In this episode of Markets in Focus
The business cycle and the strength of the consumer are expected to play key roles in setting the direction of the financial sector for the rest of 2022. Enrique Acedo, Research Analyst on the Equity Income Investment Team at Eagle Asset Management, joins Matt Orton to discuss signs of worry and signs of promise in financials — an industry group that it is anything but uniform.
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Financials started off the year on a strong note, outperforming the market as rates rapidly moved higher. In fact, the sector was perhaps the most favored amongst analysts heading into the year outside of energy, which was already on a tear and has further been aided by war between Russia and Ukraine. Unfortunately, financials have lagged since February despite rapidly tightening financial conditions and rising rates.
But what gets lost at the sector level is some meaningful dispersion under the hood. For example, banks have performed differently from consumer finance companies, which have performed differently from insurance companies, and regional banks have also performed differently from the larger money center banks.
So as we now sit heading into the fall in the last half of 2022, the economic outlook looks a little bit less dire than originally feared, but there's still a lot of uncertainty around the growth outlook and whether tighter financial conditions are here to stay. Given this backdrop, how should we think about the potential opportunity in financials? Can the current rebound and outperformance continue, or will the sector disappoint investors like it has for most of the year? To help answer some of these key questions going forward, and to dive deeper into the financial sector, I'm happy to have Enrique Acedo join us today.
This is Markets in Focus from Carillon Tower Advisers. I'm your host, Matt Orton. Join me and my colleagues as we discuss the latest trends in developments driving the markets. Visit us at marketsinfocuspodcast.com for additional episodes and insights. Enrique is a research analyst with the equity income team at Eagle Asset Management, and he focuses on financials and the real estate sectors. So Enrique, thank you for joining us today.
Oh, it's my pleasure. Thank you for having me.
Of course. So let's start by going back to the start of the year, there was lots of enthusiasm around the idea that rising rates would have a positive impact on the interest rate business of banks, but that optimism has faded pretty quickly with an acceleration of inflation and concerns over a hard landing. So Enrique, perhaps you can provide a more nuanced view around the change in sentiment towards financials and how the sector has historically performed during rapidly rising rate environments?
Sure. I'd be happy to. So first of all, you're a 100% correct. There was a lot of enthusiasm because banks generally do tend to perform well in a rising rate environment, at least initially. Obviously interest rates do determine the price of some of their products. So it's not surprising that they do at least perform well for a certain period of time as the Fed starts to raise rates.
When you look at mega-cap banks, more than 50% of their revenue comes from fees, while that number is around 30% for the broader industry. That said, smaller or regional banks tend to have a little bit more interest rate sensitivity, meaning that they benefit more as rates tend to rise. But I digress.
Anytime we get a rate hiking cycle, to be honest, I get this sinking feeling that somehow the thesis won't pan out as is expected. So I did a little bit of math here and I looked at the last four rate hiking cycles as determined by S&P Global. You can play a lot of games here as far as shifting time period. So I'm going to use S&P Global's last four rate hiking cycles.
So if you look at S&P banks and you look at their performance relative to the broader index in the last four rate hiking cycles, they outperformed the index exactly 0% of the time. I think the issue here is that it takes about 18 months for a rate hike to work its way through the financial system. And that's really enough time for economic prospects to start to sour and for some negative economic data to start getting priced into these stocks. Keep in mind that banks are hyper-cyclical stocks, so they tend to trade very much in line with the economy's prospects.
As far as performance this time around is concerned, since the first rate hike in March of 2022 S&P banks have underperformed the broader index by about 750 basis points. I know these numbers will shift a little bit based on when this podcast airs, but the numbers should hold. The majority of this is due to worsened economic prospects. To be fair, expectations going into the second-quarter earnings were pretty dire. So that led to 70% of banks either meeting or beating expectations. Nonetheless, earnings in the aggregate are down about 24% year over year. So this earning season wasn't exactly great. It was just less bad than expected.
Yeah, I think that's really enlightening, especially the fact that zero banks have outperformed exactly 0% of the time during previous rate hiking cycles. I think that tends to get lost in a lot of the dialogue. And I think it might also be worth calling out what I think is another common misconception around banks, which is that interest rates are the key driver of share price performance. But I think it's more the business cycle. So I'm curious whether you agree and where you think we are in the business cycle right now and how that might influence banks going forward?
I do agree with you. I think the business cycle does definitely determine how these stocks perform. These things, again, are hyper-cyclical stocks. As to where we are in the business cycle? That is the $64 million question. Some things to consider: Inflation is starting to slow, but unemployment claims are moving in the wrong direction. Housing is starting to cool off actually pretty quickly. ISM's are moving in the wrong direction. So all in, I think we're closer to the end of the business cycle than not. Again, we don't know exactly when the recession is going to strike, but I think I agree with Jamie Dimon that the odds of a soft landing are around 10% or essentially pretty low. The Fed doesn't have a very good track record of engineering soft landings.
