In the current environment of rising interest rates, lower costs, and higher loan growth, we believe earnings and equity valuations for the banking sector should recover in earnest.
Ryan Kelley, CFA
We believe the price of financial stocks could move much higher over the next few years, powered by what we believe will be an increase in profitability. Consider the following:
Rising Interest Rate Environment
The low interest rate environment over the past eight years caused overall bank profitability to deteriorate and earnings growth rates to remain low. But this period of ultra-low, short-term rates appears to finally be over. The U.S. economy is steadily growing, the labor market is buoyant, and the Federal Reserve has signaled its intention to continue raising rates. We believe this anticipated rise in rates should boost bank lending margins over the next few years, allow banks to approach more normal levels of profitability, and drive several years of more robust earnings growth.
Potential Regulatory Relief
Following the Financial Crisis, stricter compliance standards, capital requirements, and lending controls were implemented. While these new regulations helped banks rebuild their loan books with more robust, higher quality loans than in the past, they also raised expenses and increased required capital levels, which impacted profitability. Regulatory relief being considered could allow banks to lower their compliance costs and increase their lending activity, leading to a boost in profitability and earnings growth.
Increased Loan Demand
The Trump administration passed a tax reform bill in late 2017, and they have signaled they plan to increase investment spending on infrastructure. These policies could lead to a jump in economic activity and an acceleration in loan demand, which could further propel earnings growth for the banking sector.
NIMs Begin to Turn
The majority of a bank’s profits are derived from the net interest margin, or NIM, which measures the spread between what a bank earns on its loans and what it pays for its deposits. The key to faster growth in earnings for banks hinges on this important metric. With rates having now started to rise, and with a widespread expectation of additional future Fed rate increases, we believe NIMs, and likewise, banks’ profitability, should rise in the coming years.