State Street: Bank Stocks Can Run Higher In 2018

Financial services stocks and the related exchange traded funds tumbled last week. The Financial Select Sector SPDR XLF, the largest ETF devoted to the sector, and the bank-specific SPDR S&P Bank ETF KBE fell 2.7 percent and 1.1 percent, respectively.

Still, those two ETFs and rival financial services funds are sporting solid year-to-date gains, indicating investors should not be hasty in departing the S&P 500's second-largest sector weight. Some market observers believe bank stocks can continue climbing in 2018. Of course, some of the bank bull thesis is tied to expectations that the Federal Reserve will continue raising interest rates this year.

“Despite a flattening yield curve in 2017, banks’ net interest margins continue to expand — a positive sign for banks’ corporate profits,” State Street said in a recent note. “Part of the reason is that banks’ interest expense — interest rates on deposits — remains near zero, even though short-term rates moved higher. On the other hand, the interest rates that banks earn on their commercial and personal loans have increased along with Fed fund rates, boosting banks’ interest income.” 

Benefiting From Lower Taxes

A plethora of industries and sectors have been highlighted as beneficiaries of the Tax Cuts and Jobs Act, including the financial services sector. Data suggest XLF and KBE components will be paying significantly lower taxes in the years ahead.

“In addition, the corporate tax rate deduction included in the 'Tax Cuts and Jobs Act' provides a tailwind for bank earnings,” said State Street. “Banks, on average, currently pay a 30-percent tax rate; the new tax bill will lower the corporate tax rate to 21 percent. A simple calculation indicates this could potentially save US banks 30 percent on taxes and boost earnings by 13 percent.”

Lower taxes are likely to translate to higher earnings, which could give way to increased shareholder rewards, such as dividends and buybacks.

“Since the passage of the tax bill late last year, analysts have revised 2018 earnings growth expectations for banks upward to nearly 29 percent from 12.1 percent at the end of the third quarter,” according to State Street.

Compelling Value

As has been widely documented in recent months, the financial services sector is a legitimate value play, one of the few sectors in the U.S. deserving of the description.

“Despite the aforementioned tailwinds that could drive this sector, bank valuations are still below historical averages relative to the broader market,” said State Street.

The S&P Bank Select Industry Index, KBE's underlying index, currently trades at noticeable long-term price-to-earning and price-to-book discounts relative to the S&P 1500 Composite Index.

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Todd Shriber owns shares of XLF.