We recently had the opportunity to meet senior management of over a dozen U.S. mid-cap banks headquartered in the Washington, DC area. Anchored by the capital city, the Washington-Arlington-Alexandria MSA (Washington MSA) is the sixth largest U.S. MSA ([1]) with real GDP of US$507 bln ([2]) and a population of 6.3 mln. Importantly, it is also the second wealthiest MSA ([3]) in the entire country, supported by a strong labour market ([4]). While not completely “recession-proof”, the large impact on the economy from government spending provides a strong economic and demographic backdrop across economic cycles. While the bankers we met expressed optimism for the local economy’s prospects supported by robust private and public sector demand, a benign credit cycle and ongoing bank consolidation, they had some concerns about margin trends.
Note to Reader: This Insight includes references to certain Hamilton ETFs that were active at the time of writing. On June 29, 2020, the following mergers took place: (i) Hamilton Global Financials Yield ETF and Hamilton Global Bank ETF into the Hamilton Global Financials ETF (HFG), (ii) Hamilton Australian Financials Yield ETF into the Hamilton Australian Bank Equal-Weight Index ETF (HBA); (iii) Hamilton Canadian Bank Variable-Weight ETF into the Hamilton Canadian Bank Mean Reversion Index ETF (HCA), and (iv) Hamilton U.S. Mid-Cap Financials ETF (USD) into the Hamilton U.S. Mid/Small-Cap Financials ETF (HUM).
The financials operating in this MSA are primarily mid-cap banks. Three of Hamilton ETFs’ have exposure to this sub-sector– Hamilton U.S. Mid-Cap Financials ETF (HFMU.U), Hamilton Global Financials Yield ETF (HFY) and Hamilton Global Banks ETF (HBG).
Below are the main takeaways from our meetings:
Stable Economic Outlook for Washington
With a real GDP of $507 bln, Washington boosts of a large and stable economy. Federal spending accounts for ~30% of the region’s GDP ([5]) and tends to even out economic cycles. In the private sector, Washington is home to 15 Fortune 500 companies. Earlier this year, Amazon picked the DC suburb of Arlington, VA as the location for its coveted second headquarter. Over time this is broadly expected to attract more companies in the technology and related sectors into the region. Overall, bankers we met were confident of the region’s economic outlook.
Credit Cycle Benign with Few Signs of Stress; Community Banks Selective on Construction Loans
Amid robust economic growth in both the U.S. and this MSA and steady consumption outlook, bankers see few (if any) signs of borrower stress. The credit cycle remains benign with sporadic incidents of credit deterioration restricted to specific circumstances related to either borrower (for instance, fraud) or sector (retail, fast food restaurants).
In 2019 credit growth is expected to be in the mid-to-high single digit range for most of the participating banks. Within overall lending, competitive intensity remains high in CRE lending particularly for high quality, stabilized assets driven by institutional demand (from life insurers, pension funds, private equity/debt managers and others). Amid heightened economic uncertainty and downward pressure on asset yields, a few of the community banks in the region have consciously reduced volume growth targets and in certain cases exposure to the construction sector (particularly development).
A pickup in mortgage originations is expected to help offset some of this demand slowdown. Generally, most banks in the region were looking to add to C&I lending capabilities in order to build a more diversified and less CRE dependent loan portfolio.
GDP Growth Supports Loan Growth; Margin Outlook Muted Near-Term
Since 2007, GDP grew at a CAGR of ~2.7% for the Washington MSA, which was higher than the U.S. average of just over 1.6% ([6]). Given the health and resilience of the underlying economy, loan growth is expected to be in the mid-to high single digit range in 2019. However, after two years of highly material expansion in net interest margins, the outlook for the next twelve months is more muted, given the decline in the benchmark LIBOR rate ([7]). This has caused asset yields to drift lower in the quarter even as funding costs are expected to decline with a lag. As a result, net interest margins (“NIMs”) are expected to largely remain under pressure in Q3. A few of the larger banks highlighted the use of interest rate swaps and floors as tools to offset NIM pressure.
Most banks expect NIMs to stabilize towards year-end as lower funding costs flow through (particularly for the long-dated certificates of deposits).
M&A Wave to Continue; Elevated Valuations Cool Near-term Outlook
While bankers share our view on secular, long-term trend towards consolidation in the region, near-term elevated seller expectations (particularly for franchises with attractive and sticky deposit bases), activity in the short-term could remain muted. For example, lower bank stock valuations, an uncertain economic backdrop (2020 U.S. elections, U.S.-China trade war headlines, rate outlook) and new credit loss provision accounting rollout ([8]) are all impacting activity.
Banks continue to seek opportunistic and accretive bolt-on acquisitions especially as recent M&A in the region (including the BBT/STI transaction; see our February 8, 2019 insight, “U.S. Bank M&A: Implications from the Largest Deal in a Decade”) has resulted in both customer relationships and key employee contracts being up for grabs. General preference remains for contiguous or in footprint M&A.
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HFMU.U Posts Robust 13% EPS Growth Y/Y; 500 bps Ahead of U.S. Large-Cap Financials
Insights from Atlanta: (Growth, M&A) Going Strong
Notes from Chicago: Opinions on the Canadian Banks (part 1)
A word on trading liquidity for ETFs …
Hamilton ETFs are highly liquid ETFs that can be purchased and sold easily. ETFs are as liquid as their underlying holdings, and the underlying holdings trade millions of shares each day.
How does that work? When ETF investors are buying (or selling) in the market, they may transact with another ETF investor or a market maker for the ETF. At all times, even if daily volume appears low, there is a market maker – typically a large bank-owned investment dealer – willing to fill the other side of the ETF order (at net asset value plus a spread). The market maker then subscribes to create or redeem units in the ETF from the ETF manager (e.g., Hamilton ETFs), who purchases or sells the underlying holdings for the ETF.
Notes
[1] An MSA is typically a large city and outlying suburbs, analogous to the Greater Toronto Area (“GTA”). MSAs are defined by the U.S. Office of Management and Budget.
[2] Federal Reserve Bank of St Louis; For 2018
[3] Washington MSA’s median household income of $99,669 is 35% higher than U.S. average of $60,336; Source: 2017 Census
[4] Unemployment rate of 3.3% compared to U.S. average of 3.7%; as of July-19
[5] Source: Stephen S. Fuller Institute – George Mason University
[6] St Louis Federal Reserve
[7] Benchmark 3 month and 1-month LIBOR rates have declined 18bps and 37bps QTD respectively.
[8] Current Expected Credit Losses (CECL) is a new credit loss accounting standard that was issued by the Financial Accounting Standards Board (FASB) on June 16, 2016. CECL replaces the current Allowance for Loan and Lease Losses (ALLL) accounting standard. The CECL standard focuses on estimation of expected losses over the life of the loans, while the current standard relies on incurred losses. The standard is set for implementation January 1, 2020.