Higher net interest margins, an improving U.S. economy, and de-regulation are all expected to be tailwinds for the Financial Services sector. Steve Biggar, Director of Financial Institutions Research, Argus Research, talks to Sara D’Elia about why they’ve raised their outlook, their earnings forecasts, and which stocks may benefit. Argus Research reports are available on TD WebBroker.
Joining me to explain why he's raised his outlook on financials is Steve Biggar from Argus Research in New York. Thanks for being here.
So I want to kick things off by asking you, last week, Argus changed their recommendation for the outlook for financial services to overweight from market weight. What drove that change?
Well, a few things, first the group itself has not done particularly well so far this year. And we see that as a kind of a disconnect with the fundamentals for financials. Year to date, they're down about 2% versus up a little over 2% for the S&P 500. Last year, they tracked the index roughly. But fundamentals are very strong. In fact, if we look at corporate profits this year for the financial sector at large, we see them up over 30%. It's one of the best-performing sectors in terms of earnings growth looking out into 2018.
Second, you have the backdrop of favorable interest rate story. You have the Fed is increasing rates. That's beneficial for most banks.
And also on the deregulation front, whereas for much of last year the expectations were pretty high for deregulation for financial services. And that really didn't happen. Congress and the Trump administration focused on health care reform and corporate tax rates, which did ultimately go through. But banking and other financial regulation seemed to stall. So that seems to be coming back en vogue now.
You mentioned deregulation. Tell us a little bit about how you see that playing out and acting as a good thing for financials.
Sure. Well, the Dodd-Frank Rule or Act, rather, something that was enacted post the financial crisis of 2008 and 2009, put a lot of onerous regulations on banks. And one of those things was stress test requirements. So the banks would have to do scenario analysis where high unemployment, housing prices that reduced by more than 20%, interest rates moving much lower, that sort of thing. So they had to run through the numbers and see how their capital levels would fare under those scenarios and still be able to lend to customers, to business and consumers.
So at the time of the regulation, they said any banks with greater than $50 billion, these were deemed systematically important to the financial industry, that those banks would all have to go through that stress test requirement. Now, that was about 40 banks in total. But the reform that was signed just a few weeks ago by the administration and passed by Congress is that now you've raised that level to $250 billion. So it means that fewer than 10 banks now are subject to those stress test rules. So that's a big benefit for those mid banks, those mid-tier sized banks, a lot less onerous regulations.
Also the Volcker Rule, there's been conversation recently about easing the Volcker Rule. That's the proprietary trading restriction on big banks. So that would be another way that banks can free up their ability to trade. And that's a profit center.
Now, in terms of what you think this could mean for earnings, what are you expecting or what's your outlook for the sector?
So the financial sector, as I mentioned, is one of the biggest beneficiaries of the tax law changes. Banks are largely domestic in the US. And they pay, prior to the tax cut changes, in the low 30% range in terms of tax rates. They didn't get a lot of offsets. In other words, they didn't have international businesses. They're not depreciating a lot of things. They're not building, so they're paying pretty much the statutory rates.
So as the tax rates come down for corporates, they're paying now much less, more like in the low 20% range. So that's a big benefit to achieving what happened with the corporate tax rates in order for them to see much higher earnings growth than the average sector.
So we're looking at a 30% growth this year from financial earnings versus only about 20% for the S&P 500. And that's second only to energy, which is basically doubling profits because of higher commodity costs.
So that's a big benefit. And then, of course, they've got the backdrop of higher interest rates coming along. They've got benign credit quality. So those are all favorable trends for earnings right now.
On the piece, you mentioned credit quality. How do you see that playing out? Are we seeing stronger trends? Are we seeing some weakening? What's your outlook there?
Well, credit quality has stayed strong throughout the post-financial crisis period. Now, normally at this stage, later stage you would say, we're 9-plus years into an economic expansion, banks tend to stretch, if you will, on underwriting standards. They're looking for additional borrowers. And they tend to go down in the credit scores in order to get those borrowers.
But banks have maintained the underwriting standards. And there's some terrific trends in the US too from the employment statistics. So there's a very strong correlation between the amount of employed folks or the amount of unemployed folks and their ability to pay off debts.
So we've had a very strong jobs picture in the US. And that means people, when they borrow, they're able to pay back those funds. And so chargeoffs have remained kind of low. And as long as the job picture stays positive, I think credit quality trends will stay positive also.
So it sounds like deregulation, earnings, credit quality, all positive things for banks. What are some of the names that you're watching or that you like right now?
Well, for the large cap banks, if you segment those as the international banks, if you will, or global that have international exposure, we like Morgan Stanley. I like JPMorgan Chase and Bank of America. If they're in the US, they've got terrific franchises. They've got good capital markets activities. They have good credit card, generally, in the case of JPMorgan and Bank of America, great credit card franchises. So they're in the sweet spot in a lot of different areas and doing pretty well.
On the regional bank side, I would say names like BB&T Corp, PNC Financial Services. These are regional banks that are also benefiting from the higher interest rate scenario. So rising net interest margins, the good credit quality I mentioned, and they also have rising fee-based income as well.
One of the things you talk about in your report, which you mentioned there in your answer, specifically around JP is payments and how that's also changing or creating a bit of an evolution in terms of non-bank names you like. What are some of the players you're watching in that space?
So the payment processing area is very strong right now. And it's really a secular trend that's going on, where people are charging more on credit cards and/or debit cards. The online trend has been one thing behind that trend, because when you walk into a physical store, you can pay cash, you can pay with a check, or you can pay with card. But when you buy something online, it's pretty much universally going to be either a credit or debit transaction. So names like PayPal, Visa, and Mastercard, they're all very, very strong and benefiting from the rapid growth in payment processing.
Sounds like there's a lot to think about in terms of players, both in the big banks and the credit card or payment space as well. Thanks for being here, Steve.