As far as the misconception that you noted, I'll actually go one step further and say that there's actually a misconception about how bank business models work, and bear with me, I'm going to get into the weeds a little bit, but hopefully I'll leave you with something useful. So first of all, and as I said before, more than 50% of mega-cap bank earnings are fee-driven. These are investment banking, trading, fees on deposits, et cetera. So this means that the banks that are generally top of mind will certainly benefit from higher rates, but less so than smaller players. And I think this dynamic creates some disappointment amongst some generalist investors. And I think this is really reflected in mega-cap bank performance.
Secondly, and this is where it gets a little bit nuanced, loan loss provision rules changed materially at the very onset of the pandemic, making banks even more pro-cyclical than before. So under the previous incurred loss model, a bank’s earnings could actually sustain through a nasty downturn as banks only needed to set aside provisions as loans went bad. So you saw what's called negative credit migration. So companies were facing stress and loans get downgraded, but basically banks could ease into provisioning. Under the new CECL rules — and CECL stands for Current Expected Current Loss — banks now have to maintain an economic model that they then have to use to estimate the expected loss on every single loan they have on the books. So under the new regime, if the odds of a recession increase, so will the bank's loss estimates and therefore so will their provisions.
So what you're seeing now is, in my opinion, investors are getting ahead of a negative revision cycle since banks will indeed have to adjust their economic models. During this last earning season, several banks, mostly on the mega-cap side, overtly chose not to update their assumptions, which I think is a little bit disingenuous. Let's face it: The odds of a recession between the first quarter and the second quarter clearly went up.
As a follow-up question then, do you think there's still more pain then as banks start to realize a more sour economic environment? I guess we can't, and we'd be foolish to predict, soft landing versus not soft landing, but like you said before, we know economic growth is decelerating. So do you think the share prices of banks are fully inputting what could be a more challenging economic cycle going forward?
No. I don't think that the estimates reflect these provisions. I think there is potential to see some negative revisions going forward. I don't think these provisions, mind you, are going to be as bad as what we saw at the onset of COVID. So I don't really foresee a disaster.
I just foresee, again, a negative revision cycle, and the way to think about provisioning this time around it's more algorithmic than not. These companies will be forced to update their economic models and that's going to force them to provision. It's only a matter of time until this happens. If it happens in the third quarter or the fourth quarter, I'm not a 100%, nobody knows, but I do think it's going to happen before the end of the year.
All right. Well, yeah, thank you for that. So, Enrique, let's break down the sector and look at some specific industry groups now. So we've talked about banks. Banks have been more challenged, but on the flip side, consumer finance companies have actually fared decently well, and insurance companies have performed even better. So maybe you can help us understand why have we seen this dispersion? And do you think it can last? Are there any insights you've gained through the most recent earning season that might influence our outlook going forward?
Absolutely. Well, first of all, insurance companies are in large part interest-rate sensitive, meaning that they benefit from higher interest rates. In the short term, you might get some temporary reductions in book value as you mark to market the bond book, but generally earnings are actually doing quite well.
Moreover, as we saw in the latest earning season, property and casualty insurance pricing continues to be quite strong. It's a hard insurance market. That's what we call it. So the underlying trends in insurance are actually very, very healthy. All in all, insurance has generally been a pretty good place to hide in a turbulent environment. So I would expect this sector to continue to perform quite well.
Secondly, as it relates to consumer finance, consumer loan growth has been coming in as high as 20% for some credit card companies, and overall loan growth has been coming in at levels that, quite frankly, I've never seen throughout my career.
Now consider this: Some lenders and retailers have seen consumers engage in substitution. This means that consumers are spending the same or more money, but buying cheaper or let's call it store-branded goods. That's a sign of stress. One of the nation's largest telecom companies also told us this earning season that consumers are taking longer to pay their bills. And these are what we call inelastic services, and it's quite concerning to see that consumers are taking longer to pay their bills on services that they need. These are not discretionary services after all.
Finally, consider that one of the largest and most respected banks in the U.S. is also telling us, actually this earning season, that consumers are starting to chew through their cash cushions. So overall I think the consumer is perhaps in a bit of a more tenuous position than what most people believe, and they're levering up to pay for record levels of high inflation as real wages decline.
And most of this we're starting to see at the lower income range, but this will eventually bleed into the general consumer. As to whether the outperformance in consumer finance can continue? Look, I'm really not inclined to chase the rally here. If you want to see what the market thinks of aggressive consumer lending, just pull up a chart on any of these buy-now-pay-later companies and the results are pretty dismal.
