MS analysis: Midcap banks upgraded to attractive as tide turns with rate cuts

Investing.com - Morgan Stanley upgraded the midcap banking industry to "Attractive" on Monday, amid growing expectations that the Federal Reserve will begin cutting interest rates.

This move is expected to lower funding costs and boost loan demand, providing a positive outlook for Net Interest Income (NII) which is projected to grow steadily through 2025. Valuations are currently at a 4x discount compared to historical norms, making midcap banks an appealing investment.

Key Insights from Morgan Stanley Analysts:

Rate cuts are set to reduce funding costs and stimulate loan demand, which is credit-positive for the midcap banking sector. The Q2 2024 earnings reports have increased confidence that NII is at a turning point, with expected steady growth through the next year. Given the current cheap valuations, Morgan Stanley has upgraded its view of the sector to "Attractive."

NII as a Major Growth Driver:

The primary factor behind the upgrade is the projected increase in NII, which accounts for 80% of revenues for the banks covered. After several quarters of decline, Morgan Stanley expects NII to rise each quarter as the Federal Reserve cuts rates. This will initially be driven by improved net interest margins, as banks can swiftly reduce deposit costs. Growth will further accelerate in 2025 as loan demand increases, with a forecasted 11% median rise in NII from Q2 2024 to Q4 2025.

Credit Quality and Rate Cuts:

The stabilization of credit quality has been pivotal. During Q2 2024, nonperforming loans—a leading indicator of credit losses—increased minimally by 1 basis point, down from higher increases in previous quarters. While commercial real estate (CRE) pressures are currently concentrated in the office sector, lower rates are expected to help stabilize both CRE and Commercial&Industrial (C&I) net charge-offs. Overall, NCOs are anticipated to peak in the near term and then stabilize or decline through 2025.

Valuations Remain Attractive:

Despite recent gains, midcap banks are still trading at a significant discount. The current trading multiple is 10x the 2025 EPS estimate, compared to a historical average of 14x. Morgan Stanley has increased price targets and EPS multiples but maintains a conservative approach given lingering credit concerns. They see a median 22% upside for the sector, with a more substantial 30% potential for their top picks.

Rationale for the Upgrade:

1. Increasing NII: As revenue growth is the most crucial driver for the midcap banking sector, the anticipated rise in NII supports the case for higher valuations and improved stock performance.
2. Rate Cuts Alleviating Credit Pressure: Lower interest rates are expected to enhance credit quality, allowing banks more flexibility to work with borrowers and reduce stress on debt service coverage ratios.
3. Attractive Valuations: Current valuations remain low compared to historical levels, and steady NII growth through 2025 should bring multiples closer to those historical averages.

Top Picks and Positioning:

Based on their analysis, Morgan Stanley favors midcap banks with higher quality assets and greater liquidity, such as M&T Bank Corp (NYSE:MTB), Huntington Bancshares Incorporated (NASDAQ:HBAN), East West Bancorp Inc (NASDAQ:EWBC), and Prosperity Bancshares Inc (NYSE:PB).

They are upgrading PB to "Overweight" due to its strong net interest margin expansion and excellent capital and liquidity position. In contrast, WBS has been downgraded to "Equal-weight" due to fewer near-term catalysts and higher recent credit pressures.

Bull and Bear Scenarios:

• Bull Case: Economic growth accelerates while inflation slows, leading to a rapid increase in loan growth and NII by the end of 2025. Net charge-offs remain low, benefiting commercial credit.
• Bear Case: A mild recession with ongoing quantitative tightening could lead to weak loan growth, higher deposit competition, and increased credit losses in both CRE and C&I sectors. This scenario could result in banks pausing stock buybacks and maintaining high reserve ratios, impacting EPS negatively.

Overall, the expectation of rate cuts and improved loan demand provides a positive outlook for the midcap banking sector through 2025, with increased confidence in stabilizing credit quality and attractive valuations offering significant upside potential.