It’s been a difficult year so far for the financial sector.
First, it was worry over falling oil prices that dragged financials lower, along with the broader market, to start the year. Then, through April and May, financials lagged because the Fed delayed another interest rate hike. Most recently, the vote in the U.K. to leave the European Union, also known as Brexit, dragged financial stocks lower as fears over contagion spread.
On top of all this news that’s adversely affected investor sentiment in financials, another macroeconomic theme is in focus ahead of Q2 earnings: the strong dollar.
The U.S. Dollar was down by about 2% for the year through late June, but it had a sharp rally in May and surged following the Brexit vote on Friday, June 24.
A strong dollar can erode corporate profits among companies that sell products or services in international markets. These sales are eventually converted back to U.S. dollars and if the greenback is stronger, it reduces these sales. To be sure, some of the largest financial companies derive significant sales and profits from international markets. But there’s more to the strong dollar story and its linkage to the weakness in financials.
The Incredible Shrinking Net Interest Margin
The strong dollar is sending a message that the Federal Reserve is less likely to hike interest rates this year after the hike back in December 2015, which was the first hike rate hike in almost a decade. In fact, since the Brexit vote in late June, interest rates around the world moved measurably lower, some of which fell to all-time lows.
This was bad news for financial companies because of something called net interest margin (NIM). NIM is a measure of the difference between the interest a financial company earns and interest it pays out to lenders. For example, a financial company might charge 3.5% interest on a new car loan and pay 0.50% interest in its customers with savings accounts. The difference, or spread, between these two is NIM.
The strong dollar and historically low interest rates have contributed to shape an expectation that NIM might shrink for financial companies in coming quarters. This is why some financial stocks have performed poorly relative to the broader market so far this year.
The chart in figure 1 reveals the poor relative performance of several large-cap financial stocks relative to the S&P 500 (SPX). The black line is the SPX and the candlestick chart is a basket of six large-cap financial stocks: J.P. Morgan (JPM), Wells Fargo (WFC), Citigroup (C), Bank of America (BAC), Morgan Stanley (MS), and Goldman Sachs (GS).
Are Expectations Too Pessimistic?
On the matter of interest rates, and in the immediate wake of Brexit, some analysts think the selling in financial stocks was overdone. For instance, Betsy Graseck from Morgan Stanley recently said, “We believe bank stocks are already pricing in a front-end rate cut. This is a more negative outlook than the forward curve is baking in.”
According to the Chicago Mercantile Exchange’s FedWatch Tool, the probability of the Fed cutting interest rates stood at 13% in late June. This probability goes all the way out to February 2017.
Is Winter Coming to M&A?
Away from the interest rate story, some investors are worried about how Brexit might impact earnings relating to merger and acquisition (M&A) activity. Goldman Sachs analyst Richard Ramsden had this to say about the impact on M&A, “We believe the M&A advisors could be one of the most negatively impacted sectors from the U.K.’s decision to leave the European Union, particularly in the near-term.”
According to Goldman Sachs, M&A activity has already dropped by about 85% in the U.K. For some context, Europe accounts for about 30% of all M&A activity.
Stress Tests: Pass or Fail?
Despite the worries over interest rates and Brexit, some analysts believe the big money-center banks like JPM, WFC, C, and BAC, are in a position to boost shareholder returns through increased dividends and share buybacks. Part of this optimistic outlook stems from the fact that these banks, among many others, recently passed a round of stress testing required by the Fed.
After a round of stress testing in late June, research firm Keefe, Bruyette & Woods said, “Overall, we believe that stress test results are most positive for C, BAC, and MS, where meaningful increases in capital returns are projected.”
Given the most recent leg lower in financial stocks thanks to Brexit, increased dividends or share buybacks might be a welcome development for investors during the upcoming Q2 earnings season. This is because prices of financial stocks have generally moved lower, already increasing dividend yields. If the banks increase dividends and buybacks, it could make these yields among bank stocks all the more attractive, especially in a world where the 10-year Treasury Note is yielding about 1.5%.
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