S&P 500: Financial sector to be a particularly good opportunity – Morgan Stanley

Both banks and US consumers have a much stronger financial foundation than they did prior to the 2008 crisis but many investors may remain skeptical that the sector can outperform coming out of the current recession. Lisa Shalett from Morgan Stanley explains three main reasons to add financials to the portfolio.

Key quotes

“Second-quarter earnings for financials have largely beaten expectations: Recently reported financial results included some meaningful upside surprises, with banks reporting credit charge-offs that were better than thought, reserve ratios in good shape and, on average, solid balance sheet health. Unlike previous recessions where capital market activities have slowed, Federal Reserve policy moves seem to have boosted transactions.” 

“Valuations seem attractive: As a result of underperforming the S&P 500 since the 2008 crisis, the financial sector now appears sharply undervalued. For the past 20 years, the financial sector has had a price-to-earnings ratio just below the S&P 500. Now the sector trades at nearly half the P/E of the index.”

“Rising interest rates could lift profitability: Financials have tended to earn more money when long-term rates are higher than short-term rates, since they can borrow at low rates and lend at higher rates, allowing for higher net interest margins. The yield curve is nearly flat now, but already, inflation expectations are moving higher, which should eventually lead to rising long-term rates. Interest rates may need to lead the way before financials outperform other sectors, but our confidence is growing that rising rates are coming.”