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Why banks and insurers should still top your investing list

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banks-0515-ph

By Marius Jongstra

One area of the U.S. equity market that has shown consistent relative strength in our models has been the financials sector. While this may seem counterintuitive considering our belief that we are in the latter stages of the economic cycle, there are multiple signals aligning behind this call.

After taking a knock in our sector rankings post-Silicon Valley Bank and the regional banking crisis of a year ago, this part of the stock market has consistently ranked among the top of our list since August (occupying the first or second spot in each of the past six months) — outperforming the S&P 500 by four percentage points over this time.

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Support has come from consistently strong fundamentals: 2024 estimates have been pushed nearly five per cent higher since the start of the year, while first-quarter earnings surprised to the upside at eight per cent year over year compared to the two per cent expected at the end of March.

Despite the run-up, valuations and positioning indicators are not showing signs of extremes. In short, we believe there is more room to run and for multiple expansion to occur before taking a more cautious stance.

For one, this part of the market has shown to be among the better-performing sectors. To state the obvious, owning financials during a recession is not recommended given the highly cyclical nature of these businesses, but up until the economy tips over, this group is a historically top performer. With the United States Federal Reserve seeking to extend this phase of its monetary policy cycle, there is more room to run.

Financials is a diverse bunch, however. A late-cycle economic backdrop poses natural questions about owning the U.S. banks. A recent Webcast with Dave featuring Gerard Cassidy dove into this topic, providing valuable insight into the banking industry. Cassidy echoed our prior work showing that capital buffers are far stronger than at any point in recent history — a direct result of industry reform coming out of the great financial crisis.

Big banks best

The median CET1 ratio of the big six banks is bumping up against 14 per cent (the U.S. regionals are lower at just under 12 per cent). This compares to three per cent and six per cent, respectively, in the aftermath of the financial crisis back in 2009. With credit quality concerns remaining top of mind, sticking to higher-quality, larger financial institutions with the balance sheet to absorb credit losses compared to their smaller regional peers is prudent (the former also has lower commercial real estate exposure compared to the latter).

The bigger risks are outside the banking system in private lending and credit, but that is a topic for another day. Helping profitability in the short run should be what Cassidy referred to as “Act 3” in the net interest margin (NIM) cycle. Asset yields will reprice faster while funding costs have stabilized. Cash flow from “back of the book” loans can be reinvested at higher yields and NIMs will widen with a positive effect on revenues. In addition, banks that have moved to more “fee-based” income have also helped smooth out sales and profitability.

More appealing from a long-term perspective is that this era of regulatory change is coming to a close with the expected Basel III endgame announcement in August. Beyond short-term cyclical forces, this means the banks are about to enter a new period without regulatory overhang, providing more clarity and less uncertainty to investors, which could pave the way for increasing return of capital through dividends and buybacks (for those in a strong capital position to do so).

Insurance gains

Beyond the banks, another area within financials that deserves a mention is the insurance industry. This industry has the strongest growth profile along with consistent earnings revision strength. Valuations reflect the run-up in prices (sitting in the top five per cent of historical values), but are justified by the growth outlook. Any dips in this industry should be bought.

Bottom line: the financials sector has been a consistent leader in our list of sector rankings, achieving the first or second spot in each of the past six months. Late-cycle concerns are valid, but with the Fed seeking to push out the pause period, there is room for this group to continue its run (typically outperforming during this phase of the cycle).

A turning in the credit cycle should be monitored, but risks can be mitigated by focusing on the large U.S. banks, which have never been healthier (avoid smaller regionals and consumer credit companies). Beyond the next downturn, we are entering a period of fading regulatory risks to the benefit of shareholders by way of increased clarity and less uncertainty.

Marius Jongstra is vice-president of market strategy at independent research firm Rosenberg Research & Associates Inc., founded by David Rosenberg. To receive more of David Rosenberg’s insights and analysis, you can sign up for a complimentary, one-month trial on the Rosenberg Research website.