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Banking Stocks Could Be Set For Another Bumper Year

Banking Stocks Could Be Set For Another Bumper Year

After a successful run in 2021, banking and financial stocks and exchange traded funds are finding themselves in a strong position as 2022 kicks off. 

The sector’s early gains can be chalked up to the fact that U.S. 10 Year Treasury yields have taken off to 1.78%, up 28 basis points this year.

Three banking ETFs that appear supercharged by rising yields are the Invesco KBW Bank ETF (NASDAQ:KBWB),  First Trust Nasdaq Bank ETF (NASDAQ:FTXO), and the SPDR S&P Bank ETF (NYSEARCA:KBE), with the three funds boasting gains of 8.4%, 9.0% and 7.5%, respectively, after the first trading week of the new year.

The financial sector of the economy is one of several segments of the market that tend to benefit from a steepening yield curve, mainly because banks perform better in a situation where longer-term rates are higher than shorter-term rates. This setup allows banking and lending institutions to generate a higher spread on lending loans, which makes up a big part of their revenue base.

Indeed, David Lefkowitz, CIO Americas at UBS Wealth Management, has tapped the financial sector as the third-ranked cyclical sector expected to outperform, "earnings should recover as economic growth rebounds and interest rates move gradually higher."

UBS has Consumer Discretionary (NYSEARCA:XLY) as its top pick because "the sector should benefit from economic recovery, lower mortgage rates, and secular trends in e-commerce,"

while Energy (NYSEARCA:XLE) takes second place because "relative to oil prices, the sector looks cheap. Free cash flow yields are very attractive, capital discipline has improved, and the sector should benefit as demand recovers.

UBS is neutral on Info Tech (NYSEARCA:XLK), Communication Services (NYSEARCA:XLC), Industrials (NYSEARCA:XLI), Materials (NYSEARCA:XLB) and Real Estate (NYSEARCA:XLRE).

Meanwhile, the Wall Street bank is bearish on Consumer Staples (NYSEARCA:XLP) saying "the sector initially benefited from 'panic' buying, but it could underperform as economies reopen."

The bank also rates Utilities (NYSEARCA:XLU) negatively because "the sector will likely lag as investors look toward more cyclical opportunities in the market."

Meanwhile, Barclays has tapped Bank of America (NYSE:BAC)  and Wells Fargo (NYSE:WFC) as its top picks among money center banks.

Barclays has upgraded the latter to Overweight from Equal Weight with a $62 price target, saying bank stocks are likely to continue outperforming the market in 2022 as net interest margin improves off historic lows.

The Barclays team, led by Jason Goldberg, say BofA and Wells Fargo are two of the most asset-sensitive names in the group and the least exposed to the capital markets. The analyst also expects Wells will benefit from "substantial progress on its regulatory issues, expense saving opportunities, and above-average excess capital."

Barclays has also upgraded super regional banks  PNC Financial (NYSE:PNC) to Overweight from Equal Weight with a $250 target and Regions Financial (NYSE:RF) to Equal Weight from Underweight with a $26 

Meanwhile, Barclays has downgraded U.S. Bancorp (NYSE:USB) to Equal Weight from Overweight with a $68 PT and also lowered Huntington Bancshares (NASDAQ:HBAN) to Underweight from Equal Weight with a $17 PT.

New Business Model

You can always trust wily Wall Street banks to unleash new revenue streams when the chips are down.

With interest rates stuck at historical lows, American banks have discovered a new business model: instead of lending money to people who don’t have money and need some, they are now lending more money to people who already have lots of it but don’t want to liquidate their assets.

Wealthy Americans are now funding their lavish lifestyles while minimizing their tax bills by taking out low-interest loans backed by their investments at record rates thanks to ultra-low interest rates and bullish stock markets.

Wall Street banks are saying that their wealthy clients are borrowing loans backed by their stocks and bonds portfolios more than ever before. Morgan Stanley has revealed that its wealth-management clients have accrued $68.1 billion worth of securities-based and other non-mortgage loans, more than double the figure five years ago. The situation is not any different at Bank of America where $62.4 billion in securities-based loans dwarf its book of home-equity lines of credit.

Even the merely rich are borrowing heavily against their portfolios: Advisers at big firms such as Merrill Lynch (now a part of Bank of America) have dozens of two securities-based loans outstanding in their book of business compared to just one of these loans two decades ago.

Banks typically don’t mind the low interest rates because they continue to earn management fees on assets that clients might otherwise sell. Indeed, top investment banks are willing to lend a borrower at least 50% of a diversified portfolio’s value, though in the past they advised clients to avoid tapping more than 25% of their portfolio value to minimize risk if markets tanked.

Low interest loans

It’s easy to see why the wealthy are increasingly turning to bank loans to fund their lifestyles even when they really don’t need the extra money. In a low-interest environment, many assets have been appreciating much faster than the interest rates on loans, meaning it makes plenty of economic sense to borrow and use the money to purchase higher-yielding assets. 

They also have some legal loopholes making life easier for them: Under current law, investors and their heirs only pay income taxes when their shares are sold. Although the assets may be subject to estate taxes, heirs only pay capital-gains taxes only on gains after the death of the prior owner.  In essence, the more they can borrow, the longer they can hold appreciating assets and the longer they hold, the bigger the tax savings.

These loans also have another major benefit: They allow borrowers in need of cash to avoid selling in a hot market. This way, startup founders are able to monetize their stakes without losing control of their companies.

Securities-based loans also face less red tape than mortgage or auto loans; paperwork is light and the debt often doesn’t show up on credit reports. In fact, many borrowers exercise the option to indefinitely accrue interest without making monthly payments:

Ordinary people don’t think about debt the way billionaires think about debt. Once you’re already rich, it’s simple, it’s easy. It’s just buy, borrow, die. These are planks of the law that have been in place for 100 years,”Edward McCaffery, a University of Southern California law professor has told the WSJ

McCaffrey is famous for coining the buy-borrow-die mantra. 

Giant Escape Hatch

The Biden administration and congressional Democrats are looking to seal those loopholes saying the richest Americans are using them as a giant escape hatch from the income-tax system.

They have unveiled a tax plan that would raise top capital-gains tax rates to 43.4% from 23.8% and also make unrealized gains subject to capital-gains taxes at death after a $1 million per-person exemption. This would make borrowing less attractive but would still leave many of the benefits of deferring taxes by taking loans against wealth intact. But chances of the laws passing in a  closely divided Congress, where Republicans are dead-set against any tax increases, remain slim.

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