Market Commentary | November 18, 2021

Financials Sector Rating: Neutral

The Financials sector includes banks (banks, thrifts and mortgage finance); diversified financials (diversified financial services, consumer finance, capital markets, and mortgage real estate investment trusts); and insurance.

The Financials sector has many favorable attributes, but uncertainties about the path of the economy, interest rates and the market overall raise the level of risk for the sector. While macroeconomic conditions remain strong, we’ve likely seen a peak in the rate of growth. Historically, relative performance of the sector is positive in the expansion phase. Even as the Federal Reserve embarks on the process to unwind accommodative policy as inflation remains somewhat less-transitory than previously expected, we think that this interest-rate-sensitive sector will gain a tailwind from rising interest rates in the coming months.

In general, large banks still boast strong balance sheets, with ample capital to withstand even a significant rise in loan defaults, according to the latest Federal Reserve Board annual bank stress tests.1 While the expiration of stimulus payments likely will contribute to an uptick in loan defaults, reserves for a large spike in loan loss were set aside last year—and not needed. Many banks are now able to reverse some of those reserves, which were booked as expenses.

However, a surge in cash deposits overtook loan growth, which is weighing on its bread-and-butter net interest margins (the money earned by reinvesting cash in the short-term money markets, and/or the difference between the rate paid to depositors and the rate charged for loans). We are now starting to see an upturn in loan demand, but it is still trailing the growth in deposits.

Valuations are still attractive relative to other sectors—but forward earnings expectations have flattened out. Unless forward estimates turn higher, any significant price rise in the Financials sector would increase the price/earnings ratio, eroding the attractiveness of its valuations.

Many of the sector’s favorable attributes—strong financial position, higher interest rates, and attractive valuations—are tailwinds. However, the peaking of economic growth and the potential for higher volatility somewhat offsets positives.

To be clear, we do not have a negative view on the sector, though there are notable risks (see the risk bullets below). It still has strong underpinnings, and many of the issues noted above could be resolved in the coming months; if they were, our view could change. However, from a three- to six-month tactical perspective, we think outperformance of the sector is less likely.

Positives for the sector:

  • Strong financial position, as reflected in the latest Federal Reserve Board stress tests, allowing banks to increase dividends
  • The sector has attractive valuations relative to its historical average and other sectors, but earnings growth expectations have flattened out
  • High loan loss reserves are being released due to low default rates amid strong economic growth (supports earnings growth)
  • Expansion phase of business cycle is typically a tailwind—though investors should expect choppiness in sector rotation

Negatives for the sector:

  • High cash levels and low loan demand are hampering revenues, although loan growth has turned positive recently
  • The peak in the rate of economic growth could offset the favorable rise in interest rates

Risks for the sector:

  • The Federal Reserve raises short-term interest rates sooner than expected in response to an inflation surge, threatening economic growth
  • Interest rates fail to rise amid weaker-than-expected economic growth
  • There is a significant increase in banking regulations
  • Financial technology companies could take market share from traditional banks 

 

1 Board of Governors of the Federal Reserve System, “Federal Reserve Board releases results of annual bank stress tests, which show that large banks continue to have strong capital levels and could continue lending to households and businesses during a severe recession,” June 24, 2021. The annual stress tests evaluate the resilience of large banks by estimating their losses, revenue, and capital levels under hypothetical scenarios over nine future quarters.

What do the ratings mean?

The sectors we analyze are from the widely recognized Global Industry Classification Standard (GICS®) groupings. After a review of risks and opportunities, we give each stock sector one of the following ratings:

  • Outperform: likely to perform better than the broader stock market*
  • Underperform: likely to perform worse than the broader stock market*
  • Neutral: no current view on likely relative performance

 

* As represented by the S&P 500 index

Want to learn more about a specific sector?  Click on a link below for more information or visit Schwab Sector Views to see how they compare. Clients can log in to see our top-rated stocks in the Financials sector.

Communication Services Industrials
Consumer Discretionary Information Technology
Consumer Staples Materials
Energy Real Estate
Health Care Utilities

 

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