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In the previous article, we examined the sensitivity of changes in price and sales on the price-sales ratio of Wells Fargo (NYSE:WFC), U.S. Bancorp (NYSE:USB) and PNC Financial (NYSE:PNC). In this article, we'll examine the economic dynamics impacting the financial sector.

Recent FOMC Decision

The recent FOMC decision should add about 2-4 percentage points to real GDP growth over the next year or two. Further, inflation should increase by 1-3 percentage points. The decisions boost equity and commodity prices. It all increases interest rates and weakens the dollar.

Economic Dynamics of Financials

In the period following the year 2000, there was overproduction of loans to consumers. The overproduction of loans resulted in a social loss. Part of the reason for the overproduction of lending was the price of money or interest rates.

The Federal Open Market Committee, in response to the bursting of the technology bubble, decreased the price of money substantially and allowed the benchmark interest rate to stay at one percent for an extended period. Cheap money provided incentive to borrow for the purpose of investment. Some of those investments weren't prudent and resulted in substantial losses.

At the same time, the U.S. Congress was subsidizing consumer loans through government sponsored entities. Subsidies, typically, result in overproduction.

So, there was cheap money and loan subsidies, and the result was an unsustainable level of investment and consumption. The financial institutions benefited from the increase in investment consumption and consumption expenditure. However, when interest rates rose and buyers became less willing and able to invest and consume, overproduction became underproduction and the economy contracted.

Today, we are in a cheap money environment, however, government subsidies are scaled back. Further, the willingness and ability to invest and consume is below pre-2007 levels as the unemployment rate hovers near 8 percent. Unemployment and reduced federal subsidies should continue to weigh on revenue growth. Further, increased regulation will have a material adverse impact.

The U.S. banking system operates somewhere between monopolistic competition and perfect competition. Firms offer pretty much the same products, but some firms offer differentiated products. However, in perfect competition the barriers to entry are low. The barriers to financial industry entry are high. Also, consumers of financial products face a markup, the difference between marginal cost and the price, as firms seek to profit maximize. The markup is consistent with monopolistic competition.

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The pace of jobs growth accelerated in recent months, however, jobs growth remains subdued. As jobs growth increases, consumption expenditure and investment expenditure will increase. Further, the multiplier impact of increased expenditure will benefit financial firm investors.

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The pace of expansion in the non-manufacturing sector increased in recent months. However, the pace of expansion remains subdued relative to previous cyclical expansions. An increased pace of expansion, and its inflationary characteristics, would benefit financial firms.

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Consumer confidence turned lower recently. Further, consumer confidence remains well below levels of previous expansions. Confident consumers increase consumption expenditure and investment expenditure. The relatively low level of confidence and decreased velocity of money is weighing on the top line of financial firms.

From an economic perspective the financial sector remains an unattractive short-medium-term investment. Subdued economic growth, increased regulation and uncertainty, decreased consumer confidence and investor risk appetite, should weigh on the financial firm performance and position. If the future is different from the current environment, there could be a mis-pricing of risk in the financial sector.

To be continued...

Disclaimer: This article is not meant to establish or continue an investment advisory relationship. Before investing, readers should consult their financial advisor. Christopher Grosvenor does not know your financial situation and ability to bear risk and thus his opinions may not be suitable for all investors.

Source: Valuing Bank Shares, Part VI