Bank stocks are up by double digits since the world learned that Donald Trump won the presidential election two weeks ago. What explains this remarkable rise?
In this episode of Industry Focus: Financials, The Motley Fool's John Maxfield and Gaby Lapera discuss the three main things that played into the steep rally in bank stocks in the wake of Trump's victory in the presidential election.
A full transcript follows the video.
This podcast was recorded on Nov. 21, 2016.
Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You are listening to the Financials edition, taped today on Monday, Nov. 21, 2016. My name is Gaby Lapera, and joining me over the phone is John Maxfield, one of The Motley Fool's top financial correspondents. Hey, Maxfield! How's it going?
John Maxfield: It's going great, Gaby. It's good to finally reconnect. It's been a month and a half or two months since we've been on the show together.
Lapera: That's true. I'm also super happy to be back. In case you're wondering why, listeners, you can listen to the episode from two weeks ago. Today's show is about Donald Trump and banks. Having said that, I want you guys to know that this show is not about politics. The Motley Fool does not have an official stance and we never will, so please don't email me angrily. Having said that, we do feel like we should report on how potential policy changes could affect the stock market in general, and for this show, the banking sector in particular. I don't know if you've noticed, but after the election, the KBW Banking Index, which tracks how banks are doing at large, is up about 14% since Nov. 8, which is a lot for banks. In general, there's a reason for this, and it's because in general, people think that the Trump administration is going to be very positive for banks. Right, Maxfield?
Maxfield: Yeah, that's exactly right. Here's what's interesting: Going into the election, a lot of people were thinking that if Trump were elected, that stocks were going to fall precipitously. But actually, the opposite happened, which creates this interesting irony. Here, you have a Republican -- and we'll get into all these different reasons, but one of the reasons that stocks went up so much, bank stocks in particular, is because here you have a Republican coming out and being really pro-growth economically, but not in terms of just reducing regulations, but in terms of massive fiscal expenditures. Just, when you're looking at the market overall and why it's gone in that direction, that's one of the reasons.
Lapera: Yeah. Part of the reason that stocks dropped during the election and right before is because there's so much volatility, they didn't know who was going to be president, and it seemed unclear what would happen if either one would become president. Let's talk about what the Trump administration has said. I will say, sometimes the Trump administration has said different things on the same topic, so we will do our best to cover that. We'll try our best, OK? Everyone knows that campaign promises and what actually happens sometimes don't 100% line up. Again, we're covering what they said during the campaign, what's coming out now. Having said that, we also know that we don't really 100% know what's going to happen when Trump becomes president. It's always a roll of the dice. Especially living in D.C., you know that Congress sometimes pushes things through and sometimes says, "Ha-ha, no, thank you." You never really know what's going to actually happen, despite whatever campaign promises were given.
Maxfield: That's exactly right. To dig in to banks in particular, this is the financials podcast, I'm a banking guy; you're an editor of our financial bureau. One of the biggest questions is, what are the exact reasons that have caused investors to bid up bank stocks so far since Donald Trump was elected? We were talking about this before the show; we identified three different reasons. The first, which I alluded to already, is that Trump has come out and said that one of his principal priorities is to get the economy growing at a much faster pace. Again, they haven't provided a ton of details around their ideas in this regard. But I think we can break it down into three different things, in terms of their attempt to spur the economy.
The first is, they are recommending a huge infrastructure project, a huge investment in infrastructure --
Lapera: When you say huge, you mean $1 trillion, which is a lot of money. A lot of money.
Maxfield: Yeah. They're talking about absolutely huge numbers. The great thing -- well, "great" is probably not the right adjective -- but it's an irony, because what we're talking about here is a full-throated embrace of Keynesian economics, which suggests that the way to get an economy out of a funk is through higher government expenditures. Of course, that has been anathema to the Republican Party, basically ever since Keynes recommended that in the 1930s.
