Large banks' second-quarter results likely helped downplay recessionary fears, but many investors will remain on the sidelines until it is clear that a severe recession is not on the horizon, according to Gerard Cassidy.

In the latest "Street Talk" podcast recorded on July 25, Cassidy, managing director and head of U.S. Bank Equity Strategy at RBC Capital Markets, discussed banks' second-quarter results, how institutions' deposit bases are reacting to rate hikes by the Federal Reserve and what results suggest about the health of the U.S. economy.

Cassidy said many investors have assumed the Fed's efforts to tame inflation will push the U.S. economy into a recession, resulting in higher credit costs and lower earnings for banks. Those concerns have impacted bank stock performance this year, with the regional bank index having fallen close to 20% since the peak in mid-January.

Meanwhile, Cassidy, who covers Bank of America Corp., Citigroup Inc., JPMorgan Chase & Co., Fifth Third Bancorp, The PNC Financial Services Group Inc., Regions Financial Corp., Truist Financial Corp., U.S. Bancorp, Wells Fargo & Co., and a number of other regional and trust/custody banks, said the group reported improving credit trends in the second quarter and management teams guided to continued strong performance through the remainder of 2022.

If a recession occurs in 2023, Cassidy believes it would be similar to the experience in 2001, when loan losses rose but remained manageable.

"This downturn, should one come, is a financial markets-driven downturn rather than a credit-driven downturn, which 1990 and '08, '09 were, and were very problematic debacles for the banking industry. 2001 was not a debacle for the industry," Cassidy said in the episode.

The veteran analyst said the results and commentary from banks helped take some investors who were wavering about whether to invest in banks' stocks "off the ledge," but Cassidy noted that flows into financial-focused exchange-traded funds have been negative for the last two to three months.

Before investors become more constructive on bank stocks, Cassidy believes that investors might need to see either the Fed ceasing rate hikes because inflation is under control or witness banks navigating through a credit cycle without having to cut or eliminate dividends.

"I think it is a show-me story," Cassidy said. "I could tell you that many of the long-only investors that we have spoken to are taking the attitude of — I want to wait this out for six months. And when I see evidence that the banks are not going to collapse in a downturn should the downturn materialize, that's when I'll start to consider or jump into the bank."

While credit concerns have received plenty of attention, increases in interest rates have put core deposits back into focus, Cassidy said. The analyst said he is trying to determine which banks have the best, cheap core deposits, which he called "Grandma and Grandpa accounts," in rural areas that will not move to another institution for an additional 100 basis points.

Banks with those deposits will be the outperformers over the next 12 to 18 months since those funds should be less sensitive to rate increases and are the most likely to remain sticky, Cassidy said. Thus far, deposit betas, or the percentage change in rates that banks pass on to customers, have been lower than banks expected, Cassidy said. He said banks expect those betas to rise during the remainder of 2022, but the analyst still expects the industry to record relatively low betas versus prior tightening cycles because institutions continue to report depressed loan-to-deposit ratios and their funding need is not as great.

Cassidy encouraged investors to focus on the value that core-funded banks can offer at current valuations. He said some bank stocks currently offer a dividend yield of 4% or higher and noted that once the "all clear signal comes," their valuations likely will return to post-financial crisis highs of about 2x tangible book value, compared to the current level of 1.5x tangible book value.

"There is upside, but the catalyst is really going to be that people are going to have to feel more confident that the country is not going to go into a severe recession. And if we go into a mild recession, they have to be confident that the banks are going to come through it in much stronger shape than they've come through other recessions," Cassidy said. "Once those lights go green, that's when I think people are going to pile into the banks."

"Street Talk" is a podcast hosted by S&P Global Market Intelligence.

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