Outlook on 2018-19 Financials Sector


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


The State of Emerging Markets


2018 is shaping up to be an exceptional year for U.S. equities. The S&P 500 Index, comprised of the 500 largest U.S. publicly traded companies, has smashed through all-time highs and set a record for the longest bull run in history. This exceptional performance has been due, in large part, to a strong earnings season tied together with encouraging economic data points. Some of these key data points include:

  • A record-low unemployment rate.

  • A rising advance-decline line (a technical indicator measuring the number of advancing stocks less the number of declining stocks).

  • 27% year-over-year earnings increase and 11.2% sales growth in the S&P 500 since 2010 and 2011, respectively.

Though these figures are cause for celebration, Wall Street seems to be ignoring the elephant in the room: emerging markets. While the S&P 500 has gained 7.5% year-to-date, MSCI’s Emerging Markets ETF (EEM) has declined 11.8% since the start of January. Much of this significant decline can be attributed to three causes:

  1. The fear of an impending trade war sparked by President Trump's tariff and trade balancing measures.

  2. The U.S. Federal Reserve's decision to follow through with rate hikes going into 2019. Emerging market countries tend to run account deficits and rely on foreign capital to fund these deficits. When the Fed raises rates, ‘carry trade’ becomes increasingly expensive and less attractive to investors.

  3. Currency woes across the globe. As of now, the mayhem in emerging market seems to be contained, heavily impacting the countries depending on overseas money. Some of these affected countries include South Africa, with the Rand down 19.43%; Argentina, with its Peso down 52.70%; Turkey, with the Lira down 43.23%; Brazil, with the Real down 20.37%; and India, with the Rupee down 11.03%.

    • As these currencies tumble further, governments frantically try to halt, or at the very least decelerate the fall. For example, the Turkish Government increased regulations on foreigners shorting the Lira, the Brazilian Central Bank offered 15,000 currency swap contracts in an effort to reduce volatility, and the Argentine Central Bank raised rates from 45% to 60%, in addition to requesting a speeding up of the $50 billion bailout from the International Monetary Fund. Despite all these proactive measures, currencies continue to falter against the U.S. dollar.

Even though the US market is performing well, the Federal Reserve's effects on emerging market currencies has highlighted international dependence on the USD. Worries are now shifting to EM contagion as higher bond yields and expensive debt (caused by the Fed’s rate hikes) could possibly shift currency flow out of emerging markets, hindering local economies and international trade. Some of these effects have already been highlighted in the most recent Institute for Supply Management survey, indicating that America’s factory activity is at the highest level since 2014.

By Sean O’Dea and Paul Menestrier - Portfolio Management Analysts, Baruch Investment Management Group


A Review of Summer 2018 Markets


Let’s begin with the market update and catch ourselves up with what transpired this summer.

Starting off with major indices, since the official end of the Spring term on May 24:

  • The S&P 500 rose 5.39% (147 points) to 2874. This marks a new record high for the index.

  • The NASDAQ Composite rose 7.03% (522 points) to 7,946.

  • The Dow Jones Industrial Average rose 3.94% (978 points) to 25,789.

  • The Russell 2000 rose 5.96% (97 points) to 1,725.

Data as of August 24, 4:00PM

On to other economic indicators, the unemployment rate fell to an 18-year low of 3.8%, and gross domestic output grew at an impressive 4.1% annual rate in the second quarter, with the final year projection set to be 3%. The P/E ratio over the summer clocked in at around 18.8x as opposed to 21x highs in February. This has been primarily due to huge earnings growth in this quarter.

If there’s one word to mention, it’s “tariffs.” President Trump continued addressing his trade deficit campaign promises by instituting tariffs on Chinese goods, now totaling $50 billion. There are on-going discussions to set tariffs as high as 25% on an additional $200 billion, which if approved, are thought to be instituted in September of this year. China retaliated, placing tariffs on $50 billion worth of American goods. China hasn’t been the only target of the Trump Administration; the European Union, Mexico, Turkey, Japan, and many other countries have been targeted.

Markets have been sensitive to the tariff developments, and fear of a full-out trade war, and a subsequent drop in international trade, has put downward pressure on the markets. With every talk, threat, and speech, markets have bounced back and forth between optimism and despair. It will be interesting to see how this whole debacle unfolds.

The other major headline this summer has been interest rates, specifically the Fed raising the Federal Funds Rate, the interest rate that depository institutions charge each other for overnight reserve balance lending. In mid-June, the Fed announced their second hike, raising the rate a quarter point, to a range from 1.75% to 2%. The Fed Chairman Jerome Powell cited that strong growth and labor markets, tied with a close-to-target inflation levels were some of the drivers behind the decision. Rate hikes are a preventive measure to keep the economy from overheating and causing high inflation. However, the compromise is slowing down economic growth. Following the news, the stock market fell, as investors expect that higher borrowing costs will negatively impact earnings. There are currently two more projected interest rate increases for 2018, and with a September rate hike to 2.00-2.25% at a 96% chance.

The 10-year treasury note, an important confidence indicator, proxy for other interest rates, and widely observed financial instrument, had a yield between 2.82% and 3% over the past three months. Trade tensions and recent emerging-market economy concerns applied downward pressure to the yield, however, the guilty plea of Michael Cohen, President Trump’s former lawyer, over campaign-finance violations spiked yields. The current 10-year treasury yield sits at around 2.83% as of 4:00PM, August 24th, 2018.

Moving on to the yield curve, the curve formed by plotting treasury yields with respect to their maturities has markets talking. Typically, longer term yields are higher than shorter-term ones to compensate investors locking up their money for longer. However, the gap between those yields is closing, or in other words, the yield curve is “flattening.” This has led to a drop in financial stock prices, whose earnings will be negatively affected. There is also a fear that there will be an “inversion of the yield curve,” which occurs when short-term yields surpass long-term yields. Historically, inversions have been correlated with upcoming recessions. Could an approaching inversion be a harbinger?

In world news, Turkey and Venezuela have been grappling with out-of-control inflation. Turkey’s CPI increased by over 15% on the year, and with President Maduro’s program, the International Monetary Fund is prediction and inflation rate over 1,000,000% by the end of the year.

Lastly, to end with miscellaneous noteworthy news, Apple is the first company to hit the coveted one trillion-dollar market value mark. Amazon and Alphabet are approaching as well. Elon Musk tweeted that he was considering taking Tesla, the most shorted stock in the US on a dollar-basis, private (securities fraud?). He later abandoned the idea. Amazon announced it will diversify into healthcare, through its one billion dollar acquisition of the online pharmacy PillPack. AT&T is acquiring Time Warner, valued at around $80 billion. Microsoft acquired Github for $7.5 billion.

By Sean O’Dea, Karol Rychlik, and Paul Menestrier - Portfolio Management Analysts, Baruch Investment Management Group