To be sure, one could argue that the financials are actually holding up quite a bit better than they should be holding up given the flattening in the curve we’ve seen since the post-election reflationary euphoria.
The CCAR results helped, earnings (by and large), didn’t.
But another thing that’s not helping is the macro backdrop – specifically, the extent to which turmoil in Washington (i.e. the policy agenda getting continually delayed) and lackluster incoming data has weighed on 10Y yields.
On the econ side, this has become the labor market and sentiment against the world. That is, it’s not just the inflation prints that are coming in cold. Have a look:
Now have a look at the relative performance of the financials versus the S&P plotted with 10Y yields:
Underscoring a similar dynamic, Goldman notes that “the correlation between Financials’ excess returns and 10-year US Treasury yields stands at nearly the highest level on record (Exhibit 1) as fundamentally, Financials and interest rates have sensitivity to economic growth and the sector’s profits are strongly related to interest rates”:
So why be bullish the financials given the likelihood that the situation in Washington is only going to get worse and given the fact that we’ve yet to see any convincing signs of a sustained upturn in realized inflation?
Well for Goldman, the answer is simple: capital returns.
The standard cycle playbook supports the macro case for Financials underperformance. With the US at full employment, the clock is ticking on the current economic and market cycles. Financials was the only sector to lag the S&P 500 during the period between reaching full employment and the pre-recession equity market peak in each of the last 4 economic cycles.
While portfolio managers are focused on the macro story, we believe micro tailwinds present an underappreciated opportunity for investors. Our economists forecast faster inflation and Fed tightening than the market expects. Although we have met with few equity investors who share our macro view, we believe the micro presents a compelling case on its own.
Increased capital return is one major micro reason that Financials will outperform. The Fed’s 2017 CCAR “stress test” results released on June 28th gave the green light to banks to boost by $40 billion or 43% the amount of capital they will return to shareholders compared with last year. Financials has only slightly outpaced S&P 500 since then (2.9% vs. 1.5%).
We believe 2017 will mark an inflection point in the amount of capital the Fed allows Financials firms to return to shareholders. This is the first year that certain money center banks have been permitted to pay out more than net income. If that trend continues, our banks analyst estimates that total capital payouts could grow at an average annual pace of 19% through 2020. He expects the capital return will boost EPS and ROE as well as share prices.
Accelerating dividend growth should attract equity income investors, who are broadly underweight the Financials sector. The top 25 equity income funds, which account for nearly 80% of the category’s $450 billion in assets, hold a 19% weight in the Financials sector. This equates to a 700 bp underweight relative to the Russell 1000 Value index, a common benchmark for equity income funds. Our equity analysts’ view that the largest banks will boost dividends at an annualized rate of 17% during the next two years could inspire funds to lift allocations.
Buybacks for the largest banks will soar by 45% this year. Repurchases will lift EPS, ROE, and share prices. We estimate that the repurchases will equate to 3% of average daily trading volume, roughly twice the S&P 500 average during the past five years (Ex. 2). Given 10b-18 rules prohibit buybacks during the trading-heavy starts and ends of the day, these figures likely understate the potential price impact of increased share repurchases.
After embedding significant optimism post-election, Banks share prices now reflect little expectation of deregulation. The gap between actual share prices and the prediction of a macro model rose to 12% in December 2016 but registers just 3% today following policy disappointment out of Washington, D.C. We believe the increased capital return should boost Banks stocks beyond levels implied by interest rates. In addition, the recent nomination of Randal Quarles to oversee supervision at the Fed suggests other deregulatory tailwinds may be building for the Financials sector.