Morgan Stanley
  • Wealth Management
  • Dec 21, 2020

5 Reasons to Consider Investing in Financials in 2021

The sector is benefiting from trends that we expect to continue, including a steeper yield curve, attractive valuations and improving consumer and corporate balance sheets.

Lisa Shalett Chief Investment Officer, Wealth Management

Every market cycle has its laggards, and for the cycle that began with the Great Financial Crisis and ended with the COVID-19 pandemic, it’s not surprising the financial sector is among them. The S&P 500 Financials Index appreciated at a 9% annual rate over that time compared to a 14% average for the broad S&P 500 Index. 

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Now, suddenly, financials are outperforming. Since positive news on vaccines started in mid-November, financials are up 14%, easily outpacing the broader market. Despite the rebound, we still consider them attractively priced. Relative valuations as measured by price/book value are at a 25-year low. In addition, consider these four reasons why we expect financials to outperform in the coming years:

  • We may see significant upside earnings revisions in 2021. Banks accumulated reserves due to the pandemic, anticipating a wave of loan losses and bankruptcies. Thanks to unprecedented fiscal and monetary stimulus, most of the credit losses never materialized and the reserves are likely to be released next year, directly boosting profits. Currently, not only are consumer credit card charge-offs near a 20-year low, but consumer loan delinquencies, including mortgages and auto loans, are also at record lows. On the commercial side, bankruptcies are actually down and corporate cash balances are up. Companies that need new financing will find the cost of capital near all-time lows and capital markets wide open.
  • The yield curve is steepening, a plus for bank profits. Currently, long-term rates are inching higher, while short-term rates remain anchored by dovish Fed policy, a condition known as a steepening yield curve. Already the yield curve is near the steepest levels in three years and we expect that trend to continue. That should boost net interest income at banks as they earn more interest on the money they lend while having to pay less interest on deposits.
  • Economic growth should boost revenues for financial services firms. Equity markets are strong, loan growth should be solid, IPOs are booming and we expect the strong deal and M&A volume to continue. That all translates into higher fee volume for investment banks. Regulators are already starting to ease up on banks, allowing the resumption of share buyback programs and that trend may expand to include allowing dividend hikes next year. Both tend to lift stock prices.
  • Increased productivity is coming. Digital and consumer behavioral changes that were accelerated by the pandemic have led to increased adoption of online business models, cashless services and branchless banking, which should all play a part in lowering costs. Automation and economies of scale may lead to another round of industry consolidation that benefits the largest players as well as the small fintech innovators they ultimately acquire. 

Some investors may see recent gains in the financial sector as nothing more than the traditional pro-cyclical rotation that comes at the end of a recession as growth starts to improve. We see long-lasting forces at work. We recommend investors watch for positive earnings revisions in financials to continue as the era of financial sector underperformance likely comes to an end.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Dec 21, 2020, “2021 Best Ideas: Financials.” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.

Risk Considerations

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. 

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.  Technology stocks may be especially volatile.

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.

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