One final point I'll make here is, as it relates to consumer finance, is that the CFPB (Consumer Financial Protection Bureau) is embarking — this is breaking news, by the way — is embarking on a new initiative to lower credit card interest rates. So while the bureau doesn't have the statutory authority to do so, they do have a lot of levers they can pull. So look all in: Yes, consumer finance has been attractive, but it's far from being a panacea.
So let's dig into that a little bit more. And focusing on the banks specifically, like you mentioned, we've seen lending activity jump in recent months. We've seen increased spending on credit cards, and on the one hand, this should be beneficial to the banks. But on the other hand, it begs the question as to why consumers are taking on the extra credit. Has their purchasing power meaningfully eroded, and is this a harbinger of potential pain in the future? And we get conflicting reports from this. Some data from some large banks say that deposits are fine, that they're healthy. You hear from management of other banks, that it's a different story. So I'm curious to get your thoughts on what you are seeing across the broad sector?
You are a 100% right, Matt, that you're starting to see some disparate commentary up among different bank CEOs, whether the consumer's doing okay or not doing so good. I'm inclined to believe that you're starting to see a lot of stress at the lower-end consumer, and I do think this is going to bleed into the general consumer. Again, some more subprime, heavy lenders are giving us data that indicates that there is quite a bit of stress, but hey look all in: If you teleported me into the current environment without any knowledge of the macro and you just showed me the loan growth numbers, I would be backing up the truck on these stocks.
I just think the consumer's purchasing power has materially eroded and that these companies are lending into what has potential to be material weakness. To put numbers around it, if you annualize real wage growth in the first half of 2022, that number is -7.6%. That is clear erosion. And as I said before, I think consumers, especially at the lower end of the spectrum, are being forced to incur additional leverage to pay for inflation.
So let me follow up on that too, because it's also interesting you hear different reports from the auto loan market, which is kind of front and center with the health of the consumer. So are you seeing any signs of stress in the auto loan market? That could be a tell for what might be to come for the broader consumer credit going forward?
So it's funny you bring up auto because it's one of these fear-du-jour categories. In bank land we have certain number of loan categories that come up periodically as a potential threat to the sector. And this has been going on for a while in auto, but consumers keep rolling negative equity into longer duration loans so that they can afford that monthly payment. So you can stay on the treadmill only for so long, obviously.
In the current environment where vehicle prices, both new and used, have skyrocketed and interest rates have begun to increase, things are getting a little bit more challenging and we actually see some moderation in loan balances sort of industry wide. And I think banks are starting to tighten standards as it relates to auto lending. So that's a good foreshadowing as to what banks are seeing in the auto loan sector. They're starting to pull back a little bit.
Yeah. That's helpful color and maybe that'll help on the inflationary picture as well for auto, since I believe used car prices are still 50% higher today than they were at the start of COVID, which is just mind-boggling when you think about how expensive automobiles already were to begin with. But I want to pivot a little bit and maybe call out the capital markets industry and move away from just the banks since this industry tends to be overlooked or misunderstood in our broader discussion of financials. So here this industry includes some investment banks, data providers, asset managers. Enrique, as an active stock picker, how do you look at this space, and are there different themes or opportunities that are standing out right now?
Sure. So obviously I'll look at everything that's investible in that sector, meaning that I'll pay most attention to dividend payers in this space. There's a certain company within the S&P financials that makes up 14% of the sub-index, and it's managed by a very famous and very wealthy value investor. It gets very little attention from me because it does not pay a dividend; thus it's un-investible. Also, I have a phobia of opaque conglomerates or conglomerate-a-phobia.
I do like asset management plays that are simply more than beta plays. There are certain asset managers out there that are offering financial advisors tech tools to help them screen for risks and in doing so have an opportunity to gain market share. I think those will be very successful. As it relates to investment banks, they're very interesting and we've actually seen some pretty generous dividend growth over the last couple of years. We don't think this continues at the same pace considering the current environment. As you know, M&A and IPOs have really slowed down materially this year, and they're unlikely to rebound in this current volatile environment.
As it relates to the data providers, these things have been ESG and growth darlings for several years now and have since materially underperformed, but longer term I really do like these stories. Over time, let's face it, we're going to consume more financial data, not less. So those stocks tend to be compounders over time. Unfortunately, for the most part, the dividend yields tend to be too low for us on my team. Lastly, I'll actually throw in exchanges. I tend to like those because they perform well in turbulent environments and are good places to hide in periods of high volatility. They're also a great way to lean into more of a recurring revenue model within the financial sector. Again, most of these companies don't have a yield high enough for us to play ball, but there are a couple of stocks that are investible for us.
