When looking at the financial sector in the beginning of 2018, it may be surprising that the sector’s performance did not lead the S&P500 with the tailwinds pushing the market. With the rising interest rates, recently passed tax reform, strong global economy, and regulatory relief the financial sector should have outperformed the broader market. These factors did contribute to performance but the financial sector ran into headwinds such as a flattening yield curve, trade concerns between key trading partners, and global economic concerns.
Potential Growth Factors:
Rising interest rates helps financial companies because as they lend out money, they earn more with a higher interest rate. Banks also are required to keep a certain amount cash reserves, which they will also earn a higher rate on. The Federal Reserve is expected to keep raising rates as the US economy shows no signs of slowing, continually beating expectations. The continual rate rising should help boost revenue for most banks.
Bank regulatory reform represents a re-balancing of many Dodd-Frank constraints implemented after the 2008 crisis. One of the recent Dodd-Frank changes regards banks and the total amount of assets that warrant stress testing. The limit used to be that banks with $50 billion in total assets would have to regularly pass a Comprehensive Capital Analysis and Review (CCAR) by the Federal Reserve – that limit has now been raised to $250 billion. This means that regional and community banks that were hesitant to make deals now have more freedom to expand their businesses. Given this, we expect M&A activity to pick up.
Volatility in the market boosts trading revenues despite the price declines that may affect the fees that financial companies make off of assets under management. The increased volatility is positive because the higher the volume of trades, the more traders have the opportunity to make spreads as well as commission on those trades.
Potential Negative Factors:
The yield curve has been a good predictor of how the financial sector will trade as it has been trading in unison as the curve flattens and steepens. The reason that a steeper yield curve helps banks is that they borrow in the short-term and lend in the long-term. This means that as the spread between the 2- and 10-year Treasury yields tighten, the less money banks are going to earn from net interest income, the main component of banking revenue.
Trade concerns hurt corporate confidence which could affect the amount of M&A deals in the broader market. Although trade concerns should affect deal-making, in theory, there has been no slowdown of M&A activity yet, according to S&P Global Market Intelligence, but these affects could be realized as time passes and these problems linger. A lack of corporate confidence also lowers the demand for loans leading potentially hurting the major corporate lenders. These trade conflicts have also contributed to the volatility in the market, a positive thing for financials.
Global economic concerns cause risk to financial institutions as an economic instability is bad for loan quality, creating more credit risk. The European economy has been sensitive to episodic events like Turkey’s inflation problem which could disrupt the otherwise positive global economic outlook. All financial institutions are more at home in a strong economy.
The general rating of the financial sector remains to be neutral in the short-term and positive in the long-term. The neutral short-term view is rationalized by the fact that we believe the headwinds in this market will be more impactful in the upcoming months than the positive growth factors. The tailwinds, specifically regulatory reform, tax benefits, and rising rates, should help the companies more in the long-term growth of their businesses. This viewpoint could change if the probability of recession increases at an unexpectedly.
By Noah Mazzola - Director of Financials, Baruch Investment Management Group