US banks have not just shown a stellar performance this week, but have also performed well throughout the entirety of this year. The ‘Direxion Daily Financial Bull 3x shares’ is an ETF which tracks the performance of the Russell 1000 financial services index. Its biggest holdings include Berkshire Hathaway, JPMorgan Chase & Co, Bank of America, Wells Fargo, and Citigroup. The ETF has returned 47.56% YTD. So what is causing such a high performance in the financial services sector? There appear to be three fundamental factors driving the performance of financial equities: interest rates, tax reform and regulation.
The US benchmark lending rate has been hiked twice already this year, and a third rise is quite firmly priced in for December. The hikes have been supported despite inflation running below the central bank’s target of 2%. Furthermore, Jerome Powell, the new Fed chairman, has publicly said: “We expect interest rates to rise somewhat further.”
Interest rates are not just rising in the US, but also globally due to the strong growth in the global economy. A large proportion of banks’ profits come from the interest that they charge on loans to customers. Therefore, it is only logical that as interest rates rise, banks will start to become more profitable and hence their stock prices are rising.
Trump’s Tax Cut
The proposed tax cut which hopes to slash the corporate tax rate from 35% to 20% could hand banks a $6.4bn profit boost and increase net income by 7%. The biggest six US banks would benefit disproportionately to institutions in other sectors as banks do not claim as much in deductions as other sectors do. Additionally, the extra cash that corporations will have due to paying lower taxes will likely flow into banks in the form of higher deposits, especially in the asset management and trading departments.
Following the global financial crisis, there were, of course, necessary regulations imposed that would theoretically make the financial system more crisis-proof in the future. However, the former investment banker Jerome Powell is keen to look after his own and hopes to ease the burden for banks and aims to have differing regulations for financial institutions of differing sizes and attributes. He proclaimed that the Fed must ensure the financial system remains “stable and efficient” and his opinion on financial regulation is firmly supported by Trump and Republicans in Congress. Trump is openly critical of the post-2008 regulations, suggesting they go as far as stunting lending and hence economic growth.
Overall, there are two main avenues that will allow banks to be more profitable. Firstly, lax regulation allows banks to take on more risk, which can potentially open up the gates for higher returns. Secondly, the administrative costs of complying with regulation are surprisingly large – one can ask any finance department of a European banking institution about how they feel in regards to the costs of Mifid II.
US vs Europe
Now is undoubtedly the time for US banks to make hay whilst the sun is shining, especially as when that stops, they are often the ones to feel the chill the most. For now, it seems like investing in the US financial sector is the best option by far. Unfortunately, the European banks will have to gaze across the pond in envy as they painstakingly wait for the ECB to start its own hiking cycle.
Furthermore, as mentioned above, the costs of the EU’s newest piece of regulation are likely to hurt banks’ balance sheets at the beginning. However, as better compliance technology is created, these costs will likely abate. But with another former investment banker leading France and the EU to greater things, perhaps European banks can also expect a leg up in the coming years.
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