Of all the books that might be penned by the current US President after he leaves office, one may talk about his ability to move financial markets, even though there should be no debate as to whether one should or try to do so. Yet, we have seen confusion and concern over US trade policy again put a halt to upside momentum in stocks this month, essentially removing all the gains made since May. US financials have been a big part of this.
The business media outlets have been crammed with guests talking up the state of the US economy, the benefits of tax cuts and why we don’t have to worry about a flat yield curve. We are also told not to worry about the fact that this equity cycle is now approaching a record age and that somehow the de-synchronization of global growth won’t affect market sentiment. Somehow these optimistic messages haven’t reached holders of US financial stocks.
This week, the S&P500 financials sub-group extended its slide to 13 days, making it the longest uninterrupted losing streak on record. Prior to the late-week bounce, the index had fallen to its lowest level since November and it was down 20% from its peak in January. This constitutes a ‘bear’ market and it has contributed to the reversal in the overall S&P this month. This isn’t the first time for this cycle that financials have delivered red to the screen. After two years from the bottom in 2009, the sector fell 35% and then in 2015 we saw a slide of roughly 30%. Both ended up being relatively minor pauses in what was a 640% rebound from the 2009 lows to the January high. Some view this current retracement as being no different and merely a rest stop on the way to yet new record highs. Those that do will cite a strengthening US economy, tax cuts and deregulation as the main reasons why. The counter argument is that the economy is cresting and whatever benefits the latter two factors offer have already been built into the market.
The state of the US economy is up for debate. While economic growth is expected to accelerate from the anemic pace of 2.0% in Q1 (revised lower this week from the previous estimate of 2.2%), we are still tracking below what was talked up for 2018 growth at the start of the year. Tax cuts, however, have probably not trickled all the way down the pipe. One example would be capital expenditures. Even though the new tax rules allow for a full writing off of new investment, rather than through a graduated depreciation schedule, durable orders in the US have been relatively staid. In fact, we have seen back to back declines since the first quarter and this can be partially attributed to uncertainty over things like trade policy.
In terms of new rules for the banks there has been plenty of speculation about the potential benefits that would come from more relaxed regulation on capital. This month, US bank regulators proposed a new supplementary leverage ratio for the banks that lowers the amount of capital banks have to keep on board as protection ahead of financial shocks. The amount being bantered about is $90 billion in terms of excess capital—money that can be diverted to lending and other areas which, all things being equal, could enhance revenues and profits. That would be positive in terms of stock price multiples, but the counter argument is that this was largely priced in after Trump took office and started tweeting about ripping up regulations.
Since the middle of this week, investors have appeared less pessimistic about US financials, with the sub-group rallying into the weekend. This could be some month and quarter-end cherry picking, or perhaps the sector is just too oversold relative to other sectors. There also is some correlation between what has happened to US financials and the state of European banks, which arguably are in worse shape. Even Canadian banks have come under pressure after coming close to breaking their May highs earlier this week.
From a near-term strategy perspective I still like banks on both sides of the border and, depending on where the Canadian dollar goes in the summer, US banks could outperform their northern neighbours. That said, this sector is going to remain volatile as long as policy uncertainty exists.
Canada: Leading indicator, merchandise trade, employment
US: ISM manufacturing, construction spending, factor orders, vehicle sales, ISM non-manufacturing, FOMC meeting minutes, trade, non-farm payrolls