Interest Rates And The Financial Sector

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by: Brian Gilmartin, CFA

The Financial sector is one of the client's overweights and it's lagged the S&P 500 badly all year.

Up just 2% YTD, versus the roughly 8% total return for the S&P 500, banks and brokers have been pretty punk, with the yield curve being seen as the biggest culprit, whether that is the real reason or not.

BlackRock published a recent research piece making the case for the Financial sector, and given that clients remain overweight, we would agree. Note Chart 2 and Chart 4. (Love BlackRock's research.)

4 big banks report their Q3 '18 financial results before the opening bell Friday morning, and by the end of October, most of the Financial sector will have reported their 3rd quarter. In other words, of the S&P 500, the 67 names within the Financial sector release earnings before much of the S&P 500 releases their own earnings.

The point being that we get a good read into other sectors from perusing the banks and Financial's segment results i.e. consumer spending, consumer credit, commercial loan growth, capital market activities, trading results, investment banking, where increased net charge-offs (NCOs) are being seen, yada, yada, yada, etc.

As a sector, the Financials are expected to report 40.8% earnings growth on 8% revenue growth. How does expected Q3 '18 revenue growth compare to historical Financial sector revenue growth? (The insurance sector compares vs. Hurricane Harvey from Q3 ’17 and the impact from Hurricane Flo this year could distort the numbers. Per Thomson Reuters commentary, if the multi-line and prop/cat insurance is pulled out of the Q3 '18 estimates, the sector is still looking at +30% y/y EPS growth.)

Historical revenue growth for the Financial sector:

  • Q3 '18(e): +8.2%
  • Q2 '18(a): +8.2%
  • Q1 '18: +2.2%
  • Q4 '17: +4.4%
  • Q3 '17: +2.2%
  • Q2 '17: +4.1%
  • Q1 '17: +8.8%
  • q4 '16: +4.0%
  • Q3 '16: +6.9%
  • Q2 '16: +0.9%
  • Q1: 16: -1.2%
  • Q4 '15: +2.7%
  • Q3: '15: +1.0%
  • (e) - estimate
  • (a) - actual

(Source: internal s.sheet from Thomson Reuters IBES data)

The Financial sector is still working off the post-2008 restrictions and handcuffs the government and the regulators put on the sector. In the "fighting the last war" mentality, clients still ask me if the relaxed regulation under the current President and Congress might mean another 2008 is around the corner, but my opinion is that we are a long way from something like that happening again. The leverage within the Financial sector not to mention the stronger capital positions should help the sector tremendously.

Here is a quick summary of what is expected from the banks reporting Friday morning, October 12th, 2018:

JPMorgan (NYSE:JPM): $2.26 in EPS and $27.6 bl in revenue for expected y/y growth of 27% and 9% respectively. 9% y/y revenue growth for a bank the size of JPM is pretty nice. Loan growth will be a focus and since JPM is the first big bank to report, looking at capital market activity will give readers good insights into the other brokerage and larger banks results. (Long JPM for clients, top 10 holding.)

Wells Fargo (NYSE:WFC): $1.17 in EPS expected on $21.7 bl in revenue for expected y/y growth of 15% in EPS on an expected 2%-3% drop in revenue. Wells is still fighting the damage to the brand on the extra accounts and what is a never-ending onslaught of headlines about Well's internal controls and internal culture of generating new business. (Clients are long the stock through the XLF.)

Citi (NYSE:C): $1.65 in EPS expected on $18.5 bl in revenue for expected y/y growth of 29% and 4% respectively. Citi is one of the most oft-cited names by the larger-firm strategists in terms of its valuation since the stock continues to trade at 1x book value and just a smidge above tangible book value (TBV). (Clients are long Citi through XLF).

PNC Bank (NYSE:PNC): PNC is expected to earn $2.72 on $4.3 billion for expected y/y growth of 30% and 6% respectively. Never owned or followed the stock/bank.

Summary/conclusion: The long-lasting impact of Dodd-Frank and the post-2008 regulation on the banking system was to reduce leverage and force banks to hold more capital and that is/was a long-term drag on the sector's returns. While the current Administration and Congress have loosened the constraints a little bit, I don't think the sector is anywhere close to revisiting the Perfect Storm that hit in 2007-2008. Now that being said, the Financial sector is a credit and capital conduit for the US economy in general, so when there are excesses in the US economy, they are likely to occur within the Financial system as well.

The loosening of CCAR (Comprehensive Capital Analysis & Review) will let banks increase dividends, repurchase shares and in general manage capital more effectively for shareholders. Financials are sufficiently capitalized to be able to absorb credit shocks for now, but we don't want to move too far away from the lessons learned in 2008.

Charles Schwab and JPMorgan continue to be two of clients typical "Top 5" holdings. JPMorgan is expected to grow revenue 10% and earnings +30% in 2018 and yet the stock is trading with low teens multiple. The issue is what's expected for 2019? JPM - given current consensus - is expected to grow revenue 5% and EPS +10% in 2019, so the stock looks like it's being valued off a conservative 2019 consensus.

Personally, I think JPM is the perfect large-cap Financial - investors get consumer and commercial lending business, a more-subdued capital market exposure, the asset management business and good management in the form of Dimon and the team.

The whole sector saw a bid this week with yield curve steepening only slightly, so even a modest rise in longer-term Treasury yields seems to put a bid under the stocks. However, widening net interest margins (NIMs) will likely be offset by slowing mortgage banking and mortgage/housing business as the rise in the 10-year Treasury yield to the highest yield in over 7 years will likely put a damper on housing, if only temporarily.

Financials represent a "value" sector today. Be patient. The first table above shows gradual accelerating revenue growth for Financials. That's never a bad thing.

Thanks for reading…