One day is hardly anything to get too excited about, but the financials sector finally broke its record 13-session losing streak last Thursday after results from the second phase of the Federal Reserve’s (Fed) capital review offered some good news. As a reminder, banks subject to the review must meet certain minimum capital requirements in a simulated severe recession and credit market downturn scenario. Based on the results of that analysis, the Fed approves or rejects banks’ requests for share repurchases and dividend increases.
Of the 35 institutions subjected to this process, 34 passed the review, with only three having conditions attached to their approvals and just one—not totally unexpected from a European bank with U.S. operations—receiving an objection. An overall positive result, which was initially well received by market participants, was followed by a wave of dividend hikes and large share repurchase announcements. “Dividend and share repurchase approvals may help garner renewed interest in financials, which continues to struggle with a flattening yield curve,” noted LPL Chief Investment Strategist John Lynch. The sector’s relationship to the yield curve is featured in the chart below.
The connection between the yield curve and bank profits is clear; but keep in mind that the financials sector enjoyed a strong election-driven rally in the fall of 2016. While recent underperformance is disappointing, on a relative strength basis the sector has preserved a fair amount of its election-driven outperformance versus the S&P 500 Index. That said, we think the yield curve pressures on the group will ease over the balance of 2018 due to our strong economic growth outlook and prospects for modestly higher inflation (more on those topics in our Midyear Outlook 2018 publication, slated to be released sometime next week).
Some other reasons we like the financials sector include:
- Regulatory pressures on banks’ capital reserves have eased, making more capital available to lend and return to shareholders.
- Lending conditions remain favorable. Despite some recent widening, credit spreads remain historically narrow and banks’ lending standards remain relatively loose.
- Valuations are attractive. Recent weakness has brought valuations in the sector down to about 1.38x trailing four quarters book value, well below the long-term average of about 2.0 and the post-financial crisis highs of about 1.53.
*A spread is the differential between a yield of a bond and the yield of a comparable maturity Treasury security. As Treasury securities have very low risk, this spread can be seen as an investor gauge of sentiment, with a higher spread indicating greater concern.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. The economic forecasts set forth in this material may not develop as predicted.
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Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The S&P Financials Index is a market capitalization weighted index that tracks the performance of financial companies.
Yield Curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.
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