US financial sector performance: falling down the (yield) curve

02 Jul 2018

The financial sector had been assumed to be one of the equity sectors that would outperform the broad S&P 500 index in 2018. Robust US economic growth following the passage of tax cuts would boost cyclical sectors and deregulation would enhance profits. But instead of market-beating returns, the sector’s total return up to 27 June was -4.3%, compared to a 3.0% gain for the rest of the index. What are the reasons for the disappointing figures? Might things turn around by the end of the year?

 

The principal cause of the underperformance has been the ongoing flattening of the US government bond yield curve. The yield spread between 2-year and 30-year US Treasuries has declined from 87bp at the end of 2017 to just 46bp as of 27 June. The relative performance of the financial sector has mirrored this decline (see Figure 1).

Figure 1: US yield curve and financial sector relative performance vs. S&P 500

us-yield-curve-and-financial-sector-relative-performance

Spread is between 2-year and 30-year US Treasuries. Performance is total return of S&P 500 finance sector relative to S&P 500 ex-financials.

Source: FactSet, BNP Paribas Asset Management, as at 27 June 2018

The higher absolute level of short-term interest rates is raising deposit funding costs for banks and thereby reducing net interest margins. Given the likelihood that the US Federal Reserve will increase the fed funds rate two more times this year and perhaps four times next year, while longer-term Treasury yields remain low due to modest inflation and the ever-present weight of Treasury holdings on the Fed’s balance sheet, this flattening could well continue.

Moreover, two of the key drivers of performance for the sector – tax cuts and deregulation – are now well understood by investors and are largely reflected already in stock prices.

On the other hand, we expect loan growth, particularly in commercial and industrial (C&I) loans, to pick up meaningfully in the second half of the year. The latest revisions to second-quarter US GDP growth data illustrate why this might happen. While the quarterly growth rate was revised downwards from 2.2% to 2.0%, not all the changes in the components were negative. Slightly lower household consumption and net exports were offset by an increase in business investment, which is now expanding beyond the energy sector into other parts of the economy. Rising C&I loan growth should feed into higher bank profits (see Figure 2).

Figure 2: Commercial and industrial loan growth

Year-on-year change

commercial-and-industrial-loan-growth

Source: US Federal Reserve, BNP Paribas Asset Management, as at 27 June 2018

The flip side of loan growth, however, is credit quality. Investors are paying more and more attention to this as the US economic cycle ages. At least so far, there is no sign of a significant deterioration in credit conditions, but the marginal change in some indicators is negative. According to data from Bank of America Merrill Lynch, high-yield credit default rates, which rose sharply in 2016, have since stabilised (see Figure 3). But the upgrade/downgrade ratio for investment-grade corporate bonds has been declining since last September (note: the ratio is shown on a reverse scale to align with the high-yield default rate).

Figure 3: High-yield default rates and investment-grade upgrade/downgrade ratio

high-yield-default-rates-and-investment-grade-upgrade-ratio

Note: High-yield excludes commodities. Upgrade/downgrade ratio is trailing six months.

Source: Bank of America Merrill Lynch, BNP Paribas Asset Management, as at 31 May 2018

Valuations are still largely in the sector’s favour, although the dramatic changes in markets since the global financial crisis make comparing price-to-book (PB) multiples today to historical averages somewhat problematic. While the PB multiple for the MSCI USA index is 13% above the median from 1995, for financials it is still 21% below. If there is a part of the market that appears expensive, it is small and mid-cap banks. These had been expected to benefit particularly from deregulation. In this segment, the multiple compared to the average from 2007 – no earlier data is available – is 30% above the median compared to a just 12% premium for large-cap banks.

Analysts are not notably bullish on the financial sector relative to other sectors. Earnings expectations jumped markedly at the beginning of the year with the passage of the tax cuts, but since then the pace of earnings revisions for financials has been largely in line with that of other sectors – excluding technology (see Figure 4).

Figure 4: Earnings revisions

Next-twelve-month estimate

earnings-revisions-2

Source: FactSet, BNP Paribas Asset Management, as at 31 May 2018

With little new news on deregulation expected, high valuations among small and mid-cap banks, and the prospect of a further flattening in the yield curve, we believe financials are likely to continue underperforming the broad market through the end of the year. We would expect our weighting in the sector to decline in the second half of 2018.