As the yield curve inverted and economic data weakened, there have been a lot of brewing concerns about banks and financial stocks would fare if the next slowdown turned into a recession. It turns out that lower net interest margins may be only part of the problem as 2019 starts to merge into 2020.

Wedbush Securities has issued a report on the top regional banks that noted solid loan growth as one of the few bright spots for the group this year. The firm has concerns over whether that loan growth can continue and sees a disconnect between positive borrower sentiment, strong loan pipelines and a lack of signs of emerging credit deterioration — not to mention how the media portrays the economy and the shape of the yield curve in particular.

Other issues were seen after weak ISM manufacturing data. Capacity utilization and commercial construction spending looked weak, and capital spending trends from a year before indicated a softer spending climate for business investment. Wedbush’s Peter Winter suggested that margins are already under pressure in the third quarter and the 2020 net interest margin outlook remains bleak.

While regional banks are trading at a 12-month forward price-to-earnings multiple of 9.0 (versus a historical average of 12.6) and 9.9 times for the mid-cap banks (versus a historical average of 14.7), Winter remains cautious as the consensus earnings estimates are likely too high with the combined effects of the decline in interest rates and an expected credit costs increase from unsustainably low levels.

Winter’s report also pinpointed some specific issues about the odds of a recession, ahead of naming the investment banking firm’s few top picks for the tougher climate ahead. The report said:

The fear is the headline risk of a recession turns into a self-fulfilling prophecy. That said, we maintain our cautious view of the bank group given the unfavorable rate environment, which has gotten worse since July with the precipitous drop in the 10-year treasury. Plus, a number of leading economic indicators are down from recent peak levels and most are in a downtrend, making us even more cautious on our 2020 outlook. … We lowered our EPS estimates for our entire bank group by 2% in 2020 and are below consensus on almost every bank.

Of the 30 or so regional and mid-cap banks covered in the report, only these were named as the top picks with ample upside against the overhang and risk that is facing the sector. We have included implied upside to the target price mentioned, as well as the market caps, valuations and dividend yields.

Fifth Third Bancorp (NASDAQ: FITB) was a top pick for the regional banks with a $31 price target. That is roughly 20% upside from the $25.74 price, and the firm does see earnings per share growth continuing into 2020 and a valuation of only 8.4 times expected 2020 earnings. Fifth Third also comes with a 3.7% dividend yield, but Wedbush’s “favorite” comes with a target price that is about 2% under the consensus. Fifth Third’s market cap is over $19 billion.

Citizens Financial Group Inc. (NYSE: CFG) is another top pick from the regional banks, and Wedbush’s $40 target price implied 22% upside from the $32.89 reference price. Citizens also comes with a 4.3% dividend yield. Earnings growth is expected in 2020 to $4.01 per share, and that translates to a projected 8.2 times 2020 earnings. Citizens has a $15 billion market cap.

Regions Financial Corp. (NYSE: RF) was the third of the named top picks among the regional banks and has a $14 billion market cap. With a $14.26 reference price, Regions was shown to have 19% upside to the $17 target price, and it also comes with a 4.3% dividend yield. Earnings growth is expected to rise to $1.65 per share in 2020, and that would value it at about 8.6 times that estimate.

Winter Securities also highlighted his few top picks for the mid-cap banks as well:

• Western Alliance Bancorp (NYSE: WAL), with 31% upside to the $55 target price and a 2.3% dividend yield ($4.5 billion market cap)
• East West Bancorp Inc. (NASDAQ: EWBC), with 33% upside to the $52 target price and a 2.9% dividend yield ($5.8 billion market cap).
• First Republic Bank (NYSE: FRC), with an implied 16% upside to the $102 target price and a 0.8% dividend yield ($15 billion market cap).
• BOK Financial Corp. (NASDAQ: BOKF), with an implied 25% upside to the $93 target price and a 2.6% dividend yield ($5.7 billion market cap).
• Wintrust Financial Corp. (NASDAQ: WTFC), with an implied 22% upside to the $74 target price and a 1.6% dividend yield ($3.6 billion market cap).

Remember that all “upside targets” are implied gains based on current prices and are just the targets within this one call. Most traditional S&P 500 analyst calls with Buy and Outperform ratings at this stage of the 10-year-plus bull market come with total return projections of 8% to 10%. These implied upsides range from 16% to over 30% to the firm’s targets.

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