Home Insights Equities Financials are leveraged for a soft-landing

Financials are leveraged for a soft-landing

December 5, 2024 | 6 min read
Mary Brown, CFA
Analyst, Equities
Mark McGrew, CFA
Research Analyst
Nedret Vidinli, CFA
Associate Portfolio Manager
Scott Leiberton, CFA
Managing Director, Client Portfolio Manager
Christian Floro, CFA, CMT
Market Strategist

The positive economic outlook—with a soft-landing increasingly likely—combined with positive results from the third quarter earnings season have created a favorable setup for the largely unloved financial sector. Together with several industry specific green shoots, such as beneficial credit conditions, improving loan growth, higher net margins and fee income, as well as an easier regulatory environment, the previously anemic financial services industry is set to finally see earnings growth over the next few years.

The green shoots to the financial sector

Despite recessionary concerns for most of the past two years, it is increasingly evident that the U.S. economy is not as weak as once thought, with overall momentum geared towards a soft-landing.

This strength has been underpinned by sturdy corporate balance sheets and solid consumer fundamentals. Corporate profit margins remain elevated and, with asset coverage and cash levels also high, this should support a pick-up in business spending. Meanwhile, consumers remain resilient amid labor market stability. Debt burdens among lower-end households and lingering pockets of weakness in commercial real estate remain cautionary but may be at a turning point contingent on continuing disinflation and Fed easing.

Looking ahead, while the outlook isn’t without risk—as inflation and interest rate trends remain the most crucial variables to watch—the dissipation of election uncertainty paves the way for the new U.S. administration to build on economic resilience, helping create a constructive environment for cyclical stocks.

This positive economic environment, when coupled with a bottom-up review of recent earnings reports from the financial services industry that is pointing to several industry-specific green shoots, should benefit financials—notably the banking and credit lending industries.

Beneficial credit conditions

Strong economic fundamentals should support overall credit conditions staying manageable, particularly across consumer and commercial real estate lending books.

Despite the earlier rise in consumer loan delinquencies, there are signs that this stress may be easing. Indeed, according to the latest credit lender metrics and aggregate data, the trend looking forward is encouraging. New delinquencies are showing signs of slowing rather than a continued deterioration and, for certain segments of large-cap financials, may also be peaking.

Most banks have adopted a conservative approach with loan loss provisions, with some large banks expecting a peak 5% to 6% unemployment rate. With economic consensus estimates calling for unemployment to peak at only 4.3% in 2025, if this less than dire economic outcome plays out, then these banks may be able to begin releasing loss reserves. Only a third of total loss reserves built during COVID have been released to date so far—amid lingering fears of recession since 2022—so this could be a significant tailwind to earnings surprises, particularly as analyst estimates do not yet appear to have any loss reserve releases baked in.

Another trouble spot, commercial real estate (CRE) loans may also see a reprieve amid continued interest rate relief, helping stimulate transactions and support refinancing. While the balance sheet retrenching is far from finished, particularly for lenders with large office exposures who may need to revalue their positions lower given more price discovery, the amount of non-performing CRE loans, excluding the office sector, appears to be plateauing overall. Lenders remain cautious, however, and continue to add to loss reserves, but this nevertheless could serve as earnings support going forward as conditions gradually improve.

Improving loan growth

Loan growth has been especially anemic since the 2020 pandemic as massive direct fiscal stimulus and subsequent aggressive monetary tightening by the Fed dramatically diminished credit demand. However, with election uncertainty lifted, corporate sentiment should rebound, benefiting credit growth if businesses begin to ramp-up capital spending and M&A activity.

Bank management commentary points to lending pipelines that are at all-time highs, and corporate credit line utilization—which remains below historical levels—that have begun to stabilize and increase. The improvement in consumer-loan delinquency trends could also spur a renewed push toward consumer credit growth, with credit card loans—already a significant driver of consumer loan growth—potentially continuing to pick up. On the other hand, the recovery in mortgage loans, particularly residential, may be delayed if long-end rates stay elevated, putting a dampener on mortgage activity.

Overall, the expected uptick in credit growth is likely to be underpinned by a much-improved underwriting process that was catalyzed by the GFC, suggesting increased credit availability is likely to come with discipline and discernment to underlying credit trends.

Improving net margins and investment income

Financials typically borrow at the short-end and lend at the long-end. Amid ongoing Fed rate cuts and disinflation, if the yield curve continues to normalize, this will have an immediate positive impact to earnings through improved net interest margins. This dynamic has helped put a bottom to declining net interest income as some banks have started to reduce deposit pricing in response to the recent Fed rate cuts.

These factors are helping boost overall earnings optimism. After suffering year-over-year earnings declines to the tune of 10-15% in the first quarter of 2024, most bank earnings began to recover in the second and third quarter as deposit pressures abated—and for the larger banks, fee income recovered from multi-decade lows. Large bank earnings momentum continues to benefit from both interest and fee growth, with Q4 2024 EPS expected to grow an average of 15%+ for these larger banks benefitting from the M&A rebound. Meanwhile, small bank earnings have troughed, aided by the first two Fed cuts, with EPS expected to growth an average of 5% over the same period.

Easier regulatory environment

The Biden administration unleashed a regulatory tsunami against banks, with the so-called Basel III “endgame,” the final round of post-Global Financial Crisis era capital adequacy rules, at the forefront.

Despite the latest proposal being watered down from a 19% capital hike to 9% for the eight largest U.S. banks, with the next tier of banks facing a 3-4% hike, most large banks nevertheless held off stock buybacks in anticipation of the finalized rules, which have yet to be released.

With the Republicans controlling the executive and legislative branches of government, it is likely that the rules will be re-proposed. While this adds uncertainty, with the timeline unclear, the likely path points towards looser capital requirements, supporting a re-acceleration in returning of capital via stock buybacks.

A friendlier regulatory environment also suggests a pick-up in bank M&A activity, particularly for small to midsized banks, who will benefit from efficiencies created.

Investment outlook

A positive economic backdrop coupled with industry specific green shoots—beneficial credit conditions, improving loan growth, improving net margins and fee income, and an easier regulatory environment—should help drive an inflection point in financial services earnings. Deeply shunned over much of the past two decades, and especially in the wake of the 2023 high profile regional bank failures, financials have begun to attract more investor attention recently and have steadily outperformed the broader market. These factors should help create a powerful return to capital and earnings environment through 2026, helping extend positive investor sentiment.

Looking more broadly, not only has the bottom-up review of recent results from the financial industry been encouraging, but it also reinforces the top-down view of a “soft-landing” scenario for the U.S. economy. This, by extension, likely increases the optimism for improving market breadth and serves as a timely reminder to investors of the importance of ensuring equity participation in more cyclical industries, as well as small/mid capitalization shares, beyond just the narrow leadership that has dominated markets in recent years.

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