Morgan Stanley U.S. equity strategist Michael Wilson has uncovered a market anomaly that, he argues, “makes banks and financials one of the best risk/reward [trades] left in an equity market that looks fairly picked over.”
Mr. Wilson notes that U.S. utility and bank stocks – both underperforming the S&P 500 – are priced for different interest rate environments, and one of them has to be wrong.
In the case of utilities, their poor recent performance reflects fears of rising longer-term interest rates. Utility firms are capital intensive (that’s analyst-speak for high debt) and profits suffer when borrowing costs rise while revenue grows slowly.
But if all investors were worried about higher rates and bond yields, bank stocks would be outperforming the benchmark, not drastically underperforming.
Bank profits on loans result from the difference between the short-term rates at which they borrow money, and the long-term interest rates they charge clients on loans. Rising longer-term rates mean higher profits for lenders, and also reflect expectations for a higher growth environment when demand for loans is increasing.
The good news for bank investors is that Morgan Stanley analysts believe higher longer-term interest rates are imminent. They contend that the post-March rally reflects a new bull market and conventional economic recovery from recession conditions.
Mr. Wilson is not surprised by utilities underperforming – they historically lag during the early stages of a market cycle. Bank stocks, however, which generally perform well during the early stages of a market recovery, should be among the leading sectors, he says in a research note.
While Mr. Wilson was discussing the U.S. market, his bull case can also apply to Canadian bank stocks.
Domestically, utilities stocks have been underperforming the index for the past three months, reflecting U.S. market trends. Canadian bank stocks had been lagging for most of 2020, but are now matching S&P/TSX Composite returns after a recent rally after stronger than expected second quarter earnings.
Canadian interest rates and bond yields tend to track their U.S. counterparts. In the event longer-term rates rise as Mr. Wilson predicts, all North American bank stocks should perform well. If Morgan Stanley is wrong, however, and this is not the start of a new bull market, utilities stocks will remain the stronger bet.
-- Scott Barlow, Globe and Mail market strategist
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