It would be hard to overestimate the importance of economic growth to investors. While there are, of course, "defensive" companies that perform relatively well during periods of stagnation or recession, a rising tide lifts all boats and an ebbing tide—well, we all saw what happened in the first three months of 2009.
During the Great Recession and its uninspiring aftermath, no sector of the economy has taken more of a hit than financials. From the start of 2008 to the market low on March 9, 2009, financial stocks of the S&P 500 delivered investors a decline of about 74%, compared with a 50% drop in the broad market index. Since then, they have posted a 94% total return, vs. about 75% for the S&P 500. Both financials and the "500" are currently trading at about the same level they frequented in mid-2008, but obviously it has been a wilder ride for financials.
This type of volatility scared many investors away from financial stocks and at least partially accounts for the sector's dismally low valuation: 9.5 times estimated 2011 earnings, the lowest of the S&P 500's 10 sectors, according to estimates by S&P Capital IQ.
However, for those who are beginning to sense theU.S.economy is gaining strength, financials may be worth some investigation. With important economic indicators like consumer confidence, durable goods orders, industrial production, new home sales and now even employment showing signs of steady improvement, financials stand to benefit greatly, in our view, if the economy begins a more rapid expansion.
The Basel III Effect
While financials have always been cyclical, they are even more so now due to the Basel III regulations coming into effect in coming years, which could force some of the largest financial institutions to raise their capital holdings by a significant amount. This would be difficult to do even under advantageous conditions, and any slowdown in the economy would make these new requirements extremely hard to meet without selling new equity. On the other hand, a stronger economy would make the task comparatively easier.
"With Basel III coming up quickly, banks have little or no leeway in terms of economic growth and capital levels, thus their wild swings in response to good and bad economic news," says Eric Oja, an S&P Capital IQ equity analyst.
On the first trading day of 2012, S&P Capital IQ's Investment Policy Committee raised its recommendation for the financials sector to marketweight from underweight, in part due to its
belief that recent steps by the European Central Bank to infuse fresh capital into European banks have reduced the odds of a near-term credit crunch emanating fromEurope. (S&P Capital IQ had an underweight recommendation on financials since May 17, 2011.) In particular, S&P Capital IQ analysts have a positive fundamental view of the consumer finance as well as the investment banking and brokerage subsectors.