Lapera: Yeah, it's been interesting because the Republicans have pretty consistently recommended infrastructure bills, but it has never gotten through Congress, because the funding for it is always in the air. And that is one thing with this infrastructure project -- not a lot of details on how the funding will appear have come forth yet. So we'll see how that happens, when we get more details on the bill that he's going to have to construct.
Maxfield: I'll say this: One of the things we know from the Great Depression and the financial crisis is, if you want to lurch the economy back onto that higher growth trajectory, you do need the government in there. Right now, what does that mean? That would mean you would have to borrow a bunch of money to then underlie these infrastructure projects. So the reason that the Republican Party has traditionally been against these types of things is because, first of all, they tend to be more in favor of smaller government, which would go against huge infrastructure projects that are financed by the government; secondarily, because over the past number of years, there's been all this conversation about out-of-control government debt. If you're going to come in with a $1 trillion infrastructure project, you're going to have to finance that with debt. But here's the flip side of that, and this is the point that Trump's campaign team does understand: If you're going to borrow at any point in time, there is no better time to borrow for these types of things than right now, because interest rates are so low. You look at the 10-year Treasury yield, it's just above 2%. Think about how cheap that is for a government to borrow. So, to the extent that they are recommending a huge infrastructure project, certainly their timing is auspicious from the perspective of the cost of debt.
Lapera: Yeah, definitely. As part of this trillion-dollar plan, I know they had mentioned something about a temporary moratorium on taxes for profits earned abroad from companies. Is that correct?
Maxfield: I don't know where exactly that idea originated, but it is now out there, that one of those things that might happen under a Trump administration -- right now, if you have a company like Apple, Apple makes tens of billions of dollars selling iPhones and iPads in other countries. The problem is, when Apple does that, it makes all this money out there, but it can't bring that money back into the United States without paying an additional tax. So that basically keeps this money captive outside of the country, so it can't be brought in for Investments and distribution to shareholders, and things like that. Really, if you're thinking about this in terms of low-hanging fruit and an easy way to spur the economy in the United States, one way -- and administrations have done this in the past -- to do that is to give a temporary moratorium on those repatriation taxes so that all that money can flood into the U.S. economy, and then go out and finance further business investments, or being distributed to shareholders who can then go on to spend the money.
Lapera: Right. Would that money still be taxed as part of the company's overall balance sheet or income once it comes into the country? It just wouldn't have that extra repatriation tax on it, correct?
Maxfield: Right. I'm not an expert on this, but it's my understanding that what the repatriation tax is, is Apple paid an income tax on the income in these foreign jurisdictions when it earned it, and then what the tax coming back into the United States would be is, it would basically be the corporate income tax in the United States, so you would be facing --
Lapera: Double tax.
Maxfield: Exactly. The idea is, with the moratorium, they would just have to face the foreign income tax.
Lapera: Well, in that case, I guess we can't look at those taxes to fund this infrastructure project. On the other hand, the infrastructure project, in theory, could help spur loan demand, as you mentioned earlier, because interest rates are at a historic low. If it employs a lot of people, there could be a lot more people who are looking for loans, which will help banks in the long term, because they are the people who give out loans.
Maxfield: Right. When you're thinking about it from the perspective of a bank, one of the issues they faced basically over the past eight years since the financial crisis is that, given the uncertainty and the lack of confidence in the economy, businesses have reduced the amount of investments they're making. The flip side of this, I don't know how much you follow this, but businesses have been buying back so much stock over the past few years, and the reason they're doing that is, they're taking the money that they would otherwise be making in investments, because they don't feel like they're going to get the return on those investments, and they're instead buying back stock. Well, that doesn't do anything for the economy. But if there is going to be this stimulative impact on the economy through these fiscal expenditures and these other things, that would presumably increase confidence in businesses. And increasing confidence in businesses is going to increase the possibility that they're going to invest. And when businesses invest, one of the things they need to do is borrow money. So, what that would do is increase demand for loans, and loans are the principal product that banks sell. So, if there's a higher demand for the product, banks should make more money.
