U.S. financials performed strongly in 2017, but still lagged the broader market as well as technology stocks and momentum names. But with the Federal Reserve (Fed) normalizing monetary policy, higher interest rates, and prospects for deregulation, the sector now seems poised for growth. The U.S. ETF Investment Strategy team discusses the sector and investment considerations for 2018.
Why financials?
Three drivers could potentially propel financials stocks higher in 2018. Earnings momentum coupled with deregulation, yield curve steepening, and the potential support of the value factor.
1. Earnings and deregulation
Last year was a strong year for corporate profitability across all major regions and it will be a tough act to follow. However in the United States, corporate tax cuts and the prospect of deregulation presents new opportunities for growth in the financial sector. Corporate tax cuts could provide an extra leg up for earnings, while the prospect of far-reaching financial sector reforms, potentially not requiring legislation, is also encouraging for financial stocks. Although the impact of deregulation can be difficult to quantify, one study by Bloomberg Intelligence suggests that the Treasury Department’s plan to ease regulation could free up a combined $124 billion of capital to return to shareholders.1
2. A steepening yield curve
It is broadly expected that President Trump’s Federal Reserve Chair choice Jerome Powell will keep the Fed on its path towards monetary policy normalization. What is less certain is whether the Fed becomes more hawkish as the Board of Governors changes into the future, but bond markets appear ready to take the cue to move. The yield on the U.S. 10 year Treasury bond recently hit 9-month highs and the 2s10s spread widened on news of the Bank of Japan trimming its long-dated bond buying program and questions around China’s ongoing purchase of U.S. Treasuries (USTs) with its foreign-exchange reserves. Tempering the steepening moves are long-term factors such as a structural rise in risk aversion and savings (highlighted in BlackRock’s recent piece ‘The real story behind interest rates’), which potentially could weigh down bond yields across the curve. In addition, low inflation expectations kept rises in 10-year yields in check in 2017.
The interplay between these dynamics will play out over 2018, but as rates eventually rise, financial stocks could be poised to benefit given the long term relationship between interest rates and banks’ net interest margins (NIMs).2
3. Enter the value factor
As we noted in our November Investment Directions, in periods of rising interest rates and benchmark bond rates, value has tended to outperform. Sanguine investor sentiment towards equities could mean the market’s cheaper stocks come back into favour and as depicted below, global financial stocks appear to be trading cheaply compared to all other sectors.
Although momentum stocks appear to be well supported in the current environment, the historical negative correlation between value and momentum could also help provide cushioning in the event of sharp reversals.
Investor positioning
In the fourth quarter of 2017, U.S. sector ETP flows were dominated by cyclical exposures supported by macro tailwinds. The largest share of net inflows went to financials with $4.3 billion, followed by information technology with $3.3 billion and industrials with $1.6 billion.3 Applying a factor lens, primary market inflows into U.S.-listed factor ETFs included $1.3 billion into momentum exposures and $588 million into value exposures in Q4. Fifty percent of the latter amount came in the month of December, suggesting a more recent shift into the factor.4
Investing in the financial sector can be accomplished through a broad exposure to the sector or through a more targeted approach. Here are some reasons why one may opt for a more nuanced approach:
- A view that smaller to mid-sized banks may benefit more from deregulation and rising NIMs than industry giants with trillions of dollars on their balance sheets.
- A view that U.S. investment banks, discount brokerages, and stock exchanges specifically may have more to gain from financial services reform than the broader sector.
- A view that U.S. insurance companies may find it easier to manage their long-dated liabilities as interest rates adjust towards a more “normal” regime.
- A view that value isn’t the only historically-proven driver of returns above the broad market, and that an investor could play financials by also targeting quality, momentum and relatively smaller companies within the sector.
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