A strong capital base also helps banks cope with regulatory pressures that may have peaked. Banks are seeking to rein in the latest proposed regulations, known as the “Basel III endgame,” saying higher capital levels and restrictions are unnecessary and would harm the economy. Fed Chairman Jerome Powell announced his opposition to the proposal in March. Markets cheered at the prospect of watered down regulations.
Relatively high inflation and interest rates help
Beyond regulatory issues, financial companies are also sensitive to macroeconomic trends. We believe the U.S. economy has returned to its “old normal” and inflation is here to stay. Annual inflation has fallen to 3.2% in February from a peak of 9.1% in mid-2022, and is unlikely to return to extremely high levels. However, rather than the decline in inflation that prevailed from 2008 to 2021, we expect to see upward pressure on inflation in the coming years.
This isn’t necessarily a bad thing for risky assets. In fact, in this environment, the nominal growth rate is likely to be high, which will support earnings. In fact, S&P 500 companies delivered profit growth in 2023, defying expectations for last year’s steep profit declines. We believe we can expect upward revisions and decent growth in 2024 and 2025.
Improving nominal growth rate is not free. Even if the Fed cuts rates this year, as most expect, market interest rates could remain steady or even rise. All else being equal, we believe this is a financial advantage, as many business models in this sector can benefit from profitability with higher interest rates.
What happens if growth and inflation decline along with interest rates? In our view, this should support risk assets, but quality and defensive sectors may be better off. Spread-based finance businesses that rely on higher interest rates may be delayed, but some stocks in the sector may hold up. We believe capital markets trading, investment banking and wealth management will be resilient in this scenario.
Keeping your finger on the pulse of business trends
So far, we are seeing positive trends across key industry segments. Some major auto insurance companies are reporting double-digit price increases. Alternative asset management companies are also seeing strong organic revenue growth as interest in non-traditional investment products increases.
On the other hand, the recent rally in financial markets is good news for traditional asset managers and asset managers. And investment banking revenues have recently recovered from depressed levels.
What about commercial banks? After last year’s shock, his vital signs appear to be stable. Credit costs continue to normalize after years of extremely low levels, which bodes well for lenders. We believe that select, diversified large banks with large deposit franchises are well-positioned in an evolving environment. These banks bounced back from last year’s crisis and continue to gain market share in a fragmented industry.
Valuation remains attractive
Improvements in industry fundamentals have not yet been reflected in valuations. The broader S&P 500 Financials Index and the KBW Banks Index both trade at significant price/earnings discounts to the market (Display).
