With economy holding up, why is the market so down on America’s banks?

Just how bad off are America’s banks, really?

Bond rating agencies trash-talked banks all through August, helping drive a near-6% drop in the S&P 500 during the month. But Wall Street equity analysts who cover banks argue that their counterparts on the bond side of the research profession, at Moody’s Investors Service, Standard & Poor’s and Fitch Ratings, got it wrong. They point to a period of rising bank stock prices before the bond ratings calls and better-than-expected earnings reports as evidence that things are better than the agencies think.

While the regional banking sector as tracked by the SPDR S&P Regional Banking Index is down nearly 25% year to date, according to Morningstar — and on pace for the worst year on record back to its inception in 2006, with the long tail of the SVB collapse hard to claw back gains from — bank stocks had been in rally mode from May to July. Regional bank stocks, in particular, gained as much as 35% before the bond warnings and downgrades began. Meanwhile, second-quarter bank earnings beat forecasts by 5%, according to Morgan Stanley.  

The higher interest rates bond analysts cited hurt profits some, but most banks’ net interest income and margins were higher than a year before. Delinquencies on commercial real estate loans rose, but stayed well below 1% of loans at most institutions, with some of the banks singled out by bond rating agencies reporting no delinquencies at all. The ratings actions pushed the regional bank stock index 10% lower for the month-long period ending Sept. 8, according to Morningstar (the Moody’s bank warning was issued August 7).  

At stake is not only what bank stocks may do next, but whether banks will be able to fill their role in providing credit to the rest of the economy, said Jill Cetina, associate managing director for U.S. banks at Moody’s. Their medium-term fate will have a lot to do with outside forces, from whether the Federal Reserve cuts interest rates next year to how fast the return-to-work push from employers in recent months gains momentum. Looming over all of this is the question of whether there will be a recession by early 2024 that worsens credit problems and cuts banks’ asset values, as Moody’s Investors Service expects.

“It’s reasonable to ask, is there a credit contraction in the banking sector?” Cetina said. She pointed to Federal Reserve surveys of bank lending officers that look like pre-recession measures in 2007 and 2000, with many banks raising credit prices and tightening lending standards. “Banks play a key role in shaping macroeconomic outcomes,” she said.

By any reckoning, the argument about banks is about two things: Interest rates and real estate, specifically office buildings. (Banks also call warehouses and apartment complexes commercial real estate, but their vacancy rates are not historically high). The arguments depend on two assumptions that markets believe less than they did earlier this year.

The bear case relies heavily on the prospect of a recession, which stock investors and economists think is much less likely than many believed six months ago. Goldman Sachs chief economist Jan Hatzius cut the firm’s estimated U.S. recession odds to 15% on Sept. 4, meaning the bank sees only a baseline risk of a downturn. At Moody’s, while the bond-rating arm expects a U.S. recession next year, the company’s economic consulting unit Moody’s Analytics doesn’t.

It also turns on an assumption of sustained high interest rates. While debate continues and the Fed’s own commentary continues to express a willingness to raise rates more, many investors now think the Fed will begin to trim the Fed funds rate by spring as inflation fades, according to CME Fedwatch. And while experts such as RXR Realty CEO Scott Rechler and billionaire real estate investor Jeff Greene believe office vacancies will stay high enough to force defaults by more developers, even as employers gain the upper hand against workers who want to…