Welcome to RBC’s Markets in Motion podcast, recorded March 6th, 2023. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.
Ahead of RBC’s Financial Services conference this week, today in the podcast we’re digging into our thoughts on the Financials sector, which we remain overweight. Three big things you need to know: First, Financials has been one of the best performing sectors over the past 6 months. Second, we think the sector is an attractively valued recovery play with a positive shareholder return profile, which history suggests should benefit from a Fed pause. Third, near-term challenges for the sector, and longer-term risks to our view, include the earnings forecast downgrade cycle the sector is in the midst of and the moderation in inflation that our economists continue to anticipate.
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Let’s start with Takeaway #1: Financials have been performing better than many investors realize.
- Although the S&P 500 Financials sector has only been an inline performer YTD in 2023, most investors would be surprised to learn that it has been the best performer over the past 6 months.
- The ride has admittedly been bumpy, and we remain overweight Large Cap Financials on a 6-12 month view. On a shorter-term basis, we think the sector stands to benefit from renewed concerns about inflation and Fed policy which seem more likely to pressure the Large Cap Growth sectors like Communication Services and Consumer Discretionary.
Moving on to Takeaway #2: We think the sector is an attractively valued recovery play with a positive shareholder return profile, which history suggests should benefit from a Fed pause.
From a top-down perspective, here’s what we like about the sector:
- First, RBC’s Financials analysts have consistently been more constructive than our analysts in most other sectors in our RBC analyst survey work over the past year. While we are not beholden to our analysts’ views, they are an important input into our process and help us compare fundamentals across sectors.
- Second, the sector is appealing from a shareholder return perspective, and has been one of the positive stand outs on both dividends and buybacks.
- Third, valuations remain attractive. On our model, Financials is one of the most deeply undervalued sectors relative to the S&P 500.
- Fourth, the sector tends to outperform in recession rebounds. We continue to think that the S&P 500 priced in a short/shallow recession that largely plays out in early to mid-2023 at the October 2022 low.
- Fifth, historically, the sector tends to be one of the best performers, along with major Growth sectors like Tech, following final Fed rate hikes. Note that the RBC Economics team has pushed back their timetable for a Fed pause, but still sees a pause and cuts before year-end. In their latest forecast, they have called for additional hikes of 25 bps in March, May, and June, a pause after, and a few cuts in the 2nd half of the year.
Wrapping up with Takeaway #3: Near-term challenges for the sector, and longer-term risks to our view, include the earnings forecast downgrade cycle the sector is in the midst of and the moderation in inflation that our economists continue to anticipate.
Near-term issues and challenges for the sector that temper our enthusiasm a bit include:
- First, the sector is still going through an EPS downgrade cycle. Most of the major sectors in the S&P 500, particularly the major Growth sectors like Tech, Communication Services, and Consumer Discretionary, experienced a wave of downward revisions to earnings forecasts last year while a handful of Cyclical and/or Value sectors like Financials, Energy, and Utilities continued to see modest upgrades. This year, the sectors that were resilient last year including Financials are finally experiencing a downward revision cycle. We think that has contributed to the weaker relative performance of Financials YTD while the major Growth sectors have outperformed, but we think this dynamic could be fully played out by the time we get to the next reporting season.
- Second, its weak ESG profile. According to our ESG Strategy team the sector has a low ESG ranking relative to other sectors and is only middle of the pack on ESG momentum. While ESG flows came under pressure in 2022, we think this is a theme with longer-term staying power.
- Third, in terms of performance drivers, Financials tends to perform (relative to the S&P 500) more or less in sync with trends in inflation expectations and 10 year yields, meaning it’s typically tough for the sector to outperform when inflation expectations are easing and when 10 year yields aren’t moving up.
- Our December 2023 analyst survey also indicated from a more qualitative standpoint that Financials is less of a beneficiary of moderating inflation trends than other sectors.
- Note that RBC Economics continues to see a moderation in inflation in 2023 to 2.5-3% on core CPI by December, while acknowledging that the path may be a bumpy one. Consensus forecasts as tracked by Bloomberg also continue to anticipate that PCE and core PCE will return to ~3% by YE 2023. Meanwhile, RBC’s Rates Strategy team anticipates 3.35% at year-end 2023 on 10 year yields while consensus is still calling for 3.5%.
Overall, we find more reasons to be constructive than cautious on the sector, and are sticking with our overweight view.
That’s all for now, thanks for listening. And be sure to reach out to your RBC representative with any questions.