The other side of this is on the consumer side. Let's say they get these things up and going. And this is a big "if" for a number of different reasons. But let's just assume that they're able to get these things up and going. That's going to increase consumer confidence. If you increase consumer confidence, what happens there? Higher consumer confidence correlates into higher consumer spending. And how do consumers spend money? They spend money with their debit and credit cards, principally. Not a lot of people operate in cash anymore. Well, banks make money from a higher velocity of consumer spending because they earn interchange income each time your debit or credit card is swiped. So, not only would you get a boost to loan demand as a result of these policies, but you would also get a boost from interchange income on the consumer side.
Lapera: Yeah. I want to reiterate to our listeners that, throughout all of that thing we just said and everything we're about to say, I don't know if you noticed, but we said "if," "could," "potentially," "possibly," a lot, and that's because this is wild speculation on our parts, based on things that could maybe happen, but might not happen at all. Talking about things that might actually happen, Janet Yellen has emphasized that she thinks they are going to raise interest rates at the next meeting.
Maxfield: Right. You could tie these two things together. I think it's important to reiterate once again what Gaby is saying -- this is all theoretical. Nobody really has a good grasp of what their precise positions are. Even if we had a better sense of what their precise positions are, it remains to be seen if something like a $1 trillion stimulus package is going to make its way through a Republican-controlled Congress, given their historical aversion to big government and debt. The other piece is, it will depend on what that infrastructure spending will look like. The best way to do it, the most effective way to do it, is to do something like FDR did during the Great Depression -- just go out and build dams and bridges and roads. President Eisenhower did the same thing when the government financed the construction of the interstate highway system. But the conversation in the Trump administration -- again, this all remains to be seen, what it's going to look like -- is that they're going to do this infrastructure projects through huge tax credits that will be given to private companies that will, in a sense, own those infrastructure projects. So we're talking more like toll roads, as opposed to, say, improving an airport or an interstate that runs through the middle of Wyoming. Just to reiterate, this is all hypothetical. But this is the reason that bank stocks have gone up -- in anticipation of these.
Sorry, I'm kind of going on here, Gaby, but just follow me for one more second. If these things do work, and if the economy is jilted out of its current malaise, what that will do, theoretically speaking, is to spur higher inflation. The most recent reading on inflation was 1.6%, that was in October. Well, the Federal Reserve is looking for a 2% inflation rate. Once we get near or to that point, or the economy is headed on a fast enough trajectory to that point, the Federal Reserve will then feel comfortable raising interest rates. We've talked about this ad nauseam on this show, because it's such an important thing for banks -- once interest rates go up, banks are going to make a lot more money, because again, they sell loans, and higher interest rates correlate into higher prices for loans.
Lapera: And I just want to put out there, they're going to make a lot more money. Bank of America said that if rates go up by 100 basis points, they would have an extra $5.3 billion, which is basically an extra quarter worth of revenue for them, which is crazy. Wells Fargo has said $2.8 billion, and Citigroup has said $2 billion for them. That's a lot of money. That's not an insubstantial sum.
Maxfield: It's a very material amount. And it's worth touching on why that's the case. If you have a bank like Bank of America and JPMorgan Chase, they have hundreds of billions of dollars' worth of deposits that they use to finance the loans that they make. But a lot of those deposits, they don't have to pay any interest on them, because they're just in checking accounts. So, if interest rates go up, they will just earn more money on those loans, but they won't have to pay any more for their liabilities. So it's just a great thing for banks, when rates head higher.
