Republican Vice Presidential nominee U.S. Senator J.D. Vance (R-OH) campaigns at the first public rally public rally at the Van Andel Arena on 20 July 2024. AFP.
We came into 2024 with a more cautious stance on the global financials sector, as we had expected a mild recession in the US. There were also concerns over headwinds from more stringent regulatory capital requirements, muted loans growth, credit quality concerns and uncertain recovery prospects of capital market activities. Since then, we believe the US economy has exhibited its resilience and we are no longer expecting a recession in the world’s largest economy. While some of our other concerns such as subdued loans growth and credit quality is still valid, we believe the likelihood of a first rate cut by the Federal Reserve (Fed) in Sep will provide some breathing space and could spur a recovery in loans growth, albeit at a gradual pace. There has also been increasing hopes that meaningful changes would be made to the proposed rules of the Basel III Endgame to make it less onerous. Taking the aforementioned factors into account, we are upgrading our position on the global financials sector from ‘Underweight’ to ‘Neutral’.
As the US constitutes the largest weight in the MSCI All-Country World Index (ACWI) Financial Index, we can see the significance of the market in the sector’s performance. With the upcoming US presidential elections, conceptually with all else equal, the Democrats tend to regulate the banking sector more heavily which could hurt future banking profitability, and the Republicans tend to take on a less onerous approach, which in turn should be better for future banking profits. Although we do not take a view on which candidate will win the Nov elections, given recent developments and the latest polls, we see risks to an ‘Underweight’ position on the financials sector if Trump was to win the presidency.
We also recently flagged the encouraging start to the 2Q24 earnings season for the US banks from an adjusted earnings per share (EPS) growth perspective. Based on commentary and guidance provided, there is optimism that net interest income (NII) could bottom soon, while trading revenues and investment banking fees are likely to remain robust. This does provide a positive readthrough to the European banks with larger treasury and investment banking divisions. However, net charge-offs (NCO) remain on an uptrend, largely due to the commercial real estate (CRE) sector (particularly office) and cards. This would be areas we will continue to monitor closely in the quarters ahead. In Europe, the European Central Bank (ECB) kept its policy rate unchanged on 18 Jul 2024 as expected after a first rate cut in Jun, but left the door open for another potential cut in Sep, as there are downside risks to economic growth. We believe there is room for NII guidance to be raised by European banks this earnings season, while capital levels are expected to be maintained at healthy levels, and return on tangible equity (RoTE) can be sustained around the low-teens level.
From a sector valuation perspective, the MSCI ACWI Financials Index is trading at a forward 12-month price-to-earnings (P/E) multiple of 12.1x (as at 18 Jul 2024), which is 0.9 standard deviation (s.d.) above its 10Y historical average of 11.3x. Although we are upgrading our position to ‘Neutral’, we believe current valuations do not warrant an ‘Overweight’ position.
Upgrading our position on global financials sector to ‘Neutral’
We came into 2024 with a more cautious stance on the global financials financial sector, as we had expected a mild recession in the US back then. The cyclical nature of the financial sector has typically resulted in share price underperformance during periods of recessions. Furthermore, there were concerns over headwinds from more stringent regulatory capital requirements and thus higher capital buffers, muted loans growth, credit quality concerns and uncertain recovery prospects of capital market activities. Since then, we believe the US economy has exhibited its resilience and we are no longer expecting a recession in the world’s largest economy. While some of our other concerns such as subdued loans growth and credit quality is still valid, we believe the likelihood of a first rate cut by the Fed in Sep will provide some breathing space and could spur a recovery in loans growth, albeit at a gradual pace. There has also been increasing hopes that meaningful changes would be made to the proposed rules of the Basel III Endgame to make it less onerous. Both the Fed Chairman Jerome Powell and Vice Chairman Michael Barr have signalled the potential for major changes during recent speeches. Should there be revisions to the rules, this could pave the way for banks to raise their dividends and increase their share buybacks.
Taking the aforementioned factors into account, we are upgrading our position on the global financials sector from ‘Underweight’ to ‘Neutral’.
A Republican win in the US presidential elections would likely be positive for the US banks
The share prices of US banks generally performed well on both an absolute and relative basis before and 1-3 months after the presidential elections (based on data from 1992 to 2020). Performance data over a longer time horizon also pointed to an outperformance of the US financials sector in election years, based on data from 1976 to 2020.
Conceptually, all else equal, the Democrats tend to regulate the banking sector more heavily which could hurt future banking profitability, and the Republicans tend to take on a less onerous approach, which in turn should be better for future banking profits. Looking at the upcoming 2024 presidential election, if the Democrats win, that would mean that the Basel III Endgame proposals are less likely to be changed and we could also see the potential for additional regulation. If the Republicans are elected (and if they regain control of Congress), we believe it materially increases the odds that the current proposals are reworked (either repealed or dialled back with less onerous regulations). Overall, the Republicans holding the presidency and controlling Congress would typically be incrementally more bullish for bank stocks, and vice versa, in our view.
Although we do not take a view on which candidate will win the Nov elections, given recent developments and the latest polls, we see risks to maintaining an ‘Underweight’ position on the financials sector if Trump was to win the presidency.
Drawing reference to the composition of the MSCI ACWI Financial Index (comprising 23 Developed Markets and 24 Emerging Markets), the US accounted for 50.9% of the index weight (as at 30 Jun 2024), followed by Canada (5.9%), Japan (4.9%), UK (4.2%), Australia (3.9%) and Others (30.3%). Hence, we can see the significance of the US in the sector’s performance.
For Japan, the acceleration in core consumer price index (CPI) to 2.6% year-on-year (YoY) for the month of Jun (May: 2.5% YoY) has added strength to the possibility of a rate hike by the Bank of Japan later this month, and this would benefit the Japanese financials sector, in our view.
Mostly positive readthrough from ongoing 2Q24 results from the US, although we are watching credit risks closely
US banks had an encouraging start to the 2Q24 earnings season from an adjusted EPS growth perspective. Based on commentary and guidance provided, there is optimism that NII could bottom soon, while trading revenues and investment banking fees are likely to remain robust. This does provide a positive readthrough to the European banks with larger treasury and investment banking divisions.
However, NCOs remain on an uptrend, largely due to the CRE sector (particularly office) and cards. This would be areas we will continue to monitor closely in the quarters ahead. The start of the Fed rate cutting cycle could provide some reprieve to borrowing costs ahead, but there are still risks in a “higher for longer” interest rate environment, especially if the global economy shows further signs of softening ahead.
In Europe, the ECB kept its policy rate unchanged on 18 Jul 2024 as expected after a first rate cut in Jun, but left the door open for another potential cut in Sep, as there are downside risks to economic growth. We believe there is room for NII guidance to be raised by European banks this earnings season, while capital levels are expected to be maintained at healthy levels, and return on tangible equity (RoTE) can be sustained around the low-teens level.
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