Global Market Commentary

December 08, 2016

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The Market’s Turn:  Financials

In the wake of President-Elect Trump’s unexpected victory, two of the sectors we favor are financials and industrials, and we’ll briefly discuss why.  First, financials.

Financials have enjoyed a strong rally in the month since the election.  As of this writing, the Dow Jones U.S. Financials Index has produced a 10% one-month total return, but that broad performance masked significant divergence in the performance of different industries within the sector.  In many cases, the post-election rally brought companies into the green which had spent the year in the doghouse until the last month.

As we have noted before, regional banks and investment banks have been the strongest performers.  We think that in spite of the rally, the tailwinds behind financials continue to make many of these stocks a buy on weakness.  

What are those tailwinds?

First, financials are cyclicals — almost the definitive cyclicals — because of their role at the heart of the growth of credit that facilitates accelerating activity during a period of economic expansion.

The current expansion is the fourth-longest in post-war history, and is poised to take third place in April, 2017 when it will top the 92-month expansion that ran from 1981 to 1991.  (We won’t hazard to predict the future, but it seems unlikely to us that a recession will hit in the next five months.)

However, it has been an expansion that has been characterized by weaker-than-usual economic fundamentals and greater-than-usual skepticism and suspicion from investors and analysts.  The stock-market rally that has accompanied the expansion has also been much hated.

We believe that the current expansion has been decisively shaped by the financial crisis and the government’s response to it.  Typically, Keynesian policy responses to recession have involved fiscal stimulus, and often deregulation (consider Reagan’s effective combination of a sharp ramp in military spending, tax cuts, and deregulation).  In the current expansion, on the contrary, fiscal stimulus has been largely absent, and regulatory burdens have been increasing.  Monetary policy filled the gap, preventing the collapse of the financial system and allowing a weak recovery.  But the fact that monetary policy was long operating alone, with fiscal policy MIA and regulatory burdens increasing, has stretched the expansion out and made it weaker.  This has been especially true for regional and smaller banks.  Big banks caused many problems and they have been more tightly regulated; that’s fine.  But smaller banks have been burdened with many new regulatory costs — yet they do not trade mortgage bonds and esoteric derivatives, and were not the cause of the crisis in 2008–2009.

This is where the market’s current turn comes in.  We do not believe for a moment that Trump’s policies will be implemented without setbacks, compromises, and failures.  But we do think that some of the big-ticket items — such as fiscal stimulus through increased infrastructure spending and tax reform — will be implemented and will do much to alter the low-growth trajectory of this expansion.  It has been a long expansion, and it can get longer.

It also looks likely that the Trump administration will relieve the Fed of the growth-creation task that it took on while the Federal government was shirking its job of supporting growth.  That means higher interest rates… but probably not at a punishing pace.

All of this is very bullish, supporting growth from many directions.  It bodes well for cyclicals, especially for financials.  They will be bolstered by:

•  Tax cuts;
•  Regulatory reforms — especially those that remove onerous regulatory burdens from regional banks;
•  Higher interest rates leading to improved net interest margins and better profitability;
•  Better real estate markets;
•  Rising inflation in the context of interest rates that are rising at a contained pace, thus incentivizing borrowers.

Also, all of these policies and their effects will gradually shift the disinflationary psychology that has set in during this long and so-far weak recovery.

Investment implications:  The policy response to the financial crisis and the Great Recession was unusual, with the Fed using monetary policy to try to make up for the lack of growth-positive fiscal and regulatory policy from the Federal government.  After a seven-year weak expansion, the stage is being set for a major policy shift that will take pressure off the Fed and put pro-growth fiscal policy and regulatory reform in the driver’s seat.  The stocks of cyclical companies have soared — especially financials, and within that sector, especially regional and investment banks.  We think that even though this expansion has been long, it can get longer, and even though the rally in financials has been strong in recent weeks, it can continue, with corrections offering buying opportunities.  (Note that financials have underperformed the broader market during the last eight years.)  It will take months and perhaps years for the full policy implications of the “Trump turn” to be implemented.  While big financials were a partial cause of the financial crisis of 2008–2009, small and medium banks were not involved in the mortgage bond mess that was a big part of the problem. Yet these smaller banks were saddled with big regulatory costs even though they were not the culprit.  We remain bullish on these stocks, and remain buyers of small and medium sized financials on weakness.  The immediate post-election rally will end, the new administration will hit roadblocks, and sobriety will begin to temper the exuberance.  These will be the buying opportunities we’re waiting for.