July 29, 2013 4:54 pm

US financial stocks flying high

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Financial stocks are flying high and investors are certainly not suffering from vertigo.

Money continued flowing into the sector during the market turmoil of June, and flows have accelerated sharply this month, suggesting investors expect further outperformance from a sector that has traditionally been in the vanguard of big bull runs for the S&P 500.

Money talks

Money talks
Performance of US and European financial equities

Globally, investors are demonstrating a strong preference for US financials, illustrating the general view that the world’s largest economy is recovering and can live with rising interest rates. As a bellwether of stronger economic activity, US financials are seen benefiting from robust housing and financing activity against the backdrop of trading volumes across markets increasing.

For investors putting money to work, financials are the key sector when they look across the broad market. This month, the XLF exchange traded fund has attracted inflows of $1.7bn, more than double June’s $803m, according to Index Universe. The ETF’s total inflows so far this year of $5.1bn just shades the $6.4bn that has been ploughed into the S&P 500 Spider ETF.

The inflows highlight the belief that financials can continue to outperform. So far this year, the S&P 500 financials sector has risen 25.7 per cent, outpacing the broad market’s gain of 18.6 per cent.

The outperformance of financials versus the broad S&P 500 accelerated when market volatility began rising in May, with the XLF ETF garnering $4bn of inflows since the start of that month.

“I don’t think we are at a top,” says Sam Stovall, chief equity strategist at S&P Capital IQ, who is recommending investors overweight the industry.

One element in favour of a further run higher is that the sector is a diverse collection of big and smaller regional banks, insurers, and exchanges that has led the way during the second-quarter earnings season. The sector is expected to maintain a leadership role in terms of profits growth during the third and fourth quarters of this year.

Companies such as Charles Schwab, MetLife, Morgan Stanley, Goldman Sachs and CME Group have seen their share prices rise sharply since January, buoyed by a pick-up in deals and market activity that has boosted their bottom line.

The one exception has been real estate investment trusts such as American Tower Corp and Equity Residential, hit by losses from holding mortgage bonds as interest rates have risen sharply.

Jack Ablin, chief investment officer at Harris Private Bank, says financials remain one of the group’s favoured sectors and that valuations based on their relative price to sales ratio are still attractive.

Three-quarters of US credit is supplied outside the banking system, whereas in Europe almost all of it comes from banks. But US banks are now stepping up to fill the gap left by the withdrawal of some of that non-banking sector lending, which increased during the financial crisis

- Robert Albertson, Sandler O’Neill

“The large banks are benefiting from deal activity and relatively low financing rates.”

He says a steeper yield is also helping banks as they generate higher net interest margin, but a further rise in long term interest rates could hit housing and the economy should it curb demand for loans.

David Bianco, US equity strategist at Deutsche Bank, says: “The sector has done incredibly well this year on price to earnings expansion because there is more visibility on dividend hikes.”

He adds: “There’s a little more room for expansion if people see dividends hiked at the biggest banks.”

Mr Bianco favours those financial stocks with the most exposure to capital markets activity. “While you’ve already had a big improvement in the flow business, there’s room for more improvement if mergers and acquisitions pick-up.”

Robert Albertson, at Sandler O’Neill, says US financials compared with their global competitors are also benefiting from a pick-up in banking sector lending, a trend he thinks will lift profits in the coming months and years.

“Three-quarters of US credit is supplied outside the banking system, whereas in Europe almost all of it comes from banks. But US banks are now stepping up to fill the gap left by the withdrawal of some of that non-banking sector lending, which increased during the financial crisis.”

The picture is more convoluted across the pond.

With a moribund continent-wide economy European banks’ equities performance has been determined by the success of banks’ restructuring in the wake of the financial crisis, the strength of respective core businesses and exposure to the economic problems in peripheral countries.

“There’s a recovery trade and a divergence trade in Europe,” says Huw van Steenis, a managing director at Morgan Stanley. “There’s a huge differentiation between those banks who got on top of their bad debts early and those who are still running to stand still – between those improving their earnings and restructuring their non-core assets and some banks still feeling their way through the fog.”

A general inhibitor to recovery is the size of the European banks’ balance sheets: they are still too big.

As a result most banks continue to scale down their assets, in contrast to their US peers, while loan growth is compounded by worries surrounding the eurozone.

Deutsche Bank and Barclays are both set to unveil plans to shrink their balance sheets on Tuesday, and the latter will in addition launch a rights issue to raise more than £5bn.

“Earnings wise we can say some [European] banks are on the road to recovery but if we look at the balance sheet the situation is different,” says one senior London-based banker, who wished to remain anonymous. “Banks are in a deleveraging mode and they are trying to preserve what capital they can . . . but for a bank to report significantly bigger numbers you need loan growth and we’re still a long way from that in Europe.”

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