Lapera: Yeah, absolutely. The next thing that Trump has talked about on the campaign trail -- and, actually, interestingly, he has talked about it in different ways, depending on what portion of the campaign trail we look at -- but there has been a lot of talk about dismantling Dodd-Frank. I think that has been the major push behind the banks stocks going up. Dodd-Frank, to remind our listeners, was a bill that was passed post-financial crisis that heavily regulated the banks and insisted they had a certain amount of liquidity and capital, capital ratios and stress tests for the banks. As part of it, the Volcker rule prohibited banks from proprietary trading. We're going to get into all of this. Dodd-Frank has basically been governing banks since -- when did it pass?
Lapera: This has basically been banks' reality for the last six years. There's been conflicting information from the Trump camp on how they would actually go about dismantling Dodd-Frank -- whether they would leave provisions of it behind, whether they would get rid of it entirely -- but there has been some noise that they're interested in replacing Dodd-Frank with the Financial Choice Act, which was put forth by a Republican congressman named Hensarling. One of the big things they'd want to get rid of are the capital liquidity rules. Getting rid of the capital liquidity rules could let the banks make a lot more money.
Maxfield: Yeah, that's right. Let me put this into historical context. The last two times we've had very serious economic downturns -- I'm talking about the biggest ones, the Great Depression in the 1930s and the financial crisis in 2008 -- what you always see is, before that, what happens is, when you think about the power allocation between the industry and the regulators, going into these things, you have these deregulatory fervors, and the industry gains more and more power vis-a-vis regulators. But then these things happen, and you have a public backlash. So then, what happens is, that pendulum of power swings all the way over to the regulators, and then the regulators have a ton more power than the industry does. And that's where we're at right now; the pendulum has swung. Full disclosure: I'm a Democrat. When the Democrats went with Dodd-Frank, and when the regulators came in and started passing the rules underlying Dodd-Frank, they pushed things really far. If you listen to any bank CEO, any incredible bank CEO that really knows what they're doing, that's really interested both in their bank and the United States of America, they all talk about how heavy-handed regulations have been since the financial crisis. So, what Trump's team is basically saying is, "We're going to come in and we're going to 'dismantle' Dodd-Frank." So, they're going to swing that regulatory pendulum back, either way back to the industry, where the industry has more power, or at least closer to the center. There are a number of different ways this will help banks.
But if you're thinking about it on the revenue side -- to the point you just made, Gaby -- the really big benefit, this is a huge benefit, will come through a reduction or a relaxing of capital and liquidity standards. What does that mean? That means banks hold a certain amount of capital. A typical bank holds basically $1 in equity versus $10 they borrow to invest into assets. Well, if you increase the amount of capital they have to hold relative to their assets, you're going to decrease the return that shareholders will earn on that equity, because higher leverage corresponds to higher profits, and also higher risk. Well, these proposals, particularly Jeb Hensarling's, who is a member of the House of Representatives, a Republican from Texas, he has come out with this Financial Choice Act that says, "Look, all of these really complicated, really burdensome capital rules that have been passed in the wake of the financial crisis, let's simplify it with a slightly higher capital ratio, but it's not risk-weighted." Risk-weighted means that banks should be free to invest their money and assets in basically whatever type of assets they want to invest in, in respect to risk. Which would mean, as a bank, you're able to invest in high-risk assets, so you're going to generate higher returns.
Along the same lines, Hensarling's proposal, the Financial Choice Act, comes out and says, "Look, so long as banks meet this much more simplified capital standard, they will be free from the liquidity rules under Dodd-Frank." What that would mean is, that would further boost a bank's ability, as opposed to investing a whole bunch of money in cash or low-yielding government securities that basically carry no risk, and reallocate that money over into higher-yielding loans, which would then boost their bottom lines.
Lapera: Right. So Dodd-Frank put this all into place post-financial crisis, where people were worried about there being another potential run on the banks. They were worried about the banks failing because they didn't have enough capital to back up bad bets they had made. Which is why there are such stringent requirements in Dodd-Frank. Hensraling and, I'm not saying for sure, but potentially the Trump team, agree with the idea that this might have been too much for the banks.
