People ‘waking up to the idea’ of banking at a larger institution, strategist says

SS&C ALPS Advisors Chief ETF Strategist Paul Baiocchi joins Yahoo Finance Live to discuss banking turmoil, energy markets, Treasury Sec. Janet Yellen’s remarks on bank failures, and the outlook for interest rates.

Video Transcript

[AUDIO LOGO]

- Energy markets climbing back from yesterday's lows as the heat from bank turmoil separately eases. Here with more on all of this, we've got Paul Baiocchi, who is the SS&C ALPS Advisors chief ETF strategist. Great to have you here with us in studio. Perhaps we start on the banking turmoil that we've seen play out and especially as you think about some of the ETF exposure that people may have in their portfolios right now.

PAUL BAIOCCHI: Yeah, so I think what this has opened people's eyes to is there are unknown or unexpected bank exposures. So you look at, for example, a Russell 2000 ETF, it's got 9% in regional banks. If you look at a Russell 2000 value ETF, it's got 18% in regional banks.

And so it's forced people to maybe reconsider and reconfigure some of their exposures. We saw a graphic when we were in the green room looking at XLF, which is, of course, a portfolio of larger banks. It had 0.17 exposure to Silicon Valley Bank.

So if you're thinking about your financials exposure, what we're hearing is depositors from some of these smaller banks are starting to move their money to some of the larger banks. And we're also now seeing from an investment perspective people moving their investments from regional banking strategies into XLF for a large, diversified financial services portfolio.

- Do you think that that is going to bounce back in the other direction? I mean, there's also been a lot of vocal defenders of regional banks, right, and including Janet Yellen today, who was talking about the need to support small and midsized banks. From an investment perspective, though, do you think the ship is kind of sailed? How often do the flows, once they leave something, do they come back?

PAUL BAIOCCHI: Well, I think we're in this period now where people are trying to understand what happened with Silicon Valley Bank and Silvergate and some of these smaller banking institutions and understand, how could this play out in this way? And the reality is that unless you're a bank analyst getting into the nitty gritty of your held-to-maturity exposure or your forced-sale securities, et cetera, and the impact of interest rates on the various components of your balance sheet, it's hard to know.

And so, yes, I do think that, as we saw on the tape yesterday, there's been a rebound in confidence in some of these regional banking exposures. But the reality is is that if you're a very wealthy individual and you've got money on deposit at the bank, in theory that's the safest thing you do with your money, is just deposit it at a bank. And people are waking up to the idea that maybe there's some leverage embedded in that process that they didn't understand or that they didn't quite comprehend. And being at a larger institution is peace of mind for some of these folks.

- And so that's what we've continued to hear about with regard to the systemic issue for some of the regional banks, or at least the banks that have been hit hardest amid the turmoil and in some cases have collapsed or has had assets seized. Is that kind of mediated or remediated for a lot of the other players in this space? And, I guess, in other words, to say, what is to say that this does not happen or have a broader ripple effect across other banks?

PAUL BAIOCCHI: Yeah, so coming into 2022, I think a lot of folks were bullish on the financial sector or maybe even banks because the thought was when rates go up, net interest margins improve. Banks tend to make more money because they borrow short and they lend long. The reality is is that in the case of Silicon Valley Bank, it was the opposite. Net interest margins went the opposite direction because the money that they were loaning out through the form of bond investments had gone down considerably in value. And they had this ramp-up in deposits at higher yields.

So I think going forward, people are just trying to think about, I have to have exposure to financials just to be fully exposed to the market. But what other segments of financials are going to work? Capital markets, insurance, et cetera.

So, for example, I mentioned small caps. Our small-cap ETF has 20 plus in financials. But it doesn't have any regional banking exposure because it screens for quality. It screens for low volatility, dividend growth, et cetera. So it ends up having capital markets and insurance exposure as opposed to regional banking exposure.

And I think, by and large, why people are moving to something like XLF and financials is because JPMorgan, these large banking institutions, yeah, they have that traditional lending business. But they have capital markets activities. They have trading activities. They have a diversified revenue base.

- And then there's all this trickle-down ripple effects from what's going on with the banks. And we mentioned energy at the top, which is not-- there's a lot going on with energy markets right now. It's not just this. But when you see these sort of risk aversion causing shocks to the market, lately, really we've seen a lot of money come out of oil. And then even though people like oil stocks this year, oil prices are not cooperating.

PAUL BAIOCCHI: Yeah. So last week, at the end of the week, we got the Leading Economic Index. And that data was pretty bleak, right? And most of the indicators in that are at the very least showing signs of stress in the economy. I mean, I think the market has been focused on the demand side of energy, which has been dragging it down.

And the reality is is global energy markets are still very tight as a result of the Ukraine conflict and just coming into this cycle, the fact that there has been underinvestment in production globally. And so energy companies, if you look at those within XLE, for example, are still extremely cheap just on a valuation basis relative to where they were even at the beginning of this rally. Energy was the best performing sector in the market the past two years running.

And so you look at the top of the food chain and energy, these companies have free cash flow yields in excess of 10%. So valuations have actually come down despite having rallied 100% plus over the course of the past couple of years. So in some ways, this is a short-term market reaction to concerns about a recession and the impact on demand, perhaps overly worried about what that demand side is going to do relative to a supply side of the market that's very tight globally.

- And is there any percentage of that also factors or prices in an energy transition as well that we've been talking about?

PAUL BAIOCCHI: Yeah. And, as we've talked about previously when I was on the show, the energy transition is this massive, meaty megatrend--

- Multiyear, 10-year plus.

PAUL BAIOCCHI: Plus. And the reality is that we're going to need a lot of natural gas to generate the electricity to meet the demand for electric vehicles as well as the transition away from gas stoves in homes, et cetera. And so the reality is is that investors who want a position for that probably need some combination of legacy energy exposure along with renewable energy exposure to position for that, perhaps in addition to carbon credits exposure and even raw materials exposure, lithium, nickel, cobalt, et cetera that goes into these things.

And so in many ways, this is a short-term opportunity for some folks who were concerned that energy had run too much and were scared that they had missed it. And because valuations are still reasonably low relative to history, of course, and fundamentals have been so strong, I think, to your point, the investors who are selling energy might be in some ways overreacting to some of the concerns about economic activity going forward.

- Yeah, XLE down about, what, 9% so far this year. Paul, good to see you. Thanks for coming into the studio--

PAUL BAIOCCHI: My pleasure.

- --and visiting--

PAUL BAIOCCHI: It's great to be here.

- --us from Denver. Appreciate it.