Evolving Sector Leadership in Equity Markets

New Leadership Pushing Markets to All-Time Highs

The technology sector accounted for 36% of S&P 500 gains in the first quarter. In the second quarter, this number rose to 88%. In the third quarter, technology accounted for less than 3% of the index’s return. Financials took over, accounting for 23% of the return in Q3, closely followed by industrials and health care. Market breadth widened in the third quarter and remained in October; financials is the leading sector and has gained 4% this month.

Chart 1: Financials is the Leading Sector in the Fourth Quarter^[1]

What is Driving Financials?

JP Morgan (JPM) and Wells Fargo (WFC) kicked off the third quarter earnings season on October 11. JPM reporting beats across the board on better-than-expected net interest income (NII), investment banking fees, advisory revenues, and capital markets. WFC slightly missed NII estimates, but its management team believes they are nearing the trough in NII. We believe the return of NII will be a 2025 story and dependent on the Fed’s easing cycle, inflation, and growth expectations – all which should improve next year.

Morgan Stanley (MS), Citi (C), and Goldman Sachs (GS) followed up with strong quarters as well. We witnessed two major themes emerge across the five earnings reports and calls: investment banking strength and NII bottoming.

It is visible through the data that investment banking strength is returning across the group. Most notably, David Solomon (CEO of GS) mentioned that while investment banking revenues have improved, M&A and equity volumes are still not operating at their respective 10-year average levels. “M&A volumes year-to-date are 13% below 10-year averages… there is no reason why we are not going to get back to 10-year averages, and that is a tailwind.”^[2] Across MS, C, JPM, and GS, investment banking fees grew 56%, 44%, 32%, and 20% y/y respectively in the third quarter. Investment banking revenues and fees have been elevated even while initial public offering (IPO) activity has been muted. IPO proceeds through the first three quarters of 2024 exceed 2023 numbers but are still well behind 2020 and 2021.

Chart 2: IPO Activity was Elevated in Q3, But Still Well Behind 2020-2021^[3]

NII is one of the main revenue streams for large financial institutions. It is the difference between the interest earned on a company’s assets and the interest paid on its liabilities. Regarding banks, it is the difference between interest and dividends from loans and securities and interest paid on deposits and other liabilities. Breaking down the largest banks, here is how they rank in terms of NII over the past number of quarters, common-sized for comparison^[4]:

NII as a percentage of interest income has declined anywhere from 39% for TFC to as high as 81% for MS. Banks had near zero percent interest rates in 2021 before the rate-hiking cycle began, with an average 2s10s spread of +117 bps in 2021, it was a great environment for banks to borrow at the short-end and lend at the long-end. As front-end rates rose above 5%, margins became compressed for banks and NII was not nearly as supportive of earnings. Heading into a new rate-easing cycle, lower front-end rates should support NII; companies such as TFC and BAC who receive ~70% and ~55% of revenues from NII are likely to benefit.

Financials Awaiting Two Big Catalysts

The financial sector is anticipating a steeper yield curve. Lower front-end rates and higher long-end rates greatly support NII. The 2s/10s yield curve was -50 bps on June 25 and is near +13 bps today following the Fed’s 50 bp cut in September. We believe NII is a 2025 story – markets are expecting the Fed to lower interest rates by more than 125 bps by next fall. A steeper yield curve and better borrowing environment will support financial institutions.

Secondly, banks are awaiting further clarification regarding Basel III endgame. Basel III endgame is the final ruleset of Basel III; a framework developed in 2007-2008 regarding the amount of capital banks must hold against various types of risk. The proposal, released last summer, would raise capital by 16% overall and change risk gauges for bank lending, trading activities and internal operations. Banks with over $100 million in assets would have to account for unrealized gains and losses on available-for-sale securities and follow stricter leverage requirement.^[5]

Many large financial institutions pushed back on the proposal, and a re-proposal was released on September 10, 2024. Bank capital requirements were lowered to an increase of 9% from the 16% average – and as high as 19% at some of the larger banks. Other possible regulations were also loosened, and Fed Vice Chair Michael Barr did not provide an exact timeline on the implementation of the regulation.^[6] A lower capital requirement will support continued stock buyback and lending activities without significant disruption. Brian Moynihan, CEO of BAC, said that a 10% increase in the capital requirement could potentially restrict the ability to make $160 billion in loans, greatly impacting the bank’s ability to loan to small businesses and middle-market companies.

Continued Growth Ahead

We see a positive forward-looking landscape for the financial sector. Lower interest rates and a steeper yield curve will improve lending and borrowing and assist the low-end consumer. Financials also appear to be trending higher on the improving odds of a Trump victory; lower taxation and regulation should improve the M&A and IPO market, and thus financials. To note, we believe fundamentals are strong enough to support a move higher in financials, regardless of if the sector is considered a “Trump trade” or not. Election outcome aside, financials will continue to perform well and will be beneficiaries of strong economic growth, something we see expect with a lower rate environment and accommodative Fed.