Bullish on banks

April 25, 2017 09:00 AM

Big banks have been on fire, helping to boost the S&P 500 Financials sector up 33% in the last 12 months, the best performing sector in the index. Of the six big U.S. banks, five: JPMorgan (JPM), Citigroup (C), Bank of America (BAC), Morgan Stanley (MS) and Goldman Sachs (GS) surpassed that level. The sector also posted one of the highest earnings growth rates for Q4 2016, and is expecting a strong Q1 2017. Optimism is based on the Trump administration’s pro-business rhetoric, including regulatory relief and reduced corporate taxes. 

While many of the items are just proposals at this point, earnings reports from earlier in the year are reflective of things that happened in Q4. Stronger fundamentals for banks were attributed to a Fed that tightened rates a quarter in March with two more raises expected in 2017, which will lead to higher margins as well as strength in mortgages and a pick-up in M&A activity. 

Some analysts say the market is overly optimistic as pro-growth proposals have yet to come to fruition. If firm policies aren’t set in motion this year, or aren’t to investors’ liking, there is the chance the markets will pullback as pro-growth proposals are already priced-in. If the debate over healthcare and immigration reform obscures tax and regulation reform, the markets could retreat. There has already been a reduction in analyst expectations for corporate earnings as a result of this waiting game. At the end of 2016, the S&P 500 was expected to see earnings grow of 12% for 2017, which has now fallen to 9.5%. Financials, however, have seen a slight uptick, from profit growth expectations of 
9.8% in December to 11.5% in mid-March.

Banks want to see tax reform become a reality. Late last year, Morgan Stanley analysts estimated that reducing the corporate tax rate to 20% from the current 35% could result in double-digit profit growth for big U.S. banks, with the exception for Citigroup, which would likely only see a single-digit increase. As far as regulation is concerned, many bank executives have been very vocal about their desire for relief from tough capital and liquidity standards under current regulations.

The anticipated normalization of interest rates in 2017 should also be a big win for banks. The Fed is expected to raise rates three times this year. The first increase of 25 basis points came at the March FOMC meeting, and the Estimize community is expecting a second during the May meeting. Fed Chair Janet Yellen has made very clear that the central bank is aiming at a hike sooner rather than later, however, is unwilling to commit to a timeline as they wait for more economic data to guide their decision, as well as policy implementations from the Trump administration. 

A return to interest income, and increase in margins resulting from the hikes, will help boost financials. However, there is still some hesitation and questions around whether the U.S. economy is strong enough to handle additional raises, especially as they will be accompanied by increasing inflation. While jobs data remains robust, and consumer sentiment indicators point to a confident U.S. consumer, there is no denying that the way people spend is changing, and that the average shopper is much more value-focused. 

If normalization is not approached correctly, the resulting inflation could hamper consumers’ willingness to purchase large ticket items such as homes and cars. Traditionally, Fed rate changes have not had a large impact on long-term interest rates, however, banks do find a way to pass higher borrowing costs to consumers. This could be problematic for banks such as Wells Fargo (WFC), the country’s largest mortgage lender. 

A lot remains to be seen, but the current environment is setting up to be a bullish one for U.S. banks.

About the Author

Christine Short is a senior vice president at Estimize. An expert in corporate earnings, she produces content highlighting Estimize data. Prior to Estimize, Christine held positions at Thomson Reuters and S&P Capital IQ. @Estimize