Okay. So let's loop in valuation because you can't get around talking about financials without some discussion of valuation, and I think many investors would argue that banks and financials more broadly have been cheap for a very, very long time, but maybe there's a reason for that. And so dividend yields in some cases are also the best they've been in probably a decade-plus. And I know your team, as you've alluded to, is particularly focused on dividend growth. So it would be great if you could discuss where you're seeing the best opportunities from an income perspective and whether you have any concerns going forward?
Sure. You can almost use dividend yields here as a measure of valuation. You're correct, yields have gone up because you've seen P/E multiples fall about five multiple turns. And that tends to hold up if you look at the large-cap banks, which dominate the S&P financials.
The problem is that though earnings have come off peak levels in 2021, we really haven't seen revisions account for the recession-related loan loss provisions that I brought up earlier. That's my fear: That earnings take another two-by-four to the head in the second half of 2022, meaning that banks, which dominate financials, as I said, may not be as cheap as it appears.
As far as dividend yields are concerned, obviously we do have a yield target, but we'll rarely reach for the stars since high yielders typically have issues associated with them that have driven yields to that point. As you know, we focus on growth and income, which leads us to look for profitable, well-established companies with secular tailwinds that are growing irrespective of the business cycle, and that therefore can pay a healthy and growing dividend over time.
As far as dividends themselves, I currently don't foresee any dividend cuts among our holdings, and I really don't see cuts on the horizon for the broader market. At least not yet. If anything, we've seen some pretty solid dividend growth across multiple sectors, not just mine, this year. At the end of the day, dividend growth is a by-product of earnings growth. So I do believe that dividend growth is poised to slow a little bit, considering that I do expect earnings growth to start to cool off.
Great. And I do want to squeeze in one question on fintech as well, since that's an area that gets a lot of attention. So I'm curious how you look to get exposure to fintech in the financial sector?
Sure. That's an interesting question. There are things you think would be in financials, like the card networks, that are actually in technology, but I'll note that in 2023, those will actually be reclassified as financial. So you could go that route.
You can always invest in financial data providers, which we talked about, which are mostly classified as financials. As far as how we're getting exposure, quite frankly, it's mostly through banks and exchanges.
Banks, for one, have invested heavily in fintech. We're talking tens of billions of dollars a year, per bank, not in aggregate. While exchanges are also doing some really interesting work. One in particular is working on revolutionizing the life cycle of mortgages from end to end, from lead generation to servicing. This stands to drastically reduce costs for both financial institutions and consumers, and just to put some numbers around it, because I thought it was really interesting, the average bank actually spends around $8,000 to $9,000 to originate a mortgage in what is a convoluted, paper-heavy fragmented process, which is a mess. So this could be a real game-changer. So I do think there are some real good opportunities to play fintech.
That's great, very, very helpful. And I know where we're running a little short on time. So one last question to bring this discussion home for our listeners and maybe, Enrique, you can discuss your favorite investment opportunities in the financial sector. And, of course, some key risks that we should keep in mind as well?
Sure. Look, I think I've discussed enough of the risk here. I really don't want to bore the audience with more bearishness. Obviously the main risk is an earnings deceleration into the second half of 2022 resulting from higher provisions. But look, at the end of the day, rates are going up and loan demand is fantastic. I've never seen it at levels this high.
I think it pays to own banks that are in the business of commercial lending and have a strong track record of underwriting. And there are a couple of these banks out there. Commercial loans are variable in nature and they're tied to something called SOFR, the Secured Overnight Funding Rate. And if you pull up a chart of that, it's really parabolic. Rates are going nowhere but up. So I think that's a good place to be.
I also really like auto insurers. The fundamentals there are really tough right now because vehicle repair costs are really going up right now. And there's a lot of claims inflation. So it's kind of counterintuitive that you would buy something where the fundamentals are terrible. With these companies it's important to remember that losses precede insurance price hikes. These price increases have to be justified and approved by state regulators. And trust me, there's ample justification to get these price increases. I'll tell you if you have auto insurance you're in for some pain and investors are going to benefit as these companies right the ship. So I really do like the auto insurance. The auto insurers, I think, we're set up for a strong pricing market. So that could be a good place to be.
And finally, again, I do like exchanges because they're transitioning to a more recurring revenue model. Exchanges today are doing a lot more than people expect of them. They're not as transactional as they used to be. So that could be a good horse to ride over the long term.
All right, well those are incredibly helpful insights. And, Enrique, I think this overall conversation has been helpful, and hopefully our listeners are able to come away with some new insights on ways to look at the overall financial sector. So thank you very much for everyone for tuning in and until next time take care.
You as well. Thank you very much.
Thanks for listening to Markets in Focus from Carillon Tower Advisers. Please find additional episodes and market insights at marketsinfocuspodcast.com. You can also subscribe to our podcast on Apple podcasts, Spotify, or your favorite podcast app. Until next time, I'm Matt Orton.