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July 11, 2018

Passing Stress Test and Rising Interest Rates


By Noah Kiedrowski , INO.com

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  • The Federal Reserve increased its short-term interest rate by a quarter of a percentage point and stated that economic growth has been “rising at a solid rate.”
  • The Federal Reserve indicated that two more rate hikes are likely in 2018 followed by three in 2019
  • A consortium of domestic banks passed the Federal Reserve’s stress test that was more rigorous than last year’s criteria
  • The banks are well capitalized and positioned to withstand severe economic conditions under high unemployment, housing depreciation, and credit defaults
  • Banks are in a position to release largess to shareholders via an increase in dividend payouts, share buybacks, and more unobstructed risk appropriate growth
  • Wells Fargo (WFC), Citigroup (C), Bank of America (BAC) and J.P. Morgan Chase (JPM) received approval for their capital return plans while Goldman Sachs (GS) and Morgan Stanley (MS) received conditional approval

Rising Interest Rates


Back in March, the Federal Reserve expected the economy to continue to strengthen and inflation to rise shortly. The economic strength coupled with inflation telegraphed an environment that was ripe for more interest rate increases over the near term. This economic backdrop has gained momentum, and the Federal Reserve recently increased interest rates by a quarter percentage point and indicated that two more increases are highly likely in 2018 for a total of four this year. The consensus from the committee was perceived as very bullish on the domestic front and that the Federal Reserve will continue on its path of rising interest rates along with higher inflation expectations. In March, the committee stated that “tax changes enacted late last year and the recent federal budget agreement, taken together, were expected to provide a significant boost to output over the next few years” and more recently economic growth has been “rising at a solid rate,” unemployment has “declined” and household spending “has picked up.” The committee sees economic growth hitting 2.8 percent for the full year followed by 2.4 percent in 2019. The committee also indicated it continues to expect three more rate hikes in 2019. "The committee expects that further gradual increases in the target range for the federal funds rate will be consistent with the sustained expansion of economic activity, strong labor market conditions and inflation near the committee's symmetric 2 percent objective over the medium term." Provided this backdrop of positive economic commentary, financials such as Goldman Sachs (GS), J.P. Morgan Chase (JPM), Citigroup (C) and Bank of America (BAC) are poised to benefit as a result.

Stress Test Success and Shareholder Returns


All major U.S. banks passed the Federal Reserve’s stress test and are increasing shareholder returns via a combination of increased dividends and share buybacks. The Federal Reserve granted 34 of the largest banks approval to pay dividends and buy back stock after the stress test results passed. Wells Fargo will be buying back $24.5 billion worth of its stock. Citigroup is increasing its dividend payout by 13 cents to 45 cents a share and buying back $17.6 billion worth of its stock. J.P. Morgan is raising its quarterly dividend to 80 cents from 56 cents and buying back up to $20.7 billion worth of stock. Bank of America is increasing its dividend by 25 percent to 15 cents per share and will be buying back up to $20.6 billion worth of stock. Goldman Sachs and Morgan Stanley received conditional approval from the Federal Reserve. Morgan Stanley is increasing its quarterly dividend to 30 cents from 25 cents and will buy back $4.7 billion of stock. Goldman Sachs is raising its dividend by 5 cents to 85 cents per quarter and will buy back $5 billion in shares. Collectively, the financial cohort is unleashing tens of billions in shareholder returns via a combination of increased dividend payouts and share buybacks.

Conclusion


The financial cohort is in a sweet spot with a confluence of tailwinds with rising interest rates, deregulation, increased M&A activity, tax reform stress test results and low unemployment as their backs. The Federal Reserve increased its short-term interest rate by a quarter of a percentage point and indicated that two more rate hikes are likely this year followed by three in 2019. This bodes well for banks with large deposit bases such as Bank of America and Wells Fargo as well as all banks to a lesser extent. Tax reform and deregulation provide a windfall of cash for all banks. J.P. Morgan and Goldman Sachs are the biggest beneficiaries as they can take on more risk-appropriate growth and reduce their effective tax rate which stands in the top 15 Dow Jones stocks at 28 and 27 percent, respectively. Layer in a potential slew of significant M&A activity and IPOs also bode well for the financial cohort. In deregulation and rising revenue environment, the financials will be more empowered to increase share buybacks and dividends as witnessed by the recent largess after the stress test results along with earnings growth over the coming years to align with the economic expansion domestically and abroad. In a frothy market with P/E multiples at historic levels, the financial cohort remains appealing considering the capital return plans over the near term and tailwinds domestically and abroad. 
Courtesy of Noah Kiedrowski via  INO.com

Disclosure: The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of stockoptionsdad.com a venue created to share investing ideas and strategies with an emphasis on options trading
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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