2018 outlook: financials

Regulatory relief may boost bank earnings.

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Driving gains through less regulation

In the wake of the 2007–2008 global financial crisis, US legislators passed many new rules for financial institutions. A decade later, we may be headed in the opposite direction, with regulatory rollbacks that could have a positive impact on the sector—and on big banks, in particular. Investors have largely overlooked this potential shift due to skepticism over President Trump's ability to advance his pro-growth agenda. But it may be time to take another look.

The most comprehensive recent legislation to govern the sector was the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act for bank oversight. It imposed an annual stress test to determine if banks have adequate capital to withstand severe financial or economic stress, and restricted banks from trading for their own accounts.

While helping to stabilize the financial system, Dodd–Frank has also significantly increased the costs of compliance and regulatory reporting and has pushed banks to hold much higher levels of capital (see chart). The capital build, in turn, has hurt returns on equity—a big driver of valuations. In addition, the legislation has caused investment banks to shy away from risk, inhibiting trading activity and market liquidity.

Avenues for relief

Moving forward, newly appointed pro-growth, pro-business regulators seem likely to take a lighter touch in interpreting these rules, essentially loosening the constraints on banks. Consider the stress test: The law only mandates that the test takes place annually; it doesn't spell out the particulars. To date, the stress test has included quantitative and qualitative components, and the opaque nature of the qualitative portion has caused banks to err toward conservative capital-allocation policies. New regulators could make the qualitative test more transparent or less stringent, or even drop it entirely. Any of these scenarios would give the banks more latitude to put their capital to the best possible use, potentially leading to better returns for investors.

The potential upside

Although no one knows exactly how the regulatory landscape will unfold in 2018, rollbacks seem likely. Estimates are that big banks with more than $50 billion in assets—which have seen a disproportionate share of the incremental regulations—could be among the biggest beneficiaries, with an estimated 5% to 15% boost in earnings. Regional banks, which have tried not to exceed the onerous $50 billion threshold, could become more interested in mergers and acquisitions (M&A), and investment banks could benefit from increased trading activity. Within the sector, stocks with valuations that are not factoring in the potential benefits of regulatory relief could provide some of the strongest opportunities for future appreciation.

Next steps to consider

Research the Fidelity® Select Financial Services Portfolio (FIDSX).

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Go back to the full 2018 sector outlook.

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Christopher Lee is a portfolio manager and research analyst for Fidelity Investments. He currently manages several financials sector portfolios and subportfolios. Mr. Lee is responsible for covering global investment bank and universal bank stocks within the financials sector. He joined Fidelity in 2004.
Sector specialist Michael Griffith, CFA, also contributed to this report.
Views expressed are as of December 1, 2017, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the author and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.
References to specific investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk. This piece may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.
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Because of its narrow focus, sector investing tends to be more volatile than investments that diversify across many sectors and companies. Sector investing is also subject to the additional risks associated with its particular industry.
The financials industries are subject to extensive government regulation, can be subject to relatively rapid change due to increasingly blurred distinctions between service segments, and can be significantly affected by availability and cost of capital funds, changes in interest rates, the rate of corporate and consumer debt defaults, and price competition.
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