, at best, are now capped. Focusing on dividends for a moment, with growth on that front now limited for the time being, there's little reason to be engaged with bank stocks and traditional beta exchange traded funds focusing on the sector.
The reasoning here is simple: bank stocks are value stocks at a time when value is getting killed by growth. Second, with interest rates low, banks' net interest margins are depressed. With payout growth off the table, the other two bearish factors mentioned here enhance the case for FAZ.
“Notably, the Fed has mandated the suspension of bank share repurchases for 3Q20, which Fitch had expected banks to implement given the uncertainty of the economic environment,” according to Fitch. “However, the Fed’s new approach to capping dividends in 3Q20 to levels no higher than trailing four-quarter average of net income was unexpected and viewed as potentially a 'catch-all' for those banks that still fared relatively well under DFAST with limited capital erosion despite recent weak earnings.”
As just two examples, there's talk Capital One (NYSE:COF) and Wells Fargo (NYSE:WFC) – two members of the Russell 1000 Financial Services Index – are candidates to cut dividends. That would likely be good news for FAZ.
“If bank earnings continue to be pressured given large expected provision expenses in 2Q20, coupled with margin and other revenue challenges, dividend payout levels for U.S. banks will likely be reduced over time,” notes Fitch.