Financial Sector Outlook: Trade Spats, the Yield Curve and Economic Growth

Earnings are coming with the biggest banks in the financial sector reporting in a few weeks. Here’s a look at what’s been going on in the sector recently and what analysts expect for Q2 earnings.

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At the start of 2018, there was a lot of optimism surrounding the financial sector. Tax reform had just been passed, global economic growth remained robust, Congress was working on deregulation, and the Fed was expected to continue on its path of rate hikes.  

Fast forward to today and the sector has been lagging the S&P 500’s performance by more than 6% so far this year, as of July 2. The tailwinds mentioned above still exist, however, it appears that near term pressures have been weighing on the sector: a flattening yield curve approaching inversion, global growth slowing (or expected to slow), and the back-and-forth between the U.S. and key trading partners.  

Those near term pressures have also apparently injected more volatility into the market. Heightened volatility throughout the first quarter helped some of the major banks boost profits in their trading divisions, and many analysts have indicated that they are again expecting to see a boost in Q2 results.  

For Q2, the financial sector is expected to report 18.5%earnings growth and 3.8% revenue growth, on a year-over-year basis, according to FactSet. Both of those estimates have been trending downward over the past several months. At the end of March, the expected growth rate for earnings and revenue was 19.3% and 4.1%, respectively.  

As Q3 gets underway, it may be worth considering some themes that could influence markets in July, August and September. First, it doesn’t appear that trade worries are going to go away anytime soon, as many investors appear to be focused on the Trump administration’s trade policy with key global trading partners.  

The bigger concern regarding trade is how that could impact economic growth. Strong economies are typically a good environment for financial stocks, whereas slowing growth can negatively impact wide swaths of their businesses as business and consumer demand for loans declines.  

And once earnings season kicks off, company performance as well as what their leadership says could add to volatility. Last earnings season, traders didn’t seem to be too impressed even when companies crushed expectations, and a lot of stocks didn’t see the same movement they have in previous quarters when they beat analyst estimates by a wide margin.

FINANCIALS IN 2018. After a strong performance in 2017, the financial sector has been underperforming the S&P 500 (SPX) so far this year. The Financial Select Sector Index (IXM) is charted above. The sector has seen some support at the mid-$320 level. Chart source: thinkorswim® by TD Ameritrade.   Not a recommendation. For illustrative purposes only. Past performance does not guarantee future results.

Flattening Yield Curve

The financial sector’s underperformance has coincided with the continued flattening of the yield curve. The yield curve matters to banks because they tend to borrow in the short-term and lend in the long-term, providing consumers with mortgage and auto loans for example.

When the yield curve is steeper, there is a greater difference between short and long-term yields, which typically helps boost banks’ net interest income (the difference between revenues generated by a bank’s assets and the expenses associated with paying its liabilities). On the flip side, when the yield curve is flatter, this can pressure banks’ net interest income.

The spread between 2-year and 10-year treasuries has fallen to around 32 basis points. For a frame of reference, at the midyear point last year, the spread between the 2-year and 10-year was 93 basis points.

SPREAD BETWEEN 10-YEAR AND 2-YEAR TREASURIES. The difference between the 10-year and 2-year Treasury yields has continued to decline in 2018. TD Ameritrade clients can access economic data points by going to Analyze > Economic Data in the thinkorswim® platform. For illustrative purposes only.

Stress Tests Mostly Positive

Last week, the financial sector got a lift from largely positive results from the second part of the Federal Reserve’s stress tests.This part of the tests was looking at whether the banks are healthy enough to implement capital plans, such as dividends and buybacks, in the event of adverse economic conditions. 

The Fed approved a vast majority of the banks’ capital plans after they passed the stress tests. Morgan Stanley (MS) and Goldman Sachs (GS) passed with some restrictions on the maximum amount the two companies can return to shareholders, while Deutsche Bank’s (DB) U.S.subsidiary was the only one that had its plans rejected, according to the Federal Reserve.  

The Fed indicated that part of its leniency with certain companies was due to the impact of U.S. tax reform, which had negative balance sheet implications for some of the banks that were still carrying large losses on their books from the Great Recession.  

Regulatory Rollback: More M&A on the Way?

Congress recently passed legislation that rolled back some of the post-crisis financial regulations that were placed on the financial sector. One of the major changes is that the asset threshold where banks face stricter regulations was raised from $50 billion to $250 billion.   

Many of the smaller banks in the past had said these thresholds resulted in them not pursuing mergers and acquisitions so they could stay small enough to avoid the additional costs and complexities that came with the Fed’s scrutiny. In the first quarter, there were 5,607 banks with insured deposits, according to the Federal Deposit Insurance Corp.  

There has already been some activity picking up when Fifth Third Bancorp (FITB) announced it would acquire MB Financial (MBFI) for $4.7 billion.  

Major Earnings Dates

The big banks kick off earnings season and their reports are just around the corner. Here are some of the dates when major companies in the sector report: ·        

  • JP Morgan (JPM), Wells Fargo (WFC), Citigroup (C) and PNC Financial (PNC) all report before market open on Friday, July 13        
  • Bank of America (BAC) reports before market open on Monday, July 16        
  • Goldman Sachs (GS) reports before market open Tuesday, July 17        
  • Morgan Stanley (MS) reports before market open Wednesday, July 18 

Good Trading,

JJ

@TDAJJKinahan 

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