Banks may be hitting a wall

April 20, 2017 01:00 PM

President Donald Trump’s first address to the joint session of Congress in February may have elicited comparisons with some of President Ronald Reagan’s finest moments, but even the Gipper couldn’t compete with the Donald when it comes to setting market records. With Republicans in control of both the White House and Congress, not to mention a former Goldman COO overseeing our national economic policy, it’s no wonder the bank-heavy Dow Jones Industrial Average went from 18,000 in November to 21,000 by the start of March. The Dow hit 12 consecutive record highs for the first time since 1987 along the way. But while investors love watching the market make new highs, they seem way more reluctant to bring bank stocks back into their portfolio.  

Analysts targeted banking as the go to sector in 2017 and while the performance certainly has been there this year with the Financial Select Sector SPDR Fund (XLF) up 7.4% through March 4, that hasn’t been enough to entice investors back to the sector. No financial funds made our list of top asset gatherers during the last three months, even as inflows into ETFs continue to set records. Short covering seems a likely culprit, which explains those lackluster inflows, along with the tendency for these funds to have explosive moves around major events and our weak short ratio scores for numerous financial ETFs. However, another argument is that investors haven’t been able to look past the very political nature of this rally. 

Political tension is nothing new for investors and can have either a positive or negative impact depending on the nature of the tension. Arguments over the Affordable Care Act, which is adding another layer of regulation while altering the basic supply/demand dynamic and keeping a lid on healthcare stocks for years, is a prime example of the latter. So far, speculation around Trump’s plans hasn’t hindered bank stock valuations with many funds trading at high multiples relative to their history while the micro/small cap focused First Trust Nasdaq® ABA Community Bank Index Fund (QABA) continues to trade at the highest price multiples it’s ever seen.

But, if every rally can be viewed as a function of investors raising their expectations for future growth, here  investors are betting that the President can stimulate growth enough to give the Fed the cover it needs to boost interest rates, while simultaneously rolling back a decade of financial reform. Even the Gipper would’ve struggled mightily with that and whether Trump can enact his agenda or not is moot unless banks can use the recent run-up in long-term rates to expand their net interest margins: something that has eluded them over the last seven years.

According to data from the Federal Reserve, the net interest margins for all banks in the United States has declined from 3.83% to 3.05% at the end of 2016. The chief culprit remains a flattened yield curve as the market continues to discount the possibility of strong economic growth, while the Fed has begun, however cautiously, to raise short-term rates, in effect, squeezing the banks between both ends.  While long-term yields were rising well before the election, Trump’s victory helped send them into overdrive with the 10-year Treasury yield reaching 2.6% before falling into a tight range between 2.3% and 2.5%. But hold off on popping the champagne corks as short-term rates, based on the two-year Treasury note yield, have risen drastically faster and in effect, flattened the yield curve once again (see “Robbing Peter to pay Paul,” below).   

Most at risk from this are those small community banks that make up QABA. Maybe it’s not “morning in America” just yet.

About the Author

Matt Litchfield is content editor for ETF Global (ETFG.com) and is responsible for all posts and new product updates on ETFG.com. @ETF_Global