Strong earnings growth will continue for banks in 2026, says KBW's Christopher McGratty

Dominic Chu (Senior Markets Correspondent) 00:00.000

That's Chris McGrath, head of US Bank Research over at KBW. Chris, we spoke a little bit about the broadening outtrade with our panel just this past few moments or so. I wonder, the financials are a big part of that story. Is there a macro backdrop that makes sure that the banks

Dominic Chu (Senior Markets Correspondent) 00:15.600

are in a healthy place in 2026?

Chris McGratty (Managing Director and Head of U.S. Research) 00:19.240

Well, thanks for having me back, Dom. Happy holidays. Healthy capital markets are are really an underpinning of what's driven a lot of the strength in 2025. Your prior guest talked about credit spreads being tight. We think credit spreads are something to watch for 2026. But as

Chris McGratty (Managing Director and Head of U.S. Research) 00:34.800

you think about the dynamic and the setup for the banks, right? We're in a period of strong solidly double-digit earnings growth, and we think that continues.

Dominic Chu (Senior Markets Correspondent) 00:44.040

If that continues, what exactly is the driver? I mean, there's a lot of them, but what are the primary drivers of why that bank trade continues to be healthy from a fundamental standpoint?

Chris McGratty (Managing Director and Head of U.S. Research) 00:54.960

Right. If you separate the performance of the banks, right? The largest banks are up 40% on average year-to-date, the smaller banks are up about 15. So there's a 20% to 25% spread between the winners and the underperformers this year. For 2025, it's been about capital markets,

Chris McGratty (Managing Director and Head of U.S. Research) 01:11.200

M&A, trading, investment banking, those numbers have been absolutely incredible. Volumes up 40%. If you think about 2026, for this trade to broaden, you need to see the yield curve remain steep, and it is. You need to see loan growth return, and you're seeing signs of it. And

Chris McGratty (Managing Director and Head of U.S. Research) 01:27.880

you need to see earnings supported by benign credit conditions, which for the most part have been a real common denominator in 2025.

Dominic Chu (Senior Markets Correspondent) 01:35.400

So those benign credit conditions are due in some part, maybe a large part to what's happening with macro policy at the Fed. How important is the Federal Reserve backdrop to the health of these banks? Do interest rates need to be in a certain area or range in order for that

Dominic Chu (Senior Markets Correspondent) 01:50.320

bank's story to continue on its way higher?

Chris McGratty (Managing Director and Head of U.S. Research) 01:53.680

Right. We're We're aligned with the Fed. We think there'll probably be one cut in 2026, whether there's one or two to. I don't think it's going to change the earnings dramatically, but you do need to see the yield curve stay steep. And that's what's happened over the course of

Chris McGratty (Managing Director and Head of U.S. Research) 02:07.120

2025. We've ended the longest period of inversion. And what you're seeing now is the repricing of the balance sheet, right? So regardless if the Fed goes once or twice, there's a backbook dynamic that's really going to support net interest income. And so you get that with lower

Chris McGratty (Managing Director and Head of U.S. Research) 02:22.600

funding costs, and that's a good recipe for revenue growth.

Dominic Chu (Senior Markets Correspondent) 02:25.520

All right. If that's the case, then what types of financial institutions in your coverage unit universe fair the best. Are we talking about some of the small, medium-sized regional type banks, the traditional lenders? Are we talking about massive money center banks that also

Dominic Chu (Senior Markets Correspondent) 02:39.040

have capital markets operations tied to them? Are we talking straight investment banks? What exactly are the top picks for 2026?

Chris McGratty (Managing Director and Head of U.S. Research) 02:46.880

For sure. For all of 25 and into 26, we think the bigger banks are the place to be. We've seen the broadening out of the capital markets. They've got scale across their business, whether it's deposits, capital markets, technology spend. The returns are higher and more stable,

Chris McGratty (Managing Director and Head of U.S. Research) 03:01.120

and we think just because the stocks have worked, we think they can continue to work. But we do see broadening out to the traditional banks. Two banks I'd give you here, Dom. KeyCorp and Citizens Financial, both of these banks are taking the ROE from low double digit to

Chris McGratty (Managing Director and Head of U.S. Research) 03:14.800

mid-upper teens, and these stocks traded 10 times earnings. What we like about Key and Citizens, right, is the back book repricing regardless if the Fed goes zero or one, two times. The revenue outlook is big. So we think those are two really interesting stocks. And the large we

Chris McGratty (Managing Director and Head of U.S. Research) 03:30.640

still think Citi is one of the top picks. Yes, it's had a huge move this year, but it's only 1.2 times tangible book. They're levered to capital markets. They've got a really important capital Investor Day coming up in May. And we think Citi can continue to work.

Dominic Chu (Senior Markets Correspondent) 03:45.320

All right. And one final question before we let you go here. If you take a look at the way that those banks have performed, you mentioned before the kind of performance gap between those small and medium-sized banks versus the megacenter, money center-type banks, how much can we

Dominic Chu (Senior Markets Correspondent) 03:57.680

expect that gap to close in 2024? 2026.

Chris McGratty (Managing Director and Head of U.S. Research) 04:01.640

Yeah, it's it's the number one question we've gotten all year from investors is is why would we pay 15 times earnings when we can pay 10 for something smaller and cheaper. We think there's a sprinkle and you can you can own both. You know the the the banks at 14 15 times

Chris McGratty (Managing Director and Head of U.S. Research) 04:14.920

earnings they're growing earnings at 15 times. So we think that will continue to work. But if you do want to see this rotation trade unfold in the banks, then there are a lot of banks trading at 9 10 11 times and the ROEs are mid to upper teens. So we can get value across the

Chris McGratty (Managing Director and Head of U.S. Research) 04:27.840

spectrum.