The Financials sector has many favorable attributes, but uncertainties about the path of the economy, interest rates, and overall market raise the level of risk for the sector. While macroeconomic conditions remain strong, we have likely seen a peak in the rate of growth. Historically, relative performance of the sector is positive in the expansion phase. Even as Central Banks embark on the process of unwinding accommodative policy, as inflation remains somewhat less transitory than previously expected, we think that this interest-rate-sensitive sector will gain a tailwind from rising interest rates in the coming months.
EU: With the start of the war in Ukraine, European financials have lost much of their attractiveness which was based on the economic recovery and higher bond yields. As for now, we question normalizing earnings and strong capital levels (on the back of potential losses in Russia and Ukraine). We estimate that when the European economy recovers, the rotation into economically sensitive sectors like financials should though occur at a later stage. We think sector valuation remains attractive.
US: Fundamentals are healthy and earnings growth and profitability should benefit from an improving economic growth environment and higher long-term rates. Profitability is expected to be boosted by the Fed rate hikes. As the economic recovery progresses, margins and loan growth can be anticipated. As of now, institutions have large levels of excess capital which they are expected to return to shareholders via dividend payments and share buy backs.
Positives for the sector:
- Generally, companies are in a strong financial position, due to stringent post-2008 regulations.
- Economic recovery and fiscal stimulus are tailwinds for loan demand and will likely limit defaults.
- Cautious central banks, along with improving growth prospects, have started to steepen the yield curve.
- The sector has attractive valuations relative to its historical average and other sectors.
- High loan-loss reserves are being released (which supports earnings growth).
Negatives for the sector:
- Despite long-term interest rates trending higher, in general, rates are expected to remain low by historical standards.
- Longer-term price momentum has been weak, though it has improved recently.
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A recent stress-test shows that banks are well-capitalized and should see a sharp rebound when market volatility subsides. Bank earnings are recovering swiftly, as provisions for expected loan losses wind down. Banks are also key beneficiaries of higher interest rates, which drive an improvement in profitability and signal a potential pickup in loan growth. The Fed has given a green light to share repurchases, which should help boost earnings per share and return on equity. The sector remains attractively valued. |