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Why the financial sector is seeing steep declines

The financial sector, measured by the Financial Sector SPDR (XLF), is the worst-performing group so far in 2016, down 15%. Bank of America (BAC), Goldman Sachs (GS) and Citigroup (C) are all feeling the pain. Internationally, European banks like Deutsche Bank (DB), Credit Suisse (CS), and Barclays (BCS) are experiencing even more pronounced declines.

Why have investors lost their appetite for financials? Here are some of the key reasons:

Proxy for risk tolerance

The group's underperformance -- not to mention its current low valuation at 0.85 times book value -- reflects fears that a recession is looming (an argument under much debate now). As these fears heighten, investors are moving into safer asset classes, and banks -- typically seen as a proxy for risk tolerance -- are feeling even more pain. Sovereign wealth funds, which have been big investors in financials, are among those offloading these investments after being especially hurt by low oil prices.

Some Wall Street watchers have said that fear-induced selling in banks could itself pressure lending patterns and the economic system. But Wells Fargo equity strategist Gina Martin Adams doesn't think this self-fulfilling recession prophecy will play out. When looking at underlying financial conditions, she said she's not concerned. The TED spread -- which measures the willingness of banks to lend to one another by measuring the difference between interest rates on interbank loans and short-term U.S. government debt -- stands at 35 basis points now, significantly lower than it was during the European banking crisis in 2011 and well below 2008-09 levels.

A less robust path to higher rates

Fed policy, of course, is another factor behind financials’ selloff. The group tends to rise in anticipation of interest rate hikes. Expectations for a rate rise in March have dropped from more than 50% at the end of last year to less than 10% now. And expectations for rate hikes in 2016 have fallen, as well, leading 10-year Treasury (^TNX) yields to fall. In fact, there is increased speculation that the U.S. could see negative interest rates, following Europe and Japan. This chatter increased after the Fed asked banks to assess a "severely adverse scenario" of negative interest rate scenario in their 2016 stress tests. 

In other words, banks could be trading at depressed levels because of low interest rates that have impacted their profitability -- with no broader bearing on the financial system. "We tested the idea that bank stocks were predictors of recession, and quite frankly came up pretty short," Adams said. "In our view, bank stocks are trading with Fed tightening prospects and the yield curve."

Adams pointed out that bank stocks have historically been very sensitive to changes in the yield curve, which shows interest rates across different contract lengths. As quantitative easing ended, for example, bank stocks were battered, selling off 18% at the end of the first round in 2010 and down 16% after the end of the second round of quantitative easing in 2011.

Plus, increased regulatory overhang--especially given a political climate that reflects still-present anger from the 2008 crisis--has added to downward pressure on the group.

Oil rout negative implications

There is also a camp that believes the financial sector could be suffering from deeper systemic issues, like low energy prices and slowing worldwide growth that could be impacting banks' underlying credit quality and threaten the overall financial system.

For instance, even though financial companies' fourth-quarter earnings were generally solid, many investors question deeper implications of their energy loan exposure. European banks have more exposure to oil and gas loans than their American counterparts, with oil and gas making up 3% to 10% of their loans, according to Morgan Stanley. Energy exposure has also become a concern for U.S. banks -- though it constitutes a less significant 2% of loans for them.

Source: Company data, Morgan Stanley research
Source: Company data, Morgan Stanley research

The banks currently have a capital cushion 2 to 3 times greater than during the financial crisis, according to Wells Fargo. And Deutsche Bank tried to reassure investors on Tuesday that it has cash to pay for the riskiest debt payouts. But this, if anything, seemed to spark deeper worries about the unknown effects of a global slowdown and commodity rout.

 

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