By John Toohey, CFA, Head of Equities
The U.S. financial sector may finally be back on its feet, with growth indicators from S&P 500 financials showing profits close to the 2007 peak. Rising profits are predicted to be returned to shareholders by way of dividends and stock buybacks,and banks are poised to become dividend growers, all of which contribute to an economy on the upswing.
It’s taken the better part of a decade, with more than a few false starts and fear-driven setbacks, but it appears the U.S. financial sector finally may be back on its feet.
Second-quarter earnings reports for the sector, led by the “money center” banks, are showing levels of profitability not seen since the go-go days of 2007, just before the collapse that dragged the rest of the economy down into recession. Their balance sheets are also stronger than they’ve been in years – government-mandated “stress tests” indicate that the shareholder capital they’ve added to their books provides greater protection against a future financial crisis.
Why is all of this important? First, the financial sector accounts for a sizable chunk of U.S. gross domestic product, so its health has a bearing on the economy’s collective health. With annualized GDP growth now poking along around 1%, every little bit helps.
Even more importantly, the financials pool the resources of savers and lend them out to borrowers and investors. The creation of credit that’s both relatively cheap and widely available serves to lubricate the national economy and promote growth. It doesn’t always work perfectly, and we’ve certainly seen detrimental excesses, but we think most would agree that a financial sector in good shape is on balance better than the alternative.
The investment case is still firming up, which explains at least in part why the Standard & Poor’s 500 financial sector (+7.5% total return through July 21) is significantly trailing the S&P overall (+11.7%). The underperformance is even greater for the mid-cap and small-cap banks, which tend to have less diverse operations.
We increasingly like the story, particularly for the large caps. In addition to adding stability, the repaired balance sheets free up more of those rising profits to be returned to shareholders in the form of dividends and stock buybacks, both of which can support share prices. The big banks had to cut their payouts in the aftermath of the financial crisis, so now they are in a position to become dividend growers, which the market likes.
Interest rate increases by the Federal Reserve also stand to benefit the banks, both large and small, because much of their profitability comes from “net interest margin,” the difference between what it costs them to borrow and what they can charge when lending. As interest rates rise, typically so does the NIM, which enhances revenue and earnings. They’ve also been boosting their revenue and profits from fees and continued cost-cutting.
In addition, the economy has been performing well enough to keep loan defaults very low overall, though there are some areas of concern (including auto and student loans). Last year, the financials were hit by worries that their exposure to the struggling energy sector would spell doom. That fear seems to have abated in tandem with the oil price recovery.
Finally, there’s attractive relative valuation: The S&P 500 financial sector is currently trading at about 14 times forward earnings, well below the 18x price-to-earnings ratio for the full S&P 500. While we don’t see much room for that number to grow for the overall index, the positives listed above could help provide a path for the financials to expand their price multiples.
The biggest question we have for the financials: While they’re loaded up and ready to lend, are there enough borrowers out there? This is mostly a state-of-the-economy question. On one hand, July’s consumer confidence reading is near a 17-year high, but on the other, there’s the sluggish pace of growth and a weak inflation trend. This can be a self-reinforcing problem if individuals rein in spending and potential business borrowers put off investment in new plants and equipment out of fear of an impending slowdown or recession.
Improving economic conditions overseas could be a partial answer to our big question – companies in the S&P 500 derive close to half of their revenue from their international operations. And a weaker U.S. dollar (down 8% year to date) helps exporters by making their goods more competitive in global markets.
Even more beneficial would be greater policy certainty out of Washington. As the year began, the expectation was that fiscal policy, in the form of tax cuts and infrastructure spending, would step in as monetary policy stepped back. A clearer signal that the government is moving toward those goals could release the animal spirits, both economically and in the markets.
As always, we encourage investors to speak with one of our financial advisors, who can help determine which investment vehicles are suited for you based upon your individual goals, objectives, risk tolerance and time horizon.
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