It’s been my belief (and many others) that much of the stock markets year to date gains has been a direct result of investor optimism for tax cuts, deregulation, and fiscal stimulus. Deregulation has been coming in the form of executive orders. But tax policy and stimulus require legislative success. The first attempt to get this agenda rolling was to repeal and replace Obamacare which would reduce the government’s burden on subsidies for mandatory health insurance, while also lowering the burden for those who can afford private health care coverage. In effect, the repeal attempt was for a very large tax cut. This was targeted first for a couple of reasons, including trying to win over the Freedom Caucus for what was to come but also because of real tax reform, health care repeal and stimulus needs to be done in a deficit-neutral fashion in reconciliation. The house speaker knew without any support from Democrats, the Republicans would need to fund the other policies. The AHCA was a large part of the funding. But with repeal and replace in tatters, and major fissures showing in the Republican congressional coalition on these matters, it is unlikely that the existing team in the West Wing and Congress will be able to come to any major agreements any time soon on legislation to validate our stock market’s gains since the election.
I want to look at Bank stocks today, and consider where they have come from, why they have outperformed the broad market since the election, and why they have underperformed year to date.
First things first, interest rates. With the surprise result of the election, investors immediately started to price in higher growth, and thus interest rates rose quickly and the thought of a steeper yield curve meant greater profits by way of higher net interest margins on deposits. Higher expected growth, coupled with lower corporate taxes and repatriation would also cause companies to higher more and spend more on capex and r&d, also pretty stimulative. All good for banks which should see a dramatic increase in activity. And then there is deregulation, which many argue have strangled bank’s profits since the financial crisis and a rollback of some of the most cumbersome would open the door to activities that would sharply increase profitability. The timing of most or all of this agenda seems to be pushed back a bit, but it appears that the White House economic adviser Gary Cohn might be considering a new version of a depression area regulation that was repealed in 1999 that formerly separated banking in lending. Many believe it was the 1999 repeal that led banks to untoward behavior that led to the financial crisis last decade. I suspect many bank execs (aside from those at Cohn’s alma mater Goldman Sachs) were less than encouraged to hear those rumors as they expected a pro-Wall Street stance from the new administration.
I’ll remind you though that massive banking deregulation might not be a layup anytime soon, especially considering the re-rating in the stocks since Nov 9th and the potential for material changes to politically betray some of the President’s more populist campaign messages. There’s also the new found confidence from the Freedom Caucus to watch, as they seem to have him by the short hairs:
Trump’s financial deregulation might be bad news for banks after all https://t.co/qnaxuIfcYQ via @WSJ pic.twitter.com/4XB3CtaYnO
— Dan Nathan (@RiskReversal) January 9, 2017
Yesterday, Andrew Ross Sorkin wrote a column on his DealBook page titled Wall Street and Washington: A New Love Affair In it he debated the potential impact of deregulation vs legislation, and the “potential sway” a president can have on the economy through deregulation that might not be accompanied by legislation (tax reform and infrastructure):
If you look at the precedent set by Mr. Obama, the answer is “a lot.” His White House announced during his last year in office that it had helped save $28 billion by removing regulations, starting in 2011. And much of it was done with the stroke of a pen.
Wall Street is bullish on the approach.
“Regulatory reform that does not require legislative approval faces a lower hurdle than tax reform and would also provide a boost to S.&P. 500 earnings,” Goldman Sachs recently wrote in a note to its clients.
Reforms, the note said, “will likely come through changes to existing rules as well as the interpretation and application of outstanding regulation.”
The bank, which has seen its own stock rise since the election, suggests that “about $200 billion of excess capital could be deployed in 2018 as a result of changes in regulatory capital requirements.”
Capital requirements are largely governed by the Federal Reserve, meaning they could be adjusted without congressional approval. And the Fed is in transition: Wednesday was the last day in office of Daniel K. Tarullo, a Federal Reserve Board member who crafted some of the strictest banking rules post-crisis and led the annual stress tests that bankers loathe. He was a thorn in the side of many bankers, who complained that he was too difficult.
So there are both sides of the coin. I have no idea whether anything sweeping gets done in banking de-regulation in the near future, but I suspect the administration has bigger fish to fry.
In the next two weeks we will get the bulk of large cap banks within the XLF (the S&P Financial Select etf) components reporting Q1 earnings; Citigroup (C), JP Morgan (JPM) and Wells Fargo on April 13, and Bank Of America (BAC) and Goldman Sachs (GS) on April 18th and Morgan Stanley (MS) on April 19th, those five stocks represent about 35% of the XLF.
For those who have gains in the sector, but fear this year’s underperformance is telling that the good news is in the stocks, and that for them to make new highs they will need at least a combination of legislative reform of some kind of broad deregulation. It might make sense to purchase near term protection in the XLF as Q2 guidance might reflect a tad of uncertainty. So what’s the trade?
XLF (23.60) Buy the April 23.5 puts for .27
Breakeven on April expiration:
Losses up to 27 cents between 23.23 and 23.50 with max loss of 27 cents, or 1.1% above 23.50
Gains: below 23.23
Rationale – this is a fairly tight breakeven heading into about 50% of the weight of the XLF’s component’s earnings, it wouldn’t take much of a move before the put kicked in, any lower movement into the bulk of the earnings and some risk could be laid off by selling a lower strike and turning this into a put spread. But right now the April 22.5 puts are 5c and not worth being short vs the 23.50s.
The one-year chart below shows the importance of $23 support since the breakout in early December:
