Chapter 53: Bifurcating Banks, Bonds, and their Vigilantes
Dear Investors,
Since 2022, we have described our overarching investment thesis of bifurcation that spans across industries, sectors and geographies. This theme continues to pervade the investment landscape, whether it is bifurcated performance profiles between geographies, the quality of consumer spending, the performance profiles of large language models, or the earnings quality of large money centers. Today, we would like to introduce another theme: the bifurcation of short-term US risk free rates (2 year) and long-term US risk free rates (e.g. 10 year). A handful of investment strategists who have recently become bullish on the S&P500’s performance profile are predicating their forecasts on yield compression in the US 10-year treasury as a result of a projected rate-easing cycle in the US. We respectfully differ. Because of the impact of a highly aggressive and increasingly globalized bond vigilante (see Chapter 46), we believe the US 10-year treasury will remain range-bounded at best, likely between the 4.00-4.50% range, even in an environment of rate easing. This will likely continue to cause the yield curve to steepen, meaning that valuation multiples of the S&P500 predicated on the 10-year treasury will likely remain muted. Instead, we are of the view that earnings growth in 2026 will continue to lead the markets; in particular, the large-cap money centers (as we highlighted in Chapter 42) stand to benefit from prolonged yield curve steepening and elevated long-term borrowing costs.
To refresh investors on the business model of a bank, profits are generated through the difference in lending and borrowing rates, magnified using leverage. As a result, in a possible rate easing cycle in 2026, short-term rates fall while long-term rates remain range-bounded. This impact magnifies the net interest margins of the banks, which when amplified with high quality loan growth, leads to significant earnings expansion that we believe has not yet been recognized. Furthermore, with the pausing of Basel 3, a regulatory framework that would have raised stress test capital buffers (i.e. the amount of capital banks need to retain on their balance sheets), there is scope for elevated share buybacks in 2026. Finally, as outlined in our original piece dated May 9th, 2024 (Chapter 42), banks on book value multiples are still “climbing a wall of worry” to their historical levels, and at some point, there will likely be a transition from balance sheet valuations to earnings multiples, where we believe credit is due.
As a result, our key investment theses on the banks this year are that 1) Yield curve steepening will continue to elevate net interest margins; 2) Loan growth remains resilient and asset quality of this loan growth is improving; and 3) That easing of onerous bank capital regulations will lead to a greater return of that capital to shareholders. While bank shares underwent some volatility this earnings season, overshadowed by the Whitehouse’s proposal of a 10% credit card interest rate cap, we believe this volatility will be shortlived and that bank shares will ultimately reprice to reflect their strong and durable underlying fundamentals. Not only do rising margins and loan growth contribute to absolute earnings per share (EPS) growth, relative profitability – as measured by a bank’s return on equity (ROE) – is also rising due to the return of capital thesis (which shrinks the equity base) and more disciplined expenditure control (which raises operating profitability).
In conclusion, while year-end 2026 S&P500 targets have been raised by some notable strategists, we respectfully differ on the split between multiple expansion and earnings growth. While we see limited multiple expansion, we continue to see secular tailwinds from earnings growth and profitability expansion, in particular from the large cap financials. Bifurcation in short-term and long-term borrowing rates will contribute to elevated bank profitability, and as well, limit the degree of market multiple valuation expansion, rendering any earnings-led expansion likely more long-lived and sustainable. As always, we will remind investors that adaptability remains one of the hallmarks of our investment practice, as we seek relative value and relative growth opportunities, in what can be a fluid and dynamic investment market. With heightened geopolitical tensions and tariffs once again being used as negotiating leverage (as has been the case in the past), we again are looking through the shortlived volatility to identify, research and evaluate the best quality companies. We look forward to updating clients on our thesis throughout 2026.
Warmest regards,
Grace Wang | Senior Portfolio Manager
Samuel Jang, CFA | Investment Associate
Leslie Mah | Associate Advisor
Katherine Yang | Associate
Steven Bos | Administrative Assistant
Grace Wang Portfolio Management Practice of RBC Dominion Securities
Email: gracewangpractice@rbc.com
Phone: 604-257-2483
745 Thurlow Street, 20th Floor
Vancouver BC, V6E 0C5
gracewangpractice.com
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