Weekly Market Update (June 26 – 30, 2017)

July 4, 2017

Stocks were mixed on the week as the TSX and S&P 500 was marginally lower, the Dow was unchanged, and the NASDAQ fell by 2.0% as continuing volatility in the technology sector weighed on investor sentiment. Additionally, investors closely examined U.S. banks’ individual results of the U.S. Federal Reserve’s annual stress test, which showed that all 34 U.S. banks that were tested maintained capital ratios above the Federal Reserve’s minimum required level. This result helped the financial services sector move higher for the week. Looking ahead to next week, market moves will likely be muted until the U.S. Federal Reserve releases its June meeting minutes, which will provide more details about its plans to reduce the size of its balance sheet. The other driver for next week will likely be the June jobs report that will be released Friday morning. While the details for both of these events could add to market volatility, you should focus on the bigger picture by ensuring your portfolio’s mix of stocks, bonds and international investments aligns with your comfort with risk and your long-term financial goals.

Banks Pass Fed Stress Test with Flying Colors

Ten years ago, the world was beginning to see early signs of what turned into one of the largest financial crises in history. After the fallout, U.S. financial institutions spent the next eight years rebuilding their capital positions. Capital serves as a cushion against future losses and ensures that the banks’ maintain sound financial positions when economic conditions worsen. Looking at common equity as a measure of capital, the largest U.S. banks have doubled their capital levels from a decade ago. It is our view that the U.S. financial system is on much healthier footing today versus 10 years ago.

Banks Can Withstand a Harsh Economic Downturn

Last week the Federal Reserve announced the results of their sixth annual stress test for U.S. banks, whereby their financial positions were tested in adverse economic scenarios. All 34 U.S. banks that were tested maintained capital ratios above the Federal Reserve’s minimum required level. Additionally, all were given the green light to increase dividends, buy back stock, or both. 

Moving Out of the Rebuilding Phase and Into Capital Return

 
Unlike previous years, after this year’s test many of the companies are now paying out the majority of next year’s expected profits through dividends and share buybacks. In fact, on average, the U.S. banks that we follow are returning 99% of expected earnings to shareholders versus 79% last year. We believe these companies are at the end of their capital-rebuilding journey and therefore have the ability to continue increasing dividends and buying back stock.

 
As US Banks Recovered, Valuations Relative to Canadian Banks Have Improved 

Certainly, the negative impact of the financial crisis was significantly less severe for the Canadian banks than for those within the United States. Indeed, several Canadian banks picked up high-quality assets in the years following the crisis, as both U.S. and European banks were struggling to restore financial strength. While the U.S. banks struggled and stock prices remained depressed, valuations for Canadian banks were resilient. 

This premium persisted for several years but has all but disappeared today. As asset quality and financial strength within the US banking sector improved, so, too, did valuations for US banks. Meanwhile, valuations for Canadian banks have been pressured by declining profitability, slower growth and credit quality concerns related to commercial oil & gas and consumer loan portfolios. Going forward, we believe that investors in North American banks will be simply be looking for the banks that can deliver the strongest and most consistent loan growth and credit performance, as well as the most effective operating expense and capital management. 

Consider Opportunities to Rebalance and Diversify 

Within equity portfolios, we recommend an allocation of no more than 20% to stocks of companies within the financial services sector. If exposure to the financial services sector is much higher than that, it could be time to consider rebalancing. By rebalancing or diversifying by subsector, investors can potentially improve returns while reducing risk.

The Stock & Bond Market

INDEX CLOSE WEEK YTD
TSX 15,182 -0.9% -0.7%
S&P 500 Index 2,423 -0.6% 8.2%
MSCI EAFE* 1,883 -0.2% 11.8%
10-yr GoC Yield 1.77% 0.30% 0.05%
Oil ($/bbl) $46.24 7.5% -13.9%
Canadian US $0.77 2.3% 3.6%

 

The Week Ahead

Next week, manufacturing PMI data will be released on Tuesday and June’s jobs report will come Friday morning.

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