Cyclical sectors have the potential to perform well as the economic recovery takes hold. Recent earnings suggest the financial sector could be a particularly good cyclical opportunity.
Sometimes in investing, seeing is believing. This may be the case currently with U.S. financial stocks, many of which recently reported surprisingly strong second quarter earnings, even in the midst of the pandemic. Investors may not have expected these results, since the worst economic contraction in 70 years raised the specter of steep loan losses and consumer defaults.
The financial sector is an example of a cyclical sector, along with industrials, materials and consumer discretionary stocks, that can benefit from an improving economy. We expect the V-shaped economic recovery to continue to unfold, despite the harrowing headlines on growing COVID-19 infections. Below are three main reasons investors should consider adding financials to their portfolios:
- Second-quarter earnings for financials have largely beaten expectations: Recently reported financial results included some meaningful upside surprises, with banks reporting credit charge-offs that were better than thought, reserve ratios in good shape and, on average, solid balance sheet health. Unlike previous recessions where capital market activities have slowed, Federal Reserve policy moves seem to have boosted transactions. Examples of expense management and the success of diversified business models have also surfaced, suggesting a sector with plenty of opportunity ahead.
- Valuations seem attractive: As a result of underperforming the S&P 500 (the broader U.S. market benchmark) since the 2008 crisis, the financial sector now appears sharply undervalued. For the past 20 years, the financial sector has had a price-to-earnings ratio just below the S&P 500. Now the sector trades at nearly half the P/E of the index.
- Rising interest rates could lift profitability: Financials have tended to earn more money when long-term rates are higher than short-term rates (a steep yield curve), since they can borrow at low rates and lend at higher rates, allowing for higher net interest margins. The yield curve is nearly flat now, but already, inflation expectations are moving higher, which should eventually lead to rising long-term rates. Interest rates may need to lead the way before financials outperform other sectors, but our confidence is growing that rising rates are coming.
Of course, plenty of reasons remain for caution. Congress has yet to extend income protection measures that have so far allowed most consumers to meet their debt obligations and even resume spending during the pandemic. Retail sales rose 6.7% in June, ahead of expectations for 5% growth. For such strength to continue, an extension of government relief efforts will be needed to create a buffer for consumers until the underlying economic recovery strengthens. Meantime, we are encouraged that other economic measures, including unemployment claims, are showing improvement.
Both banks and U.S. consumers have a much stronger financial foundation than they did prior to the 2008 crisis. Many investors may remain skeptical that the sector can outperform coming out of the current recession. But recent reported results show that skepticism may prove disproportionate to potential reality.