US Bank Lending Grows, Cycle Ends…

Today we will dig into the world of US bank balance sheets and look at Commercial and Industrial (C&I) loans. The set-up here:

  • Banks make C&I loans to all sizes of companies. Lenders use the proceeds for everything from capital expenditures to working capital. Loan duration is typically 1-2 years, but credit-worthy companies can negotiate new lines as needed.
  • C&I loans by US banks currently stand at $2.3 trillion, greater than the amount lent for residential real estate ($2.2 trillion), commercial real estate ($2.2 trillion) or consumer loans like credit cards/car loans ($1.5 trillion in total).
  • Loan growth is important to bank stocks since it drives sustainable earnings growth as long as underwriting standards remain sensible.
  • C&I loan growth is also an important macroeconomic indicator, since it reflects business confidence and potential future growth from investment.

So how is C&I loan growth doing this late in the US economic cycle? Two points here:

#1. C&I loan growth has actually been improving through 2018.

  • October showed 5.8% growth versus the same month last year, the best comparison since January 2017. Average C&I loan growth for 2018 YTD is 4.3%.
  • Looser bank lending standards for large and middle market firms are a tailwind here. The Fed’s Senior Loan Officer Survey shows a marked easing of standards for such firms ever since Q1 2017. Those same loan officers show much less enthusiasm for lending to small businesses, however, with standards essentially unchanged in 2018.

Analysis: friends who follow financial stocks for a living tell us that C&I loan growth is a double edge sword. Early in an economic cycle, it is a sign that companies are emerging from their foxholes and starting to invest again. Late in the cycle, the same analysts worry that companies are borrowing money to fortify their balance sheets against the next downturn.

The upshot: that lending standards are easing for only large/mid-sized companies signals that banks are worried about the end of business cycle and therefore prefer larger, more stable borrowers. On the bright side, should the current US economic uptrend extend into 2019, at least larger companies will have excess capital to invest.

#2. Delinquency rates for C&I loans remain below prior cycle troughs.

  • Q3 2018 (latest data available) delinquency rates were just 1.0%.
  • While higher than the low point for this cycle (0.72% in Q4 2014), this is still below both the best levels from the last cycle (Q4 2006 at 1.15%) and one before (Q4 1997 at 1.7%).
  • Delinquencies did spike higher in 2016 in the wake of lower oil prices, reaching 1.59%.

Analysis: for the moment, the trend line for C&I loan delinquencies looks very healthy. They started the year at 1.11% for Q1, fell to 1.06% in Q2, and now sit at 1.0%. That is a positive for bank earnings, of course, but also a sign that even with high leverage levels US companies are not yet falling behind on their financial obligations.

Summing up with two points:

#1. On the economy: C&I loan growth in 2018 has mirrored a strong US economy, but it is really just bouncing back to normal levels. October’s 5.8% C&I loan growth looks good versus the last 2 years (average of 3.6%), but is really only on par with 2010-present levels (5.4% average). And we are far from the +10% growth of 2012 and 2014. Bottom line: this year’s C&I growth is fine, but not enough to signal a next leg for the current economic expansion.

#2. On bank stocks. C&I loans are only a piece of bank profitability, but their relative size makes them an important driver of sustainable earnings growth. The uptick we’ve noted here should be a positive for Q4 earnings and investor confidence for further growth in 2019.

But… there is a cloud over this year’s C&I loan growth in the form of late-cycle worries, a factor that mirrors worries in other bank business lines. Not only is there a concern that companies are defensively topping up their balance sheets, but also that delinquency rates sit much closer to the bottom of their historic ranges than the top.

The upshot for bank stocks, which have been stuck in purgatory all year, is that they will likely continue to underperform. Too many investors know the classic playbook, which says to only buy the group at the start of an economic cycle. We desperately want to like this group for its valuation and the chance for multiple revision. But it’s too early to make that call just yet.

Sources:
C&I Loans (1947-present): https://fred.stlouisfed.org/series/BUSLOANS

C&I Delinquency Rates (1987 – present): https://fred.stlouisfed.org/series/DRBLACBS

Mid/Large Company C&I Loan Standards (1990-present): https://fred.stlouisfed.org/series/DRTSCILM

Small Company C&I Loan Standards: https://fred.stlouisfed.org/series/DRTSCIS?cid=32239

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