The Financial Sector: Checking in Ahead of Q4 Earnings Reports

Financial stocks rallied ahead of Q4 earnings as U.S. tax reform is passed. In the next few weeks, big banks in the financial sector report quarterly earnings

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After struggling for much of 2017 to build on its post-election rally in 2016, financial stocks moved sharply higher over the past three months as investors’ optimism for the sector seemed to be renewed  by the prospect, and eventual passing, of tax reform, as well as continued economic growth and regulatory relief from Washington.

At the beginning of September, the S&P Financial Select Sector Index (IXM) had given up some of its summer gains and was almost back to being flat on the year. Since then, the sector has moved up quite a bit and ended the year with an 18.79% return, just a bit shy of the S&P 500’s (SPX) 19.42% return.

Heading into first-quarter earnings season, the financial sector is expected to report 11.7% earnings growth and 2.3% revenue growth on a year-over-year basis, according to FactSet. At the industry level, insurance and consumer finance are projected to report the highest earnings growth, coming in at 36% and 24%, respectively. One thing FactSet noted is that AIG (AIG) is the largest contributor to the sector’s projected earnings growth due to the large loss it reported in the prior-year period.

thinkorswim stock chart showing the S&P Financial Select Sector Index

3-MONTH FINANCIAL SECTOR PERFORMANCE.

As the prospect of U.S. tax reform solidified towards the end of November, the S&P Financial Select Sector Index (IXM) moved sharply higher. Most of the sector’s gains for 2017 came after September and the sector was in a tighter range for much of December. Chart source: thinkorswim® by TD Ameritrade.  Not a recommendation. For illustrative purposes only. Past performance does not guarantee future results.

Consumer and Corporate Finances

Consumers still appear to be feeling pretty good about the overall economy. U.S. consumer confidence did slip from 17-year highs in December, but remains at historically strong levels, according to The Conference Board’s monthly survey. Consumer finances have also been improving based on household debt service payments as a percentage of disposable income (see chart below). On a broad scale, that has the potential to lower the risk of loan defaults for banks, and it also gives consumers a little leeway to take on more debt. 

thinkorswim chart showing household debt service as a percent of disposable income

HOUSEHOLD DEBT.

Household debt service payments as a percentage of disposable income have declined sharply since the financial crisis and remain well below long-term trends. While consumers might choose to be more conservative with their finances, and banks might have stricter lending standards, the percentage indicates there is some room for consumers to take on more loans compared to historical averages. The gray shading on the chart indicates an economic recession in the U.S. TD Ameritrade clients can access economic data points by going to Analyze > Economic Data in the thinkorswim® platform.   For illustrative purposes only.

At the same time, corporate cash balances have continued to grow on the back of earnings growth and remain at all-time highs, according to S&P Global Ratings. The repatriation tax break could also spur companies to bring more overseas profits back to the U.S. and use that money for investments, mergers and acquisitions, stock buybacks and other activities that investment banks can earn sizable fees on. Executives have previously indicated they would primarily use that money on paying down debt, stock buybacks and mergers, according to a Bank of America-Merrill Lynch survey of 300 executives at major U.S. corporations

Yield Curve Concerns?

Before each of the past seven recessions, the yield curve has become inverted and many view this as an indicator of an upcoming recession. Despite some of the fears that people have from this indicator, Fed Chair Janet Yellen indicated that she, along with many market participants, see low odds for a recession based on strength in other economic indicators. 

Beyond the potential recession signal, 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).

thinkorswim chart showing the spread between two and ten year treasury yields

SPREAD BETWEEN 10-YEAR AND 2-YEAR TREASURIES.

The difference between the 10-year and 2-year Treasury yields continued to fall over the course of 2017. TD Ameritrade clients can access economic data points by going to Analyze > Economic Data in the thinkorswim® platform.   For illustrative purposes only.

Tax Reform and Regulatory Rollback

After much back and forth, U.S. tax reform has been passed and the corporate income tax rate was slashed to 21% from 35%, with many analysts seeing banks and financial stocks as potential beneficiaries. Of the eleven S&P 500 (SPX) sectors, financials have historically paid the highest effective tax rate at 27.5%, according to Wells Fargo analysts, and Goldman Sachs analysts estimate that the tax bill could boost large bank earnings by roughly 13% in 2018.

Congress has also been making progress on rolling back regulations imposed on banks after the financial crisis. At the beginning of November, a bipartisan Senate committee agreed on a proposal that would relieve some of the regulatory burden from smaller banks. Currently, banks with over $50 billion or more in assets are subject to additional Federal Reserve oversight. The new proposal would raise that threshold to $250 billion, eliminating all but a small number of the nation’s largest banks from the additional oversight.

Looking Ahead

Minutes from the Fed’s December meeting came out this afternoon as Fed Chair Janet Yellen’s departure approaches. So far, the Fed has signaled three rate hikes for 2018, but economic developments over the course of the year could impact that pace of hikes.

Over the next few weeks, many of the major financial companies in the U.S. are slated to report earnings. Wells Fargo (WFC) and JPMorgan Chase (JPM) kick things off and report before market open on Friday, Jan. 12. The following week, Citigroup (CITI) reports before market open on Tuesday, Jan. 16, and Bank of America (BAC) and Goldman Sachs (GS) report before market open on Wednesday, Jan. 17.

Good Trading,
JJ
@TDAJJKinahan

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