By Jonathan Soyka
Money and Investing Writer
The financial sector has been among the best performing sectors in the S&P500 as of late. Along with the impressive run, many of the big banks that watched their valuations wither away during the Great Recession have not just bounced back but have recorded record highs while doing so. As Q1 2017 is penciled into the books, now seems like a perfect time to look at this sector and ask ourselves a serious question: as financial stocks begin to pull back from their impressive rally, is it time to take profits and wait for future policy announcements or are financials just getting heated up?
This question is very complex and has many contributing components to be considered. From the state of the economy and the future policies of Janet Yellen and the Federal Reserve to President Donald J. Trump’s promise to bring tax reform and jobs to America, there is no shortage of information that will have a dramatic effect on the sector and the companies represented within.
In 2016, the XLF (S&P500 financial sector SPDR ETF) recorded an enormous 22 percent return and has recorded a 19 percent return since Donald Trump was elected into office.
If this sector is performing so well, then why are concerns rising about its ability to maintain stable growth? In March, the XLF recorded a 5.1 percent decline as it closed at $23.73 on March 31, 2017, down from its opening price of $25.01 on March 01, 2017 and 52-week high of $25.30.
While some investors are worried that the party is coming to an end in the financial sector, I urge you to consider the latter. There are two main reasons why this rally is not over yet and why financials are poised to keep up their impressive gains moving forward.
First is President Donald Trump’s promise of tax reform. Currently, there are considerable and well-founded questions as to whether or not the President carries the political power to actually pull off tax reform. While these concerns may be justified, the fact of the matter is that many do want tax reform. After the debacle that was The American Health Care Act, the President badly needs a win or will risk seeing his administration fall further into disaster.
In addition, tax reform is not a one sided proposal. Democrats and Republicans want this done and done right. The argument that the market is already pricing in Trump’s tax policies is far from true. Investors need to look at financials as meeting Trump half way. Yes, part of their run can be accounted to future policies, but we need to consider that only about half of the value of these policies have been priced in. As the Trump Administration continues and his tax reform policy begins to take legitimate shape, we can expect the “Trump-Rally” to continue.
Secondly, Janet Yellen and the Federal Reserve have not been quiet about their take on the economy and their plan for interest rates. While the Trump take on financials can be seen as majorly speculative, the economic take has solid grounds for support.
On Friday March 31, we got the Fed’s favored inflation reading, CORE PCE (personal consumption expenditures index). What this number tells us is how the economy is growing. If we look back to 2015, we can see why this is so significant.
The growth rate in 2015 was 2.6 percent, this lead the fed to raise interest rates toward the end of the year and give forward guidance that represented an additional three rate hikes in the coming twelve months.
What actually happened was 2016 paced for a 1.6 percent growth rate and the Fed choose to back off and hold rates steady for the time being.
That was until March 2017 when the fed raised rates yet again. After raising rates in March, the fed once again issued forward guidance, this time representing two addition rate hikes for 2017.
If we look back to 2015, we know that these proposed rate hikes must correlate with positive economic growth. On Friday, the CORE PCE reading came out at 2.1 percent, a number that signals the strength of the market. This growth rate can be seen as in line with fed’s stance that the economy is healing and can sustain higher interest rates.
However, it should be noted that a decline in expected growth could force the fed to hold off once again on raising rates.
You must be thinking to yourself, “I was taught in economics class that rising rates usually move money out of stocks and into bonds, decreasing their appeal and price?” Yes, this is true in most cases but is not true of financials. To demonstrate this I will explain, at a very basic level, how banks work.
When you save money with a bank, they pay you interest. They then loan out this money and receive interest on it. The “spread” is the difference in what they pay a customer for their savings and what they make on a loan. Common sense says that as interest rates rise both customers and banks will make a little more money as they will both be able to take advantage of higher rates.
Unfortunately, that is far from the case. What will actually happen is Mom and Dad will continue to accrue their near zero interest rates on their savings accounts while the bank’s loan rates will rise with the discount rate (the minimum rate set by the federal reserve for lending to other banks). This will increasing their spread. In simple terms, an increase in interest rates will increase banks margins and profits.
This makes banks appealing for yet another reason. Rising rates have a negative effect on stocks. The financial sector can not only been seen as a strong investment to take advantage of these rising rates but can also be viewed as a natural hedge for portfolios that are heavy in areas that rates effect the most, such as consumer discretionary spending. A portfolio with heavy financial stock exposure would be in a strong position to cushion potential losses from other sectors.
We have addressed why financials are a strong play from a macro standpoint. However, given the recent extraordinary run, is now the right time to buy in? Alternatively, are these companies objectively expensive due to the run up in price?
It is clear that not only is this industry poised for long term growth but is also priced very favorably. From a valuation standpoint, financial stocks have been trading well below their 20-year average price-to-book value, by around 25 percent. The price earning of financial stocks exemplify this with a P/E ratio of 15.9, compared to the overall S&P500 of 21.
While the broad market is looking more and more expensive, the financial sector still has plenty of room to run. Moreover, while the recent decline in bank prices might bring about concerns for the sector, the overall growth and outlook of the economy continue to make these companies very appealing. In addition, while now is a great time to get into financials, it must be stated that this sector does rely heavily on the expectation of tax reform and rising interest rates. A decline in the growth rate of America could stall the epic run if the fed decides to delay rate hikes.
This article focuses on the S&P Financial Sector ETF, XLF. Listed are the top 5 components of the XLF: Berkshire Hathaway (BRK-A), JP Morgan Chase & Co (JPM), Wells Fargo & Co (WFC), Bank of America (BOA), Citigroup Inc. (C).
A version of this article appeared in the Tuesday, April 4th, 2017 print edition.
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