Earlier this week in “The Trump Premium Has Drained Out,” we noted that at least one bank thinks there’s some asymmetric upside in the financials from here.
Basically, financials are another “Trump trade” that investors have faded this year as tax reform got pushed further and further into the future and as the generally dim prospects for the administration’s agenda caused investors to sour on the reflation narrative in the U.S.
The steady grind lower in yields (and flatter in the curve) and the dollar’s abysmal YTD performance mark a stark contrast with what we saw in the immediate aftermath of the election and the remarkable shift in positioning (from short USTs and long USD in January to long TY and short USD more recently) underscore the market’s growing angst and mounting impatience.
All of that said, when it comes to financials, investors still think regulatory reform and tax cuts are in the cards and the prospect of shareholder returns post CCAR helps sentiment as well. For their part (and this gets us back to what we said here at the outset about some asymmetric upside in the financials), Goldman notes that based on their model, banks have gone from outperforming their “normal” relationship with macro assets by a full 12% in the immediate aftermath of the election (the “Trump bump”) to underperforming the same model by 4%:
The implication is that there’s considerable room to run to the upside in the event anything at all goes right in terms of the fiscal agenda (it’s the old “how much worse can this possibly get?” trade).
Well, Goldman is out on Friday evening reminding you that Fed balance sheet normalization could give investors another excuse to get excited about the banks. “Financials’ returns vs. the S&P 500 continue to exhibit nearly the strongest correlation with Treasury yields on record,” the bank notes. Here’s a visual:
And here are some excerpts from Goldman’s latest:
Our economists expect that next week the Fed will announce plans to begin normalizing its $4.5 trillion balance sheet starting in October. From a stable level of less than $900 billion pre-crisis, since 2008 the Fed’s balance sheet has quintupled and now stands just shy of 25% of US GDP. The Fed will start with a cap on monthly runoff of $10bn that rises by $10bn every quarter until reaching $50bn in October 2018. In our economists’ base case, the process should end in 2021 with a terminal balance sheet size of roughly $3 trillion (13% of GDP).
The most likely immediate effect of less Fed demand for bonds is higher Treasury yields, which could weigh on equity valuations. Our economists believe that the entire balance sheet reduction should lift the Treasury term premium by about 75 bp in total, although some of this effect on 10-year yields is likely already priced in. A 20 bp shift in S&P 500 earnings yield would reduce forward P/E modestly from the current 17.9x to 17.4x (-3%), moving the S&P 500 toward our year-end target of 2400 (-4%).
Given the well-choreographed and gradual adjustment, we expect that asset markets will avoid another “taper tantrum,” the sharp and disruptive rise in yields that occurred in 2013. In May 2013, Fed Chair Bernanke’s mention of QE tapering caused 10-year Treasury yields to surge by more than 100 bp. S&P 500 dipped by 6% during the course of a month (a 50 bp rise in earnings yield), but recovered quickly thereafter.
At the sector level, higher Treasury yields and a steeper yield curve should benefit banks and other Financials stocks. Financials’ returns vs. the S&P 500 continue to exhibit nearly the strongest correlation with Treasury yields on record. At the other end of the distribution, “bond proxy” sectors with high dividend yields and stable businesses, such as Utilities, should underperform as Treasury yields rise.
So there you go. Long the banks and no need to worry about another tantrum.
Sage advice or famous last words? You decide.