Schwab Sector Views: Downgrading Financials
Last month, we upgraded our rating on the Energy sector, reflecting its improving fundamental backdrop and relatively attractive valuations. This month, Financials is on deck—although we are less optimistic about this sector’s prospects. To make a long story short, we’re downgrading our rating on the Financials sector to “marketperform” from the previous “outperform” rating that had been in place since June 2020.
The Financials sector still has many favorable attributes, but several red flags have emerged. Macroeconomic conditions remain favorable for cyclical value stocks, which are heavily represented in the Financials sector. However, much of the positive news already may have been priced in as investors rushed into the best-performing sector over the past 12 months.
Valuations are still attractive relative to other sectors—but forward earnings expectations have flattened out. The financial position of the sector remains solid, but a surge in cash deposits combined with stagnant loan growth is weighing on its bread-and-butter net interest margins, despite a rise in longer-term interest rates. Finally, the sector has strongly outperformed the overall market in the last year, and now appears to be overbought.
To be clear, we do not have a negative view on the sector, though there are notable risks. 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. Here’s why:
1. The strong macroeconomic tailwind has faded to a summer breeze. As we’ve written in recent articles, this stage of the business cycle—transitioning from recovery to expansion—historically has been favorable to cyclical value stocks that are sensitive to rising interest rates. This has been a strong tailwind for the Financials sector, which has been a relative leader since early August 2020, when the 10-year Treasury yield reached its lowest level,
Recently, longer-term interest rates have stalled out, as the market had likely discounted the economic boom and rising inflation expectations over the past year. Many investment strategists—including us—think rates will resume the advance as the economic boom settles into a more moderate cadence and the Federal Reserve takes its time in moving toward tighter monetary policy.
However, the Financials sector continued to outperform on the back of investor enthusiasm despite the pause in interest rates—as can be seen in the chart below—raising the risk that investors have already priced in the expected near-term gains in interest rates. While we think that rising rates may again become a tailwind for the Financials sector, it could take some time for this to happen.
Financials’ relative performance has jumped ahead of rates
Source: Charles Schwab, Bloomberg as of 6/2/2021. “Financials/S&P 500 Index” represents the S&P 500 Financials Index divided by the S&P 500 Index. The “10-year Treasury yield” represents the generic 10-year U.S. Treasury note yield. Past performance is no guarantee of future results.
2. Balance sheets remain solid, but revenue challenges loom. In general, companies in the Financials sector still boast strong balance sheets, with ample capital to withstand even a significant rise in loan defaults. 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, the massive injection of money into consumers’ pockets and excess cash held by businesses have caused deposits at banks to swell, which has pressured short-term rates to the lower bound of the Fed’s already low target range. At the same time, loan growth has stagnated as large businesses generally satisfied cash needs by issuing bonds, small businesses that were aided by paycheck protection programs have been slow to borrow, and consumers paid down some debt with stimulus checks.
Bank deposits surge as loans fade
Source: Charles Schwab, Bloomberg as of 6/2/2021. “Bank Loans” represents the Federal Reserve Bank of St Louis Loans & Leases in Bank Credit All Commercial Banks. “Bank Deposits” represent the US Commercial Bank Liabilities Deposits.
Together, banks’ net interest margin—a combination of the money they earn reinvesting cash in the short-term money markets, and the difference between the rate they pay to depositors and the rate they charge for loans—has collapsed despite the rise in longer-term rates. This could be resolved if the economic expansion continues, consumers draw down built-up savings and ramp up borrowing, and businesses feel greater confidence in investing. In the meantime, a continued decline in net interest margins is a significant headwind to revenues.
Banks’ net interest margins dive despite higher rates
Source: Charles Schwab, Bloomberg as of 6/2/2021. “Bank Net Interest Margin” represents the Net Interest Margin of All Insured Banks Federal Deposit Insurance Corporation. “5-yr Treasury Yield” represents the generic 5-year U.S. Treasury note yield. Past performance is no guarantee of future results.
3. Valuations are still attractive, but earnings expectations have stalled. Relative to other sectors, valuations for Financials are still very attractive. According to our composite of numerous valuation metrics, it is essentially tied with Health Care for second place behind the Energy sector—though all are still higher than their long-term average.
Financials still have attractive valuations
Source: Charles Schwab, Bloomberg as of 5/28/2021. Bars represent z-score for value composites that include up to six different valuation metrics that provide a holistic perspective on current valuations relative to each of the sectors’ own historical valuations, as well as relative to the other sectors. Standard deviation is the statistical measure of volatility, measuring how widely the data is dispersed from the historical mean or median. Z-score is the number of standard deviations from the mean or median.
Until recently, Financials were among the sectors with the fastest-growing forward earnings expectations, according to Bloomberg’s composite of analysts’ estimates. However, as can be seen in the chart below, forward estimates have flattened recently, due in part to net interest margin headwinds to earnings. 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.
Valuations are at risk if prices rise but earnings don’t
Source: Charles Schwab, Bloomberg as of 6/2/2021. Forward earnings and forward price/earnings for the S&P 500 Financial Index are based on BEst (Bloomberg Estimates) that reflect the consensus estimate for adjusted earnings per share over the next 12 months.
4. Financials are due for a breather. Many of the sector’s favorable attributes—strong financial position, cyclical tailwinds with higher interest rates, and attractive valuations—drove Financials’ outperformance during the past year. However, investors’ enthusiasm for the sector may have become too frothy, pushing it to an overbought level that historically has been followed by price consolidation.
Financials appear overbought after strong performance
Source: Charles Schwab, Bloomberg as of 6/2/2021. The relative strength index (RSI), developed by J. Welles Wilder, measures the velocity of a security’s price movement to identify potential turning points to help make entry/exit decisions. RSI indicator falling below 30 indicates an oversold condition. Similarly, an RSI value greater than 70 indicates an overbought condition. Past performance is no guarantee of future results.
Flattening earnings growth expectations, due in part to low net interest margins, and lack of a strong interest rate tailwind after optimistic investors pushed shares ahead of rates could be the catalyst for a pause in the Financials sector’s outperformance—which historically has followed overbought conditions. These red flags—in an otherwise attractive sector—have eroded our optimistic view of the sector, at least until some of these issues can be resolved.
There are risks to our marketperform rating, as well. The sector could underperform if:
- the Fed unexpectedly tapers its bond-buying programs and raises short-term interest rates in response to an inflation surge that is viewed as a risk to economic growth;
- interest rates plateau or decline on weaker-than-expected economic growth; or
- there is a significant increase in banking regulations.
We’ll monitor these risks carefully, as well as for any resolution to the warning signs. In the meantime, we’ll rate the Financials sector as a marketperform.
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
- Marketperform: likely to track the broader stock market
* As represented by the S&P 500 index
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