Interestingly, there's been a lot of back and forth on the Volcker rule. I mentioned that earlier. The Volcker rule prohibits banks from proprietary trading, which is basically the banks acting like hedge funds. They were allowed to do that pre-financial crisis, because of a repeal of the Glass-Steagall Act. It's really interesting. If they repeal that, that increases the risks of investing in banks a lot, but it also increases the banks' chances of making a lot more money.
Maxfield: This is a really important inconsistency that you're pointing out, Gaby. And here's where it comes from. Trump's team has not provided a lot of details in terms of what it would look like if they were to "dismantle" Dodd-Frank. The closest proxy that we have for what that might look like is Jeb Hensarling's Financial Choice Act. And Jeb Hensarling was, for a while, it was rumored that he was being considered to be the Treasury secretary. Then, there was also conversation in the media that members of Trump's team were in favor of a lot of the things that Hensarling was saying. So, that's where that connection comes from. It's in Hensarling's Financial Choice Act where it says that one of the things that they would do is to get rid of the Volcker rule, which, as you explained, would allow banks to go back and act like hedge funds and proprietary trade, basically do whatever they want in the markets.
Lapera: But, interestingly, Trump has also said he would be in favor of putting the Glass-Steagall Act back, of un-repealing the Glass-Steagall Act, whatever you want to call it, whatever method they would want to go through. Bringing back the Glass-Steagall Act basically makes getting rid of the Volcker rule null. It's very confusing. And I think that's something you'll see in a lot of news coverage -- A, we don't know a lot; B, the things that have been said are confusing because we don't know a lot; and C, we're just going to have to wait and see what happens. Do you want to talk a little bit more about Glass-Steagall?
Maxfield: Yeah, then I'll bring up one more point. What Glass-Steagall does is -- this was implemented during the Great Depression -- say, "If you're going to be a commercial bank that has insured deposits, you can't also run an investment bank." And part of an investment bank is a trading operation. So, to Gaby's point, the Volcker rule says a bank can't run trading operations, but the Glass-Steagall Act says you can't run any type of thing that's an investment act. So there is inconsistency between these two positions.
The one final thing that could really help banks, in terms of this conversation around deregulation, these stress tests that we've talked about on the show multiple times in the past, that banks have to go through every year and see if they're able to survive an economic downturn akin with the financial crisis -- or even worse, when you look at the hypothetical scenarios that they're applied --
Lapera: Sorry, I'm just laughing because you said that all so fast!
Maxfield: (Yeah, sorry.
Lapera: But continue, the stress tests?
Maxfield: Part of the stress tests is, the Federal Reserve under the Dodd-Frank Act -- and that's where the power to stress-test banks comes from -- the Federal Reserve was given a veto power over bank capital plans. What that means is, when a bank wants to raise its dividend, or increase the amount of shares it buys back, it has to basically asked the Federal Reserve for permission to do so. Under Hensarling's proposal, they basically get rid of that veto power. What that would mean for a bank like Bank of America, who has had its dividend request denied, I believe, two times over the past six years by the Federal Reserve, that would give Bank of America, effectively, the ability to double its dividend in 2017 or 2018, but still pay out the same percentage of its earnings each year as Wells Fargo, JPMorgan Chase does. Basically, the same is true for Citigroup, which also has had its dividend hikes denied on multiple occasions over the past few years. So when you add all of these things together -- and, again, all these things are big "if"s, and we don't know exactly how this is all going to go down -- if these things go through, banks are going to make a ton more money.
