Outlook for BMO ETFs Amid Recent U.S. Bank Downgrades

Snapshot

A weakening commercial real estate market, among other factors, has led to several U.S. regional banks receiving downgrades from both Moody’s and Standard & Poor’s, trusted credit rating agencies. Portfolio Manager Alfred Lee shares three potential catalysts for the sector and his outlook for BMO U.S. Banks ETFs.

Details

• BMO Equal Weight US Banks Index ETF (Ticker: ZBK)
• BMO Equal Weight US Banks Hedged to CAD Index ETF (Ticker: ZUB)
• BMO Covered Call US Banks ETF (Ticker: ZWK)

Benefits

• Large U.S. banks are well-positioned to withstand a recession, according to the Fed’s annual stress test results in June¹
• We have seen shares outstanding on all three of our U.S. bank ETFs, showing demand from longer-term investors seeking value
• The BMO Covered Call US Banks ETF (Ticker: ZWK) allows investors to monetize volatility in the U.S. banking sector through a covered call option overlay

Some U.S. banks get a downgrade, others on watch

U.S. banks remain in the headlines, with Moody’s recently downgrading several of them, placing more on review and assigning others a ​“negative” outlook. Last week, Standard & Poor’s (S&P) reaffirmed these views, downgrading some lenders — particularly regional banks with high exposure to commercial real estate (CRE) exposure.

Moody’s Recent Downgrades on U.S. Banks

Source: Moody’s, Bloomberg.

The recent downgrade worries add to the default concerns small regional banks faced in March. As we highlighted earlier this year, the U.S. Federal Reserve (Fed)’s rapid tightening of monetary policy put pressure on regional banks’ Held-to-Maturity (HTM) portfolios. The Fed, which responded by backstopping the Federal Deposit Insurance Corporation (FDIC) full-stop and creating the Bank Term Funding Program (BTFP), has helped in alleviating the stress in the sector, as evidenced by the declining prices of credit default swaps (CDS) on some lenders since that period.

The Fed — which released its annual stress test results in June — showed all 23 participating U.S. banks had passed. The central bank uses this test to assess whether a bank can withstand a severe global recession. Parameters include having enough capital on hand to absorb losses and continue lending if unemployment hits 10% and the stock market plunges 45%. The stress test is revised annually to ensure it applies to the current environment, and this year includes a 40% drop in CRE. It should be noted, however, that the test comprises mostly larger to mid-sized lenders and would not capture unforeseen events, such as the 2020 COVID-19 pandemic. 

Despite the concerns, we have seen shares outstanding on all three of our U.S. bank ETFs: BMO Equal Weight US Banks Index ETF (Ticker: ZBK), BMO Equal Weight US Banks Hedged to CAD Index ETF (Ticker: ZUB) and the BMO Covered Call US Banks ETF (Ticker: ZWK), illustrating demand from longer-term investors seeking value, with the current price-to-earnings (P/E) ratio on ZBK/ZUB at 5.56x and ZWK at 8.25x, as of August 25, 2023.²

Source: Bloomberg, BMO Global Asset Management Inc. 

Three potential catalysts

1. Normalization of the yield curve. The yield curve, which has remained inverted since early July 2022, tends to signal a slowing economy. In recent weeks, longer rates have moved higher, which can be interpreted as the yield curve moving toward normalization. While recent moves in the yield curve have been more of a bear steepener, its likely shorter-term rates will not move lower until 2024, when the Fed becomes more comfortable that inflation has been tamed. A normalized yield curve would signal a more stable economy and create a more favourable economic backdrop for lenders.
2. Repurposing of CRE. Working From Home (WFH) has become a trend that has persisted after the COVID-19 pandemic. As a result, capacity rates in office buildings have remained low, which has been an overhang on many of the regional lenders. However, an emerging trend is ​“adaptive reuse,” or repurposing commercial real estate. This potentially removes some of the glut of supply in office real estate over the long term.
3. Loan losses are less than anticipated. U.S. banks have set aside provisions in anticipation of loan losses. The labour market, however, has proved to be more resilient than expected despite the Fed’s efforts to slow the economy. Borrowers that took out long-term mortgages or refinanced at lower rates have been reluctant to move, and the housing market has not fallen as projected.

Outlook for our U.S. bank ETFs

Unlike in 2009 and 2020, we don’t anticipate a rapid recovery in U.S. bank stocks, as they were driven by quantitative easing and aggressive cuts to the overnight rate at the time. Today, we have the opposite policies, with quantitative tightening and higher interest rates expected to be more resilient. 

However, the low valuations of ZBK/ZUB and ZWK may make it appealing for longer-term investors. The net dividend yield is 3.4% on ZBK/ZUB and 11.7% on ZWK, as of August 25, 2023,² which is supplemented through the covered call option overlay.

While we see potential volatility in the sector, the Fed’s BTFP backstop measures and support of the FDIC have, so far, proven to provide some stability to the regional banks. However, we prefer ZWK for exposure to the space, as it allows investors to monetize volatility. The option overlay process is conservative, covering only 40% of the portfolio and utilizing out-of-the-money options, so investors still participate in some of the upside should the market rally. 

¹ ​“Federal Reserve Board releases results of annual bank stress test, which demonstrates that large banks are well positioned to weather a severe recession and continue to lend to households and businesses even during a severe recession,” Federal Reserve Board, June 28, 2023.

² Bloomberg, as of August 25, 2023.