U.S. Banks 2025 Outlook: Reshuffling Recs

• • As we approach 2025, we maintain a positive outlook on U.S. banks, albeit with a more cautious perspective on IG credit due to tight spreads. Previously, there was a bullish stance on regionals and consumer lenders following the SVB situation, but a shift towards a more defensive positioning is suggested after recent market rallies.
  • The fundamental strength of the sector and relatively cheap spreads compared to the rest of IG support a positive view. However, tight valuations and asymmetric headline risks suggest better value in quality and scale, driven by spread levels rather than fundamentals. Quality spreads within banks remain attractive relative to broader IG, but breakevens for some less favored BBB-tier banks have narrowed, indicating potential spread widening with any sentiment shifts.
  • Changes reflect a de-risking approach: profits from the past 18 months’ spread-ier names are being redirected towards quality and scale. There is still confidence in Category IV names despite concerns over CRE or consumer credit, but current spreads might not withstand further sentiment shifts. Continued rallies in lower-rated bank paper since mid-September, alongside higher long-end rates and fewer anticipated Fed cuts, contribute to sentiment risks. Additionally, potential policy impacts and deregulation favoring smaller banks pose downside risks.

The reshuffled issuer outlook aligns with a broader trend of moving towards quality and scale, echoing recent market adjustments. This approach focuses less on fundamental credit quality and more on valuations amid perceived downside risks going into 2025, such as policy impacts on borrower quality and rate uncertainties. The market’s adjustment to previously overblown concerns supports this shift, expecting banks to manage cyclical pressures effectively due to their existing strengths. However, limited room for error remains if sentiment wavers.

The recent rally in bank paper and a reduction in structural spreads have led to narrower breakevens across the board, limiting the capacity for carry to absorb any relative spread widening. For example, BBB-tier consumer lenders may underperform compared to larger banks with minimal relative widening.