Since the start of 2017, there’s been more price volatility among companies in the financial sector. Despite the roller-coaster ride in some of these stocks, the S&P 500 Financial Select Sector Index (IXM) is still outperforming the S&P 500 (SPX) over the past year, up just under 33% compared to the SPX’s 27% increase.
The financial sector is forecasted to report year-over-year earnings growth of 6.8%, the third highest out of the 11 sectors in the S&P 500, according to FactSet. At the industry level this quarter, only the insurance industry is expected to report double-digit earnings growth (20%); if the insurance industry is excluded from the financial sector’s estimated earnings growth rate, it would drop to 3.8% from 6.8%, also according to FactSet.
There’s several factors at play that some analysts think might benefit the sector in upcoming quarters. A tight labor market, continued economic growth, as well as strengthening consumer and corporate balance sheets are some of these factors. Companies in the lending business could also benefit from the prospects of higher interest rates in the future, potentially spurring consumers to buy homes and make other big-ticket purchases they’ve been holding out on.
In addition to those factors, IPO activity has started to pick up, with 31 more offerings in the first half of 2017 than the first half of 2016, according to IPOScoop. Big banks who underwrite IPOs typically can generate large fees from new offerings, but the revenue can fluctuate greatly from year to year depending on the number of companies going public and the size of deals.
Trading Activity in the Sector
Trading in some of the bigger financial companies such as JPMorganChase (JPM), Wells Fargo (WFC), Bank of America (BAC), and Citigroup (C) has been choppy so far in 2017, likely pressured by yields and regulatory uncertainty out of Washington.
Even though the post-election rally in financials has cooled, many stocks in the financial sector are still up significantly over the past year; and bank stocks started rallying again following positive results from the Fed’s annual stress test, which was seen as a vote of confidence that balance sheets at the big banks are in healthy shape. After the recent rally, the IXM is up just shy of 5% year-to-date (figure 1).
Fed Stress Test Results
34 of the nation’s largest banks passed the Fed’s stress test, giving them the green light to use extra cash for dividends and share buybacks. This is the first time in seven years all of the biggest banks had their capital plans approved following the stress test—a yearly checkup to make sure banks have the capital to survive a severe financial crisis and still be able to lend to consumers and businesses.
As a result of the positive outcome of the tests, many of the big banks announced dividend hikes that ranged from a few percent to as much as doubling current payouts. Share buybacks have also increased, with some of the biggest banks to repurchase more than $10 billion of common stock over the next year, according to capital plans they publicly released after receiving the Fed’s approval.
Proposal to Roll Back Dodd-Frank
There’s been a lot of talk about reducing the regulatory burden on the financial sector and we’re finally starting to see what those initial plans look like. Earlier in the month, the House passed the Financial CHOICE Act, which scales back or eliminates many of the regulations put in place by Dodd-Frank Act following the financial crisis. The CHOICE Act still needs to make it through the Senate.
Several days after the House voted, the Treasury Department released its first proposal of recommendations on specific steps to take to reduce the regulatory burden of Dodd-Frank. Many of the steps focused on the Fed’s stress tests. Currently, banks with more than $10 billion in assets are required to undergo the annual test. Under the new proposal, that threshold would rise to $50 billion, reducing the burden on smaller banks.
There is some disagreement between the CHOICE Act and the Treasury when it comes to the Volcker Rule, which limits the investing and trading activities banks can engage in. Treasury Secretary Steven Mnuchin has proposed loosening the rule, whereas the CHOICE Act would scrap it completely. Loosening restrictions would give companies, such as Morgan Stanley and Goldman Sachs, more freedom with their capital when trading fixed income, currencies, commodities and equities.
Interest Rates and The Yield Curve
As the year progressed, the yield curve flattened to almost 10-year lows, according to Reuters. If the spread between long-term and short-term interest rates continues to shrink, it could pressure earnings in the sector because banks tend to borrow in the short-term and lend to consumers and businesses over longer periods of time (mortgages, long-term company debt, etc.)
As of Friday morning, the 10-year Treasury yield was 2.28% while the 2-year yield was 1.37%, a spread of 91 basis points. At the start of 2017, the spread was 42 basis points higher. A flattening yield curve typically indicates that expectations of future inflation, and sometimes economic growth, are declining. A steeper yield curve typically helps boost bank’s net interest income—the difference between revenues generated by a bank’s assets and the expenses associated with paying its liabilities.
The first round of bank earnings come out before market open on July 14, with JPMorgan Chase, Wells Fargo, and Citigroup reporting second-quarter results. The following week, Bank of America, Goldman Sachs and Morgan Stanley will open their books.