Banks, insurance companies and other financial sector stocks have been big winners this year. Rebounding sharply after last year’s wipe out, the sprawling industry has advanced by 19.39 per cent year-to-date. The sector’s return has exceeded the broader world stock market by over five per cent as measured by the MSCI World Financials Index.

Financial sector outperformance has been a driving force behind the closely-watched rotation from growth to value investment styles. Because financial stocks typically have higher debt levels and are more dependent upon the business cycle, they tend to trade at cheaper relative valuations on metrics such as price-to-earnings and price-to-book ratios. Thus, the finance sector is the single largest component of the Russell 1000 Value index.

Looking ahead, the finance industry has some important tail winds likely to boost future earnings progress. Leverage to an improving economy, recent regulatory successes and potential margin improvement from higher interest rates gives them a leg up in this phase of the current economic cycle.

Bank earnings have been strong this year, driven by higher loan volumes, robust merger and acquisition (M&A) activity and declining loan losses. Among the largest banks, second quarter earnings have been benefited from reductions in loss reserves and increased activity. Importantly, bank deposits are up about 30 per cent over the past eighteen months while dividend yields have been steadily improving. In last week’s testimony to the Senate Banking Committee, Federal Chair Jerome Powell highlighted the improved capital position of most banks.

Meanwhile, global economic growth prospects have progressively brightened over the course of 2021 as the world continues to reopen. In the US, growth has been stronger than expected, with economists forecasting Q2 growth to come in at a +12.8 per cent annualized pace. Globally, growth is now predicted to rise 5.8 per cent this year after a series of sharp upward revisions from earlier projections.

The vaccine roll-out in many of the advanced economies and America’s massive fiscal stimulus have been driving the improvement. World GDP growth is expected to be 4.4 per cent next year but total global income could still be about three trillion less by the end of 2022, than was anticipated before the crisis hit.

Against the backdrop of a rebounding economy, regulators have been impressed by banks’ improved capital positions. During this summer’s government stress testing, all 23 US banks tested passed. Since the aftermath of the Great Financial Crisis in 2008-2009, banks have been mandated to hoard larger shares of their earned capital and strengthen their balance sheets to comply with more stringent regulations regarding capital retention.

From 2009 through 2019, the banking group saw relatively strong results and improving capital positions. But just when things were looking up, last year’s pandemic put a halt to dividend increases and share buybacks. Last year, most European banks eliminated their dividends while the major US companies ended share buybacks and reduced dividends or stopped increasing them to varying degrees.

Last year’s enhanced regulations were only meant to be temporary and the stress tests now provide an opportunity for change. Under this year’s hypothetical stressing scenarios, banks were expected to have sufficient capital to survive an elevated unemployment rate of 10.75 per cent, a four per cent decline in gross domestic product (GDP) and a 55 per cent drop in the stock market.

Now that the global economy is emerging from the pandemic recession, credit quality is improving as businesses reopen and become more profitable. In fact, a large portion of the hefty reserves set aside for last year’s downturn have proved unnecessary. This is capital which can be returned to shareholders.

Banks are now able to return tens of billions of dollars to shareholders in the form of dividends and share repurchases. Analysts forecast as much as $200 billion to be returned, with stock buybacks being the main vehicle for returning capital. As well, almost all of the large US banks announced they were taking advantage of the situation by increasing their dividends. On average, dividends are expected to rise by 2.7 per cent and total capital returns should be in the range of eight to nine per cent of total market capitalisations.

In addition to an improved regulatory outlook, top financial companies are seeing record levels of M&A. Several of our core holdings, including Morgan Stanley, Goldman Sachs Group and J.P. Morgan recently reported strong quarterly results featuring robust investment banking revenues. Morgan Stanley, for example, recorded a healthy $2.38 billion in investment banking revenues, easily surpassing estimates of $2.08 billion as record low interest rates spurred a flurry of merger activity.

Other niche players such as US Bancorp are benefiting from the recovery in credit card spending for items such as travel. US Bancorp has higher share of revenues from credit card related fees, with a sizeable portion of card volume tied to sectors most impacted by COVID-19 (travel, hospitality, and entertainment) and these are rebounding nicely as economic recovery continues. Consumer spending has picked up through this summer, returning above 2019 levels and expected to drive growth in overall card-related fees.

Further down the road, rising interest rates could be another catalyst for the sector. So far, longer-term interest rates have failed to rise above the March peak of 1.74 per cent on the ten-year US Treasury bond. However, surging inflation on the back of historically high levels of money-printing could eventually force a capitulation in the term structure of interest rates.

Bank net interest margins and insurance company earned income have been trending down with interest rates over the past several years, but a reversal of this pattern could mark an important sea change. Higher rates may add to the bull case for select financial companies and to the value segment of the market as a whole.

Bryan Dooley, CFA is Head of Portfolio Management at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.