Lapera: Yeah. The other thing to keep in mind is that if Dodd-Frank is repealed, and there's a much lesser regulatory burden on banks, banks are going to be able to spend a lot less money on that. That's something that -- for example, I don't know if you remember, that New York Community Bank tease that we were treated to for a few years, where they were just hovering underneath the mark where Dodd-Frank would apply to them. They were waiting until they could make a big enough acquisition that it would be worth it for them to pay all the extra money they would have to pay in regulatory management-type stuff. That would go away. Banks could spend that money on something else, on loans or whatever else it is they want to spend the money on. While that might not be as big of a push for bank profits as some of these other things we're talking about with Dodd-Frank, it would definitely help. I don't know how that would end up affecting bank mergers and acquisitions, or people starting new banks, but it would be interesting to see how that would play out.
We talked a lot about how this could help banks. There are some downsides, which I don't know the market is 100% pricing in, which is, obviously, getting rid of regulation increases the risk of banks. We don't know what that would mean, in terms of, long-term, how the banks would function if there was another crisis, if there was less regulation. Now we have a better idea. I mean, you can never predict 100%. But with less regulation, we wouldn't really know as much about how banks would be prepared to react to another crisis. Additionally, the Trump campaign has mentioned potentially erecting pretty significant trade barriers. If they do that, that could potentially hurt our economy, which could potentially hurt banks. Again, this is the episode of "if" and "could." We'll see.
The other thing to think about is that a lot of these legislators that are advocating for less regulation, a lot of them are also against bailing out banks. So if there is another crisis, we could potentially decide not to bail out the banks a second time or third time, whatever time we're on. I don't know, it's a really interesting juxtaposition of ideas. Do you have anything you want to add to that, Maxfield? About the downsides?
Maxfield: The only thing I would say is that most of the conversation right now is coming from the Trump team is, they're basically just talking about adding oxygen to a fire. The fire is the economy, and it's an important fire that you need, and our economy needs more oxygen. But you can take that too far. You can add too much oxygen to a fire. If you were to do that, and you get into this situation where you have bubbles and assets, then banks get into trouble. Let's say we have another crisis -- now, I don't think another crisis is likely, because the risk managers in these firms, the financial crisis of 2008 is so fresh in their minds, but this is all hypothetical. If that were to happen, and if you have a lot of dogmatic people in Congress -- like Hensarling and these other folks -- and they're really against bailing out banks, and you have a bank that gets into a situation where it needs to be bailed out, even though that's unsavory on the individual level, because you're basically bailing out people who make millions of dollars running these banks, the one thing that we learned in the Great Depression was that when you have a normal recession followed by a bunch of bank failures, that's what causes depressions.
That's the reason why, even under a Republican administration in 2008, the George W. Bush administration, when those banks got into trouble, those guys moved in and bailed them all out, because they knew -- they had read history -- what happens when you let that kind of thing happen. When you get dogmatic, and you're not practical about all these things, and you let a big bank fail, it can create an enormous amount of economic destruction. The only thing I would say, to Gaby's point, is yeah, there is risk that does not seem to be being priced in right now. But that type of risk is certainly further down the line than any type of tonic that all these economic proposals would offer to the economy right now.
Lapera: Thank you, Maxfield. I realize this episode ran a little long. I'm sorry, Austin Morgan, I know I'm delaying you getting lunch. To our listeners, we don't know what's going to happen. I hope you didn't get the impression at all from this episode that we are definitely predicting the future. I know we have put in a lot of disclaimers, and I just want to add one more final disclaimer, which is that we have to wait and see what's going to happen. We just don't know. And we won't know until January, when the inauguration happens, and probably not for a long time after. If there's one thing that living in D.C. has shown me, it's that it takes a long time for things to move through Congress. Don't worry, we'll continue reporting on what happens. I hope you found this episode interesting.
I would like to let you guys know that, as usual, people on the program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. Contact us at firstname.lastname@example.org, or by tweeting us, @MFIndustryFocus. I know that talking about politics can bring the worst out in people, so please try and only write in if you have something that contributes to the conversation, and not just anger. Thank you to Austin Morgan, who I'm sure is very excited to eat lunch, as am I. He is a great producer. And thank you to everyone for joining us. I hope everyone has a great week!