Enis’s Macro Wrap – Financials Weakness

by Enis November 28, 2012 7:56 am • Commentary

Dan mentioned several times in October, both on the site and on CNBC, that the financial sector could be in for a rude awakening after the elections if the status quo remained in tact.  Financials were the worst performing sector yesterday, down almost 1% on a relatively quiet day.  It is now the worst performer of the major sectors since the elections, and it looks like their downtrend is just getting started.

Here is the 3 year chart of SPY (black) vs. XLF (orange):



Financials underperformed the market from mid-2010 to mid-2011, and then outperformed on the rally off the fall 2011 lows.  The underperformance in 2010 and 2011 was a result of several factors:

  1. Increased credit market risks emanating from Europe, creating fears of counterparty risk for large U.S. banks
  2. Increased regulation and intervention in investment banking (Dodd-Frank Act), retail banking (Durbin Amendment for debit cards), and the housing market (Rep and Warranty lawsuits)
  3. Low rate regime hurting net interest margins, particularly at regional banks where non-interest income levers were fewer

Point 1 was more of a systemic concern, while points 2 and 3 were direct hits to the bottom line.  The main reason for the outperformance in U.S. financials since fall 2011 has been twofold.  First, point 1 above has been taken off the table, primarily due to intervention by the ECB.  One look at CDS spreads for U.S. banks indicates that investors are much less worried about systemic fears threatening U.S. banks today.  Second, the housing market recovery has been a boon to mortgage banking income.  That remains the one bright spot.

So the balance sheets seem more secure.  But the income statement is the new cause of worry, and rightfully so.  How will the banks grow income?  Low rates are a permanent fixture, meaning interest income from large rate spreads won’t be coming back anytime soon.  Capital markets activity remains anemic, hurting the investment banks.  And that increased regulation?  Most of the rules already written by lawmakers will be implemented by regulators in the next 2 years.  I think much of the juice from the housing recovery has been squeezed, and the foreclosure moratorium over the last couple years has kept banks from writing down losses on bad loans.

All in all, not a pretty picture for financials.  Dan’s recently traded both AXP and BAC on the short side.  I anticipate many more trades from us targeting future financials weakness in the next 6 months.

Markets overnight:

  • Asia was in the red essentially the whole session, with the Shanghai and Japan both down 1%
  • Europe has traded red since the open as well, with financials the worst-performing sector there.  Euro Stoxx 50 down 0.5%, and SPX futures indicated down 0.25%
  • The dollar and Treasury bonds are stronger (Treasury strength in the past week is particularly notable, one reason I turned bearish), and commodities weaker
  • New Home Sales data out at 10:00 am