Strong capital positions are crucial for banks to handle regulatory pressures, which may have reached a peak. Banks are pushing back against the latest regulatory proposal, known as the “Basel III Endgame,” arguing that higher capital levels and restrictions are unnecessary and could harm the economy. Federal Reserve Chairman Jerome Powell voiced his opposition to the proposal in March, leading to market optimism at the possibility of relaxed regulations.
In addition to regulatory concerns, financial institutions are influenced by macroeconomic trends. The US economy appears to have reverted to a period of relatively high inflation. While annual inflation has decreased from a peak of 9.1% in mid-2022 to 3.2% in February, upward inflationary pressures are expected in the future. This environment, characterized by higher nominal growth rates, is likely to benefit earnings, as evidenced by the resilience of S&P 500 companies in 2023 and the anticipated growth in 2024 and 2025.
Although the Fed may reduce rates as anticipated, market rates could remain steady or even rise, providing an advantage for financials due to the profitability benefits associated with higher rates. In a scenario of lower growth and inflation alongside decreasing interest rates, risk assets may still be supported, with quality and defensive sectors potentially performing better. Spread-based financial businesses may lag, but capital markets trading, investment banking, and asset management are expected to remain resilient.
Positive trends can be observed in various industry segments, with major auto insurers reporting double-digit pricing growth and alternative asset managers experiencing strong organic revenue growth driven by interest in nontraditional investment products. Traditional asset and wealth managers are benefiting from the recent market rally, while investment banking revenues have shown improvement from previous lows.
Commercial banks, following last year’s challenges, are showing signs of stability, with credit costs returning to more normalized levels. Large, diversified banks with significant deposit franchises are well-positioned to navigate the evolving environment, having demonstrated resilience during the crisis and gaining market share.
Despite improving industry fundamentals, valuations for the S&P 500 Financials Index and the KBW Bank Index continue to trade at significant price/earnings discounts compared to the broader market.