It’s no secret that bank stocks went on a tremendous rally after the election of President Donald Trump. Financials gained 42 percent between November 2016 and the close of 2017, beating the S&P 500 by 15 percentage points.
But 2018 has been a different story. The sector is down 2.6 percent this year, versus a 3.7 percent gain in the S&P.
Did bank stocks run up too far too fast? Are the best returns in the rear-view mirror?
A good hint will come during the second-quarter earnings season, which begins in earnest on Friday. Friday the 13th, as it turns out.
[See: 7 of the Best Stocks to Buy for 2018.]
Rising interest rates, tax cuts, deregulation and a generally impressive economy has given bank stocks fuel.
But it’s not all sunshine and daffodils on the horizon. Here’s a quick look at the prospects for financials for the rest of 2018.
Unappreciated challenges facing bank stocks. Banks love it when interest rates are rising, since it means they can earn more in interest income on the loans they make to borrowers. That’s finally happening after nearly a decade of record-low interest rates intended to shore up the economy and encourage borrowing in the aftermath of the Great Recession.
However, whenever something seems to be a sure thing on Wall Street, investors should be wary. The China-U.S. trade fight in particular shouldn’t be glossed over.
“The resurfacing of the trade war and the tariff issues — that absolutely would have a slowing effect on the economy,” says Adam Falcon, chief investment officer with Princeton Asset Management.
Falcon sees business confidence dwindling and commercial activity slowing if the U.S. and China ratchet up their trade tiff. While there may be a solution down the road, the current direction of these negotiations isn’t promising: This week, the U.S. announced tariffs on an additional $200 billion in Chinese goods, a major escalation from the $34 billion in imports the U.S. began taxing last week.
An economic slowdown would be bad news for most sectors, but it’s a potential double-whammy for bank stocks. Some of the uncertainty surrounding the trade war has driven investors to safe havens like long-term Treasurys.
“Rates have risen significantly on the short end of the yield curve but there’s actually been a flattening — a non-parallel rise in the long-term rates,” Falcon says. Since banks make money by borrowing at short-term rates and lending at long-term rates, banks would prefer much higher long-term rates.
If investors flee to 10-year Treasurys, for instance, that reduces earnings potential.
Bank stocks: pros you can’t ignore. Citigroup (ticker: C), JPMorgan Chase & Co. ( JPM) PNC Financial Services Group ( PNC) and Wells Fargo & Co. ( WFC) all report second-quarter earnings on Friday morning. Wall Street analysts are expecting earnings for each company to rise from where they were a year ago.
“The S&P 500 financial sector has trailed the market this year,” says JP Gravitt, chief executive officer and market strategist for Market Realist.
[See: 52 Elite Dividend Stocks With Unreal Track Records.]
That said, “as long as they meet revenue expectations this coming earnings season, I’d expect these stocks to have a stronger second half of 2018,” Gravitt says.
And while the spread between two-year and 10-year Treasurys — a common measure of short- versus long-term rates — has narrowed dramatically over the last two and a half years, the bottom line with bank stocks is that higher rates lift all ships.
“The overwhelming consensus of the market is that interest rates are much more likely to move up rather than move down in future years,” says Robert R. Johnson, principal at the Fed Policy Investment Research Group.
Consensus expectations have the Federal Reserve raising rates two more times in 2018, by 25 basis points apiece.
“If the economy remains as strong as it appears, three further rate hikes of 25 basis points each in 2019 are highly likely. These rate hikes will benefit bank stocks,” Johnson says.
That’s the straightforward bullish case for financials. But Johnson sees another one as well.
“Perhaps the biggest factor in favor of bank stocks is their low valuation levels,” Johnson says. “Bank of America ( BAC), Wells Fargo and US Bancorp ( USB) are all selling for between 8 and 12 times forward earnings.”
In a market where go-go growth stocks like Amazon.com ( AMZN) and Netflix ( NFLX) fetch 80 to 90 times forward earnings (and more than 200 times trailing earnings), it’s hard to knock big banks for being expensive while keeping a straight face.
If it walks like a duck. You’re always well-served to be wary of things that seem too obvious. There are plenty of risks to buying bank stocks; after a nine-year bull rally on Wall Street, the U.S. economy seems overdue for some sort of stumble — and if a trade war ensues, that stumble could be entirely self-inflicted.
Financial deregulation could also serve to energize the sector, but no one needs a reminder of how loose lending standards, lax oversight and bad actors can quickly poison the economy.
A downturn could come from anywhere, at any time. Risk is always around.
The best individual investors can do is manage that risk. As far as bank stocks are concerned, the bull case — higher rates and an improving economy — is clear, and has been for a few years now.
Despite that burst of outperformance, stocks in the industry still trade at extremely reasonable (and some might say bargain bin) prices, especially after 2018’s first-half pullback. Risk looks like it’s been priced in.
[See: 7 Stocks That Soar in a Recession.]
“From a value investor’s standpoint, there appears to be a healthy margin of safety at the current levels,” Johnson says.
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Mid-2018 Outlook for Bank Stocks: Top Risks and Catalysts originally appeared on usnews.com
