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Stock Analyst Update

Banking Outlook 2022: Managing Rate Risk Is Key

Citigroup is not pretty, but it's our top pick

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As first-quarter earnings approach, we have taken a hard look at what 2022 might hold and how to think about the U.S. banking sector in today’s environment. We see strong core earnings fundamentals but valuations that already account for this. With an average price/fair value estimate of just under 100%, the banking sector today is fairly valued, in our view. 

While we see some headwinds for fee growth (deposit service fees, investment banking, and mortgages all retreating), we still expect strong overall revenue growth as loan growth returns and interest rates rise, driving strong net interest income growth. We also don’t see inflationary pressure playing out in expenses as much as some might expect.

However, with interest-rate expectations high, we think it's imperative that investors consider their rate risk exposure. There is downside at today's prices if the higher rate narrative falls apart and economic growth stalls. With some indicators of recession risk rising, we can see this playing out in real time.

S&P Capital IQ consensus is more aggressive than we are with its price targets--roughly 10% ahead of us on average. We attribute the disconnect to consensus’ search for peak multiples during a cyclical upswing. In the last rising rate cycle, the relative outperformance of the banking sector essentially all occurred in a three-month period at the start of the cycle. We've already seen a similar pattern this cycle. Based on this pattern and our current price/fair value estimate average for the sector, we're wary that much of the relative outperformance has already occurred.

In this context, focusing on individual names over a sector bet makes sense, in our view. Our top pick is Citigroup (C) . The bank is trading in deep value territory and has the least rate sensitivity under our coverage. We also see some value in the less rate-sensitive First Republic (FRC) , a bit left to run for Wells Fargo (WFC) , and JPMorgan Chase (JPM) as a top-quality franchise at a reasonable price.

Eric Compton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.