There’s a stealth bull market happening right now from an unexpected market sector. But how long will it last?
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***There’s an important trend happening right now … and practically no one is talking about it.
It’s a surprising bull market from a sector you might think would be lagging … instead, it’s hitting new highs.
What exactly is going on?
Well, let’s establish some context by turning toward something that’s been all over the financial news for the last several months …
Falling interest rates.
Interest rates affect many parts of the economy, but perhaps none more so than the banking sector. That’s because banks are highly sensitive to changes in interest rates, since they’re a key driver of banking profitability.
You see, most banks borrow money at low short-term interest rates then lend at higher long-term rates. The difference between these two rates is called the “interest rate spread.” Banks earn bigger profits as that spread widens.
But as you know, rates have been falling in recent months. This is bad for banks, since a thin spread eats into profits.
Given this, you’d expect banks would be in trouble now, right?
It was this line of thinking that resulted in an investor note from Bank of America/Merrill Lynch from last spring suggesting that if the Fed lowers rates to 1.50% to 1.75% by early 2020, it would reduce large-cap bank earnings by up to 10%.
As I write, the target rate is 1.75% – 2.00%, and expectations are at 94.1% that they’ll fall to this 1.50% – 1.75% range at this week’s Fed meeting.
Despite all this, something very different is happening with banking stocks …
A stealth bull market.
***Banks are hitting new all-times highs
Here in the InvestorPlace Digest, we keep close tabs on the U.S. financial sector. Our preferred way of doing so is by monitoring the price action in the big bank stock fund IYF.
With large weightings in JPMorgan, Bank of America, Goldman Sachs, and Citigroup, IYF represents the backbone of the U.S. financial system. This fund rises and falls with America’s ability to earn money, save money, service debts, start businesses, and generally just “get along.”
As you can see from the chart below, IYF is in an uptrend and just struck a new all-time high. On the year, it’s up 25%.
Simply put, it’s a bull market in American banking.
***But how? Shouldn’t falling rates be eating into earnings?
For more on this, let’s turn to John Jagerson, editor of Strategic Trader.
Regular Digest readers will recall our issue from two weeks ago which featured an historical market study from John, evaluating the earnings from the big banks.
In short, the earnings performance of the big banks came in relatively strong, avoiding what history suggests could have led to a major market selloff had they fared worse.
Given that banks have been in John’s crosshairs, I reached out to him to get his thoughts on this covert bull market in the financial sector.
Jeff: Bank earnings this quarter were better than expected, despite lower rates. What’s happening here?
John: The banks did report above expectations over the last two weeks. This is not what I would have predicted a year ago if I had known that the yield curve was going to be as flat as it is currently.
As you’ve likely already explained to Digest readers, the most consistent portion of a bank’s profits come from the difference in interest rates between what they can borrow (very short-term rates) and what they can lend (long-term rates). Right now, that difference is nearly non-existent or even negative.
Jeff: So, how is it that earnings held up? And why are banking stocks performing so well?
John: There are two other factors that are playing out in the banks’ favor.
First, most of the major money-center banks like Citigroup (C), Bank of America (BAC) and JPMorgan (JPM) reported windfall profits from bond trading and wealth advisory services this quarter. That usually happens when bond prices are rising very rapidly which increases demand for that asset class and increases bank profits.
However, the rise and fall of bond prices is not a consistent source of profits, so investors should be careful if volatility in the bond market starts to rise towards the end of the year.
Jeff: What’s your guess on that? Is it going to rise?
John: I think market fundamentals are in favor of a flat bond market, which may negatively impact that source of profits in the 4th quarter, but not by very much.
Jeff: Back to the strong performance of bank earnings. What’s the second factor that’s offset the compressed interest rate spread?
John: Low interest rates along with positive hiring and salary trends has kept the consumer part of the U.S. economy very strong. This has been good for retail, tech, and banking because U.S. economic GDP is more than 70% consumption.
Demand for financing from consumers has been a source of bank fees and charges that helped offset the damage from low interest rates. For example, Bank of America (BAC) reported a 3% gain in consumer/retail banking revenue largely due to a 7% increase in loans and a 3% increase in deposits.
Amazingly, the strength of loan demand and retail banking revenue resulted in almost unchanged results compared to the year before. Frankly, I would not have predicted the retail side to be this strong at this point if you had asked me about it a year ago.
Jeff: As we enjoy the surge in bank stocks, are there any red flags we should be watching?
John: Yes. There is one big “but” for all this good news. Loan, investment advisory, and trading revenue are cyclical, which means if there is a broader economic slowdown in the 4th quarter this year, or the 1st quarter in 2020, the low interest rate environment will hurt the banks in a big way.
Jeff: Factoring the tailwinds together with the risk-factors, what’s your bottom-line position on banks?
John: My advice is to take advantage of bullish conditions in banking for now but to watch for any signs of change when the next round of earnings start coming in during January 2020.
Jeff: Thanks, John.
***So, as we look for clear takeaways, it appears that ancillary services from the banks are offsetting revenue declines from lower rates
And since we just cleared Q3 earnings season in good shape, we have the green light for big banks for the rest of the year. We’ll turn cautious as Q4 earnings season approaches in 2020, but for now, the U.S. banking sector is a buy.
As noted above, the easiest way to play this is with IYF, since it gives investors one-click exposure to many big banks, including JPMorgan, Bank of America, Goldman Sachs, and Citigroup.
By the way, John is putting his money where his mouth is. In his popular Strategic Trader service, he has an open trade on Bank of America. If you’re looking for ways to generate additional income in this low-yield environment, click here to learn how Strategic Trader can help.
We’ll continue to keep you up to speed here in the Digest.
Have a good evening,