Increasing capital market activities should also help boost banking stocks’ earnings. A pickup in mergers & acquisitions activity, debt underwritings and initial public offerings globally should provide a boost to investment banks’ revenues in the next few quarters. And this boost should help counteract weak secondary market trading activities.
To be sure, banking stocks aren’t without their risks. In the United States, I expect the Treasury yield curve to flatten dramatically in coming months. While the common belief is that a flatter yield curve portends shrinking financials sector profit margins as banks pay more on short-term deposit interest and earn less from long-term loans, I think this concern is overblown and has tended to push market perception of bank’s profitability in a more negative direction than what’s warranted by fundamentals.
In fact, over the past two decades, the relationship between the yield curve’s slope and bank margins has weakened significantly. Banks’ growing variety of product lines and better firm interest rate risk management have helped reduce financials’ earnings sensitivity to yield curves. In addition, given that banks nowadays have become more levered to short-rates– as much as 40% of a large U.S. bank’s loans are now priced off short-rates – a flatter yield curve may not be as harmful to margins as it was a decade ago.
Globally, the changing regulatory environment, and its associated litigation and compliance costs, continues to represent a risk to the sector, and so too do European banks.
The longer term outlook for eurozone banks does look more positive than a year ago given reasons including the substantial deleveraging, capital raising by local banks and the European Central Bank (ECB)’s recently announced ABS purchase program. However, the European sector’s earning outlook remains a risk to the broader sector in the near term.
That said, these risks are already generally reflected in banking sector valuations.
All in all, I believe the three factors I mention above should support banking sector earnings – and valuations –in the medium term. In fact, I recently upgraded my outlook for the global sector from neutral to overweight. You can read more about my thoughts on the financials sector, and other market segments offering relative value, in my latest Investment Directions monthly market outlook.
Sources: BlackRock, Bloomberg
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog and you can find more of his posts here.