Editor’s note: Our financial sector outlook is the first in a regular series sharing our views on various sectors with advisors and consultants. It’s part of our efforts to increase communication with investors at a time of economic and market uncertainty. While the sector outlooks provide a short overview of our thinking, we invite you to contact us if you are interested in a deeper discussion.
Since the coronavirus pandemic began, few stocks have been as unloved as financials. But the same headwinds working against the sector could be setting it up for a rebound with a little more confirmation about the economy.
As part of a new series sharing Dana’s outlook on each sector, we look at both the negatives and positives facing the sector, and how we are investing in the current backdrop. Given the sector’s relative underperformance this year, we start with the headwinds:
- Macroeconomic uncertainty. When the macroeconomic picture lacks clarity, the market tends to punish the economically sensitive financial sector. And currently, there is much uncertainty. Questions loom around the elections, trade tensions, and, of course, the coronavirus and its effect on economic activity.
- Low interest rates. The Federal Reserve has made it clear it intends to keep rates low, possibly through the end of 2023. With the short end of the yield curve near zero and the 10-year Treasury yield hovering around 70 basis points, the yield curve is fairly steep, which can be good for banks. But the absolute level of the long end is low, and this continues to crimp banks’ profitability. While this is a headwind for the financial sector, it isn’t new. Banks have dealt with low rates for much of the past decade.
- Regulation. The regulatory environment has also been a persistent headwind for the sector since the financial crisis. Increased regulation has left banks overcapitalized and limited the amount of capital they can return to shareholders. While an overcapitalized bank is better positioned to weather economic shocks and storms, depressed returns on capital have put a ceiling on the multiple investors will pay for bank stocks.
The headwinds above have been persistent, and stock valuations reflect those risks. What’s underappreciated are the potential catalysts that could work in the sector’s favor. Those include:
- A potentially quick economic rebound. Yes, the macroeconomic picture is unclear, and that has weighed on financial stocks lately. But here’s some potentially good news: The pandemic-induced economic downturn doesn’t look like a long-tail recession. We expect the economy to recover quickly, due in large part to the massive fiscal and monetary stimulus the government has provided to support consumers and businesses. Second, a vaccine and lower coronavirus caseload could also support increased economic activity. As investors begin to anticipate the economic rebound, we believe economically sensitive financial stocks are likely to benefit.
- Inflation could surprise to the upside. While runaway inflation isn’t likely, the massive fiscal and monetary stimulus injected into the economy in 2020 does raise the odds that inflation could start to run higher. Couple that with the fact that the Fed has said it intends to let inflation run above 2% before raising rates and it’s not hard to envision the long end of the yield curve steepening as the market anticipates rising inflation. Even a small move up in long-term interest rates could do a lot for bank profitability.
- Negative sentiment, low valuations, could set stage for financial sector rebound. Let’s start with the caveat that poor sentiment and attractive valuations alone are not reasons to own any stock. But we see more within the financial sector. We see negative sentiment and low valuations, but capital-rich balance sheets and the potential for better return of capital with just a whiff of economic improvement. We believe that provides a favorable backdrop for the sector over the mid- to long-term.
How are we investing?
While we believe the outlook for the sector will improve, the current operating backdrop for banks and other financial stocks is nonetheless challenging. In this environment, we are investing in banks whose management teams have a strong record of weathering financial storms. With profitability limited, there is no room for error in maintaining profit margins, so we are closely analyzing whether banks have levers to pull to cut expenses and manage costs.
Outside the traditional banking industry, we see opportunity with companies tied to capital markets, which benefit from market volatility. We also like the potential of businesses providing wealth management services. These companies generate steady fee revenue, and their services should remain in high demand as customers seek financial advice in an environment where economic and market uncertainty remains.
