This year’s stock market leaders and laggards have pretty much performed along with their fundamentals. So what is the data telling us about the rest of 2017?

As U.S. economic surprises slowed in the first half of the year, growth stocks—led by tech and health care—rebounded sharply from their post-election sell-off, offering the potential for growth. In this same period, economies in Europe and the emerging markets strengthened, boosting global cyclicals. Lagging have been energy, which suffered an oil glut, and retail stores, which lost ground to ecommerce. The weaker dollar has helped global staples and consumer products, and lower interest rates bolstered utilities.

So where do we see opportunities? For the second half of the year, we see potential in the lagging financial sector, where valuations—particularly of banks—are compelling as investors have yet to grasp the improving fundamentals.

                                                                                                                            sp500.png

 

Slower Lending and Flatter Curve

Of course, there are reasons for financials’ muted year-to-date returns. Notably, commercial and industry loan growth has slowed to 3%. Also, the yield curve has flattened on slower economic and inflation data, and the Fed has continued to raise the federal funds rate.

However, many larger banks profit from rising short rates, and Betsy Graseck, Morgan Stanley & Co.’s large-cap bank analyst, sees loan growth improving on the back of tax reform, fiscal stimulus and regulatory easing.

Capex Boost

A lending revival could occur in the second half as policy clarity improves and business investment and capital spending head higher. Similarly, MS & Co. Chief U.S. Equity Strategist Mike Wilson argues that GDP growth is likely to accelerate as inventory building and personal consumption combines with continued strong business spending. The Alphawise Indicator of Realtime Activity (ARIA), MS & Co.’s proprietary index, supports this view, jumping 1.8% in May—the largest move in the index’s history. Rising corporate and consumer investment would most likely coincide with a better lending environment.

Furthermore, rebounding growth and rising equity markets may spur more initial public offerings and mergers, which also could benefit the large investment banks.

Rising Dividends and Buybacks

We see not just more lending but rising dividends and buybacks supporting the total-return outlook for many financial stocks. Following nearly a decade-long effort to repair balance sheets and adhere to tighter regulatory requirements, the capitalization of big banks and various other financial companies is greatly improved.

Regulatory pressure should subside, in our view, making capital return a key catalyst for higher stock prices amid a continued low interest rate environment and aging global demographics. Following last month’s bank stress test, dividend increases were better than expected.

Reflation Redux

To the extent financial stocks are viewed as a play on rising inflation, we see some upside here as well. Lisa Shalett, head of Wealth Management Investment Resources, now favors U.S. banks, as rising capital spending and global trade can drive rates higher concurrent with a synchronous global recovery.

Indeed, the past month’s rebound in financial stocks may be signaling a divergence between equity market expectations and bond market skepticism around higher rates from the Fed. Consistent with that view, MS & Co. Interest Rates Strategist Matt Hornbach sees 2.50% as a year-end target for the 10-year US Treasury, which could help support sentiment on bank stocks.

Top Ideas

Across the various parts of the financial sector, we prefer large-cap banks because of rising dividends, faster loan growth and stronger capital market activity. We also favor select asset managers—particularly alternative leaders and multiasset managers who are gaining outsized flows and may benefit from consolidation.

Finally, we see select opportunities in property and casualty insurance, especially idiosyncratic turnaround and merger situations.