We want to circle back to the US Financials sector today, because we’re convinced this is THE lynchpin group for two important market narratives over the balance of the year and into early 2020:
#1: How US equities will perform.
- At 13% of the S&P (3rd largest weighting) and 18% of the Russell 2000 (largest group), the group has modestly lagged YTD.
- Large cap Financials have underperformed in 2019 by 2.1 points and small caps are under water by 0.5 points.
- If Financials can catch some investor optimism over the remainder of Q4, it will go a long way to allowing for a strong close to the year.
#2: Growth vs. Value and Momentum.
- Financials are 21% of the S&P 500 Value Index but just 5% of the 500 Growth Index.
- In small caps, Financials are 19% of the Russell 2000 Value but just 5% of the 2000 Growth Index.
- Unsurprisingly, the MSCI Momentum Index has little in the way of Financials exposure – just 5%.
Now, here is the headline data for the group:
On the plus side, Financials are cheap…:
- According to FactSet’s analysis of analysts’ earnings estimates, US large cap Financials trade for 11.9x forward 12-month earnings.
- That’s the lowest valuation of any S&P 500 sector by a wide margin; Health Care has the second-lowest P/E at 14.3x and the index as a whole trades for 16.6x.
- The dividend yields on both large cap Financials (2.0%) and small caps (3.1%) are higher than the S&P 500 (1.8%) and the Russell 2000 (1.3%)
… And near term fundamentals are reasonably good:
- FactSet’s analyst data shows Wall Street expects Financials to post -2.6% earnings growth for Q3, better than the S&P’s 4.6% decline. Since companies tend to “beat” expectations by 3 percentage points, the group could actually post a small positive comp to last year.
- Analysts also expect Financials to do better than the S&P 500 in Q4, with a 9.7% increase in net income vs. a +2.3% comp for the index as a whole.
- All this should keep the Financials’ net margins stable, at 16.5%. With the group’s propensity to buy back stock, this should support continued high returns on equity.
As for the downside case for Financials over the balance of 2019 and into 2020:
- It comes down to 2 words: “recession fears”.
- Yes, by any measure bank balance sheets are in great shape. Both consumer and business loan losses remain near cycle lows and well below prior-cycle levels. And the recent decline in interest rates should spur loan growth in Q4.
- But Financials are a cyclical group, so that’s slim comfort. And while aggregate reserves are high, the recent kerfuffle in the repo market shows that individual banks either have large surpluses or very few.
In the end, we think the near term future for US Financials will come down to macroeconomic sentiment, which means this is essentially a rate call.
- 10-year Treasury yields saw their lows for the YTD at the start of September, at 1.46%. Their slide from late July (when they yielded 2.1%) hit large cap Financials by 9%, the worst selloff for the sector in 2019.
- Conversely, the bounce back for Treasury yields in the first 2 weeks of September (to 1.9%) lifted Financials by 6%.
- The group has been in a volatile holding pattern since then, mirroring the tug of war in long-term interest rates. One side is pulling on the idea that the US-China trade war is ending, allowing for better global growth in 2020. The other side thinks the recessionary die is cast and rates will move ever lower.
Our conclusion: US Financials are 100% levered to an optimistic investment viewpoint that believes in a reacceleration of global economic growth in 2020. That will lift long-term interest rates, removing the specter of recession and give this cyclical group a strong shove higher. Valuations are cheap enough and fundamentals are solid. Neither of those are good enough to make the group work, however, if the world slips into even a shallow recession.
For all that, this is not a bet we’re comfortable with because there is so little margin of safety. Valuations can easily go to 8-9x or lower for a cyclical group in a downturn, and dividend yields can be 4% or higher for fear those payouts decline in a recession. Having covered cyclical groups since 1991, we’ve seen that movie too many times before. We are therefore, at best, neutral on Financials.