In an improving economic environment with potentially favorable policy changes ahead, investors may consider an overweight position in financial sector stocks, notably banks and related exchange traded funds.
“We like U.S. banks because of sustained economic growth, normalizing monetary policy and prospects for deregulation and increased payouts,” according to BlackRock strategists.
As conditions improve, the Federal Reserve will tighten its monetary policy to obviate an overheating economy. The central bank has already outlined plans to start winding down its trillion dollar balance sheet in October and left a December rate hike open.
Investors should anticipate a tighter policy as a key inflation gauge this week could confirm U.S. inflation is moving toward the Fed’s 2% target.
“We think investors are still underestimating the potential for rates to move up and the yield curve to steepen, both critical to banks’ profitability,” according to BlackRock.
The annual stress test has also paved the way for the biggest U.S. banks, increasing investors’ outlook for more stock buybacks and dividend payouts.
Deregulation could also help the financial sector improve their margins. President Donald Trump’s administration has shown its eagerness in cutting back the red tape and remove some of the post-financial crisis regulations that has stifled the industry.
“U.S. banks have lagged the broader market and European peers year-to-date. We believe this trend has turned. We see the group up in the medium term on sustained economic growth, Fed normalization and prospects for deregulation and payouts,” according to BlackRock.
BlackRock also argued that U.S. regional banks could benefit the most as they tend to have a larger share of businesses in traditional banking services, such as loans and deposits, compared to their larger peers.
Looking ahead, analysts project U.S. bank earnings to expand 12.8% in 2018, and BlackRock sees “scope for this number to improve.” Furthermore, the sector is trading at cheap valuations, with U.S. banks discounted by24% compared to 5% for European banks.
Investors interested in gaining exposure to the banking industry can look to broad financial plays such as the Fidelity MSCI Financials Index ETF (NYSEArca: FNCL), Financial Select Sector SPDR (NYSEArca: XLF), iShares U.S. Financials ETF (NYSEArca: IYF) and Vanguard Financials ETF (NYSEArca: VFH). However, these broad plays mostly target large-cap Wall Street banks.
For smaller bank exposures, investors can look to options like the iShares U.S. Regional Banks ETF (NYSEArca: IAT), SPDR S&P Regional Banking ETF (NYSEArca: KRE), PowerShares KBW Regional Bank Portfolio (NYSEArca: KBWR) and SPDR S&P Bank ETF (NYSEArca: KBE), which take a larger focus mid- and small-sized regional banks.
For more information on the banking industry, visit our financial category.