Around this time last year, the outlook for U.S. banks was tenuous at best. The global economy was shutting down, and virtually no one understood the implications for credit, loans, liquidity, mortgages, and other avenues for banking revenue. Banks went into full defense mode.
For years, banks had been preparing for another crisis, and here it was. New regulations and Fed stress tests compelled banks to boost capital ratios and to make emergency plans. Many were ready for the crisis. But given the uncertainties of the pandemic, many banks went a step further and set aside tens of billions of dollars to boost capital reserves even more, anticipating another wave of loan losses and deteriorating credit conditions. Many banks feared the worst.
Fast forward to today, and the actual impact of the crisis was far less than anticipated. In fact, many banks have thrived over the last year, thanks in part to the U.S. housing boom, fiscal stimulus, and robust IPO activity. It is often said that good companies often emerge from a crisis even stronger than they were at the beginning, and I think big U.S. banks fit this profile.1
Below, I offer three reasons why I like banks in 2021, and how banks fit into our strategies and approach at Zacks Investment Management.
- The Yield Curve Favors Bank Profits
With yields on long-dated U.S. Treasuries ticking higher, the yield curve has been steepening recently – and that’s good news for banks.
A steepening yield curve generally means a more profitable lending environment for banks. Since banks borrow money at short-term interest rates (still close to zero) and loan money out at longer-term interest rates (which are currently rising), a steeper yield curve means bigger net interest margins on loan activity. As you can see in the chart below, the yield curve has been steepening since this time last year, and I think will steepen even further as the year progresses. Again, this trend implies an improving profit landscape for banks.
Source: Federal Reserve Bank of St. Louis2
- Steady IPO, Merger, and Trading Activity
Major banks can earn significant money from underwriting initial public offerings (IPOs), facilitating mergers, and fulfilling trading activity. I think all three will see continued strength in 2021.
On the IPO front, for example, the number of publicly traded companies is on the rise after a 20+ year slump. From 1997 to 2017, the number of listed companies dropped from 8,500 to 4,500, spurred by the tech bubble bursting. Last year saw a bit of a reversal – after modest upticks in 2018 and 2019, the number of listed companies surged by 200 in 2020, and I think we’ll see even bigger increases in 2021.
As it relates to mergers and trading activity, I think the liquidity factor will play a big role. I have written many times before about the extraordinary levels of monetary and fiscal stimulus, and the trillions of dollars sloshing around the capital markets. Banks should capitalize on this excess liquidity, in my view, via more trading and more deals.
- Higher Levels of Stock Buybacks
Since stock prices are established by supply and demand forces – and since stock buybacks act as a supply reducer – buybacks can be a tailwind for a stock. In the aftermath of the 2008 Global Financial Crisis, however, banks notably had restrictions placed on the amount of stock they could repurchase – if they could repurchase shares at all.
Those restrictions have eased over the years as banks recapitalized, and in the first quarter of 2021, regulators allowed banks to engage in stock buybacks. There are still leftover regulations on how much stock a bank can repurchase, but those restrictions are due to be lifted at the end of June. I expect to see higher levels of stock buybacks as a result.
So, what does this all mean for investors?
For one, I think having some diversified exposure to Financials is a good idea for equity investors in 2021. At Zacks Investment Management, we have a few strategies with different types of exposure to banks.
Our Preferred Strategy has a significant weighting in the financials’ sector, as banks are a primary issuer of preferred shares. With yield compression continuing in the banking sector as the yield curve steepens, we hold a positive outlook for many names in the Preferred space. Some 80% of our Preferred holdings are in some of the biggest and most robust U.S. banks (our weighting shifts over time).
Financials exposure is also evident in the Zacks Dividend Strategy. The Dividend Strategy starts with an investable universe of the Russell 1000 Value Index, and many of the biggest names in banking are categorized as value stocks. Our rigorous stock selection and screening process guide us to select what we see as the highest-quality banks relative to expected 2021 earnings, which establishes our Financials exposure each year.
Bottom Line for Investors
Some of the U.S.’s biggest banks have spent the last decade shoring up balance sheets and strengthening their capital position. In my view, a true test was presented last spring with the global economic shutdown, and the banking sector demonstrated its readiness. Capital and credit markets largely operated smoothly.
Now, with the world emerging from the pandemic and the U.S. economy poised for a strong growth year in 2021, I think banks are well-positioned to deliver strong earnings results and perhaps strong stock market gains as a result. Not all bank stocks are created equal, however, so investors need to use trusted and proven research and screening methods to establish banking exposure in portfolios. Zacks Investment Management can help.