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Decline
Financials are back with a vengeance

Financials are back with a vengeance

13-12-2016 | Insight

Donald Trump’s election as the next president of the United States has firmly pushed up financial stock prices. Asset flows into the sector have picked up susbstantially.

  • Patrick  Lemmens
    Patrick
    Lemmens
    Senior Portfolio Manager Financials

Speed read

  • Trump’s election has put financials back into the sweet spot
  • Investors are now noticing the sector’s very low valuations
  • Assets are flowing back into the asset class
Mr Trump’s election was of course unexpected. Even in case of a Trump win we did not expect the scenario that has now unfolded. Initially the market reacted negatively to Trump’s election, as this unexperienced leader with no real clear agenda, increased risk premiums and a reduced likelihood of a Fed rate increase in December created uncertainty. However, very quickly markets turned and sentiment changed as investors started to focus on Trump’s plans to cut taxes, invest in infrastructure and seriously reduce regulation in the financial sector.
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New hopes

With Trump elected, there are hopes of increasing GDP growth with a 1 trillion dollar infrastructure spending plan and the promise of reductions in tax rates. Of course there is no certainty Trump will be able to push through a significant infrastructure spending plan in combination with a 20 percentage point tax cut. Even though there is a Republican majority in both the Senate and the House there are also many Republicans who are clearly opposed to the US going further into deficit.

On the regulatory side it's possible to change and adjust laws, rules and regulations, and to put different people in charge of regulatory bodies. But how soon and how much will change is still quite uncertain. We will have to see how much GDP growth and how much regulatory relief has already been priced in as the Trump government comes into power.

Meanwhile, long-term interest rates have risen as markets are expecting an increase in US debt. A rate increase in December seems to be a done deal. In fact, US bank stocks are already discounting two to three rate increases. US equities have rallied while global bonds have sold off considerably in a magnitude which does seem to suggest that we have now really turned the corner in what seemed to be forever low (and declining) interest rates.

Financials in most developed markets have clearly outperformed the overall market, and US banks have outperformed other financials. Tech and Fintech have underperformed as have emerging markets financials. Life insurers have lagged (US) banks, which is odd given the move up in long-term interest rates.

Are recent developments justified?

In the short term, Trump’s election has accomplished something no one has been able to do these last few years: getting interest rates to find their way back up again, causing inflation expectations to rise and inspiring hopes of economic growth acceleration. A world with higher inflation, a steeper yield curve with clearly higher long-term interest rates and sound economic growth is obviously good news for the financial sector.

As for the longer term, our view is more nuanced, though. We expect the financials and Fintech companies with the best relative growth and the most attractive valuations to deliver the best returns. Especially life insurers will benefit from higher long-term interest rates, and they are still way too cheap. Stock prices of developed markets banks, especially in the US, have shot up too hard, but it is difficult to time a possible correction. This may well take months. Regardless of this, we are negative on banks, which we expect to be faced with heavy IT investments in developed markets in the next five to ten years, whereas investors tend to expect costs to decline. In addition, US banks and investment banks have strongly rerated on the hope of three Fed rate increases, but for now only the long term interest rate has increased. Finally, the aging trend is taking huge proportions, which will make it more attractive to offer pension and life insurance products.

Investors are now noticing the rock-bottom valuations

Investors’ renewed interest in financials has made them aware of the sector’s rock-bottom valuations. Companies such as Citigroup and Prudential are trading at around 10 times earnings and 0.7 times book value, and European financials are even cheaper. The table below shows the valuations of the various MSCI sectors. With a Price/Earnings ratio of 12.5 and a Price/Book of 1.1, the financial sector is by far the cheapest sector, comparing with an average P/E of 17.8 and an average P/B of 2.0 for the MSCI universe. With a dividend yield of 3.3%, the sector is also well positioned in the upper half of the various sectors.

Average sector valuations 21-11-2016

Source: MSCI All Country World (ex Future, ex Right, ex Cash), in EUR.

Trump’s election has revived investors’ interest in the financial sector. Assets are flowing back into the asset class. We think this is justified, but the road ahead will be bumpy and certain segments of the sector have already discounted a lot of future good news. Stock selection and being positioned in the right long-term trends is more important than ever.

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