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Among the prime beneficiaries of the reflation trade and rising Treasury yields are bank stocks. The once moribund group is back in a big way as highlighted by a year-to-date gain of 27.1% for the S&P Banks Select Industry Index. That's more than double the 12% returned by the S&P 500.
Buoyed by the rise in 10-year Treasury yields that's now nearly 10 months old and the resurgence of cyclical value stocks, bank equities have been in a groove since late last year. For advisors, there's something of a dichotomy at play here. In prior investment eras, the financial services sector was a staple for many clients, particularly those looking to generate income while avoiding some of the volatility associated with economically sensitive sectors.
Now, with bank stocks back in style for the first time in a long time, advisors are likely fielding more questions from clients about the group. Chief among those inquiries likely is “Am I too late to the bank stock party?”
Obviously, there's fluidity in the answer and with the S&P Banks Select Index soaring to start 2021, the inquiry is reasonable. Good news: Tailwinds remain for bank names.
Momentum for Bank Equities
With the 10-and-2-year yield spread as wide as its been since 2015, there's room for bank equities to run higher, but that's not the only catalyst. Improving earnings add to the positive outlook.
“The case for investing in the bank industry becomes even stronger when considering the segment’s improving earnings prospects and attractive valuations,” notes State Street Strategist Anqi Dong. “Despite the dire economic environment last year, banks have shown resilience during the pandemic. The industry posted its first positive earnings growth since the beginning of the pandemic, 7.8% in Q4, exceeding analyst expectations of negative growth of -17.3%.”
We're in the throughs of financial services first-quarter earnings season as we speak. On that note, it's important to acknowledge, particularly when remembering this is a value sector, banks' 2021 earnings growth is estimated to be 38%, up from 16% at the start of the year. Earnings growth of 38% is usually reserved for, well, growth stocks, not large-cap value names.
Some of that earnings ebullience is attributable to the repatriation of loan loss reserves banks had to set aside last year when it looked like the coronavirus bear market/recession would last far longer than it ultimately did. Those reserves can now be moved back onto banks' balance sheets in the form of earnings per share.
“Reserve releases may provide another tailwind for bank earnings. Banks built up their largest loan loss reserves since the financial crisis in the first two quarters of 2020 in anticipation of higher credit losses stemming from the pandemic,” notes State Street's Dong. “However, due to faster-than-expected vaccine developments and an improved economic outlook for 2021, banks started to release reserves in Q4, led by big banks.”
Destination for Shareholder Rewards
As the Federal Reserve took interest rates to historic lows and Treasury yields plummeted, the primary case for advisors mentioning financial services stocks to clients was a buyback machines/dividend growth plays. After all, dividends in the sector appreciated noticeably following the dark days of the financial crisis.
Amid the pandemic, the Fed threw cold water on banks' buyback and payout growth plans, but that scenario is changing for the better.
“The recent Federal Reserve announcement of lifting restrictions on bank dividend and share buybacks on June 30th may further boost industry earnings and return of capital to shareholders in the second half of 2021,” notes Dong. “It is projected that major banks will repurchase $83 billion in stock this year, 6% of their market cap.”
Even with the good vibes facilitated by rising 10-year yields, the economic recovery, earnings growth and the improving outlook for shareholder rewards, bank stocks aren't expensive. As State Street's Dong points out, the group is actually cheap, trading at “the 35th percentile over the past 15 years, based on 1-year forward price-to-earnings ratio.”
In other words, advisors can talk banks stocks with confidence there are catalysts and valuations are attractive, not stretched.
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