Financials: Underperform
Financials have lagged the market over the past couple months as investors have reacted to the perceived impact of the increased regulatory attention on the financial sector and continued problems surrounding foreclosures and the housing market. The new regulations limit trading that financial institutions can do for themselves, which has been a major profit driver for some companies. And new capital requirements restrict the amount of money banks can lend, limiting profit potential for many of them. This continues a trend of governments around the world imposing new taxes, fees and regulations on the financial industry, which we believed would start to weigh down the group.
Additionally, although the mortgage market continues to stabilize, housing remains a risk as foreclosures mount, saddling banks' balance sheets with unwanted assets that will likely have to be marked down. Adding additional consternation was the recent moratorium put in place for future foreclosures due to uncertainty regarding paperwork. Finally, the high-yield spread that has benefitted financial institutions has started to narrow, and it wouldn't be surprising to see it continue to do so in the coming months, further crimping profit potential.
Although we continue to have confidence in the ability of the financial industry to reshape itself and adjust to the changing environment as it has done so many times in the past, we believe it will take some time and that the current headwinds will likely continue for the time being. This leads us to maintain our underperform rating on the sector.
Clients can see our top-rated stocks in the financials sector.
Positive factors for the financials sector:
- More financial institutions are paying back government loans, illustrating their growing health and stability.
- Capital market activity has been increasing, which should help boost revenues in the investment banking arena.
- Recent delinquent loan estimates have decreased among credit card companies, indicating improving balance sheets.
- Lending standards have loosened somewhat, which could help loan volume grow.
Negative factors for the financials sector:
- Revolving home equity loans are declining, typically a bad sign for bank profits and stock performance.
- New regulations have severely restricted the ability of lenders to offer "exotic" mortgages, cutting back on the volume of business they can do.
- New credit card rules have gone into effect, which could hurt profitability going forward.
- Confidence in the financials sector, though improved, remains shaky. Concerns about the still-fragile housing market—combined with increased government regulation—continue to hover over the group.
- The yield curve has flattened some lately. If this continues, it will reduce interest margins for financial institutions, potentially hurting profitability.
- Uncertainty as to how massive government intervention will affect the financial industry going forward could hold back performance for the foreseeable future.
- A new round of foreclosure uncertainty could pose problems for the financial sector.
Health care: Outperform
Performance in the health care group has started to improve, and we think it's the start of a trend we've long waited for. The sector's fundamentals appear overwhelmingly positive and we believe our patience will be rewarded. And, at least there's a nice dividend story while we wait.
Certainly, the health-care reform legislation could crimp profitability in the sector, but we still have some time before the more-damaging provisions take effect. In fact, as we get closer to the November midterm elections, it appears ever more likely that the next Congress may adjust at least some of the most damaging elements. Additionally, regardless of what happens in Washington, companies have time to make adjustments. The beating a lot of the group took leading up to passage of the bill has also led to valuations that, to us, remain quite attractive.
Given its growth characteristics combined with defensive qualities, we believe health care is the one sector that may really attract investors in this uncertain economic environment, which lacks the overall clarity some investors might prefer.
Helping our confidence in the group, higher-dividend-yielding sectors seem to be more attractive as investors become increasingly frustrated with the low yields on many fixed-income investments. Further, the large cash balances on health-care balance sheets allow for the possibility of increased dividends, share buybacks and potentially more merger-and-acquisition activity, all of which we believe would be a tailwind.
Clients can see our top-rated stocks in the health-care sector.
Positive factors for the health-care sector:
- The aging population could provide a boon for the industry as an increasing number of Americans require more extensive drug treatments and medical care.
- Americans are increasingly obese, which results in a greater need for medical attention due to the myriad health issues that coincide with obesity.
- The Index of Leading Economic Indicators appears to have peaked and may be rolling over, which historically bodes well for the health-care sector.
- Balance sheets in the health-care sector remain flush with cash, boosting the possibility of higher dividend payments, share-enhancing stock buybacks, and mergers and acquisitions.
Negative factors for the health-care sector:
- Government regulation will likely continue to increase during the coming years as more seniors demand intervention in order to theoretically lower their out-of-pocket health-care costs.
- Nominal (not adjusted for inflation) consumer spending on prescription drugs has been slowing.
- Growth in consumer spending on health insurance has been trending lower recently, potentially putting managed-care shares at risk.
- Medicare reimbursement rates are likely to fall under the Obama administration, which could hurt pharmaceuticals, HMOs and managed-care companies.
- The new health-care law could dampen profitability in some areas of the sector, although there is still uncertainty regarding the full impact of the bill.
- Health-care consumers appear to be putting off some profitable elective procedures in this uncertain economic environment.
