Q2 2017 CIO Insights – U.S. Value Equity
The U.S. stock market enjoyed a broad rally in the wake of last year’s election. However, political uncertainty may be the theme this year as the Trump administration moves to deliver on its campaign promises. While markets generally don’t like uncertainty, it’s often accompanied by volatility, which provides opportunities for value investors to find mispriced securities. This may be particularly true among financials, which could be profoundly affected by the Federal Reserve (Fed) and legislative activity or inactivity in 2017.
Interest Rate Normalization Is a Key Underlying Driver
While interest rate normalization is the underlying performance driver, financials stocks could get an extra boost from favorable tax and regulatory legislation.
While the Trump election victory buoyed the overall market, the Fed’s stated intention to normalize (raise) interest rates will be a key underlying driver of financial sector performance. The Fed’s path is expected to include multiple hikes to the federal funds rate this year, which could boost revenues for banks and capital markets firms, especially if the yield curve steepens. Banks in particular would benefit from wider net interest margins as they borrow at lower rates on the short end of the curve and lend at higher rates on the long end.
Tax and Regulatory Factors May Impact Profitability
Financials also stand to benefit from President Trump’s pledges to lower taxes and to significantly reduce government regulation. While all businesses would be helped by lower taxes, regulatory relief would be especially beneficial to financials. A decreased compliance burden would help slow expense growth, and fewer capital restrictions could lead to higher dividend payouts. When combined with the potential for an expanding economy, these developments could have a significant positive impact on earnings if they come to fruition.
U.S. banks J.P. Morgan and PNC Financial Services are good examples. Each has benefited from the Trump Bump and from their own strong business results, and they could get another boost if the variables work out to their favor. The two companies’ operations are largely conducted in the U.S., so lower taxes and regulatory easing would improve earnings potential and the attractiveness of their stocks. On the other hand, these and other higher-quality financials stocks could be set up to disappoint investors for fundamental reasons or if tax reductions and regulatory relief don’t materialize.
We’re Not Throwing Caution to the Wind
Broad discussions about the market or a particular sector are interesting, but that’s not how we manage money. As bottom-up investors, we look for higher-quality companies with strong management teams and try to buy them at attractive prices. We remind ourselves to not let extraneous events cause irrational exuberance, while also recognizing that changes in government regulations and policies can lead to meaningful changes in a stock’s outlook.
We assess each stock on its own merits, choosing to hold only those characterized by good returns on capital, low leverage and sustainable franchise characteristics. Those stocks may be rewarded should there be another Trump Bump, and if not, we will still be holding higher-quality equities we believe will benefit from the gradual normalization of interest rates.
References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.
The opinions expressed are those of Phillip N. Davidson, CFA, and are no guarantee of the future performance of any American Century Investments portfolio.
For educational use only. This information is not intended to serve as investment advice. Past performance is no guarantee of future results.