A Trifecta of Financial World Changes That Favor the Status Quo

Industry Focus: Financials edition host Michael Douglass and Fool.com contributor Matt Frankel look at three big financial news stories from the last week.

They discuss what investors should expect from Jerome Powell, the nominee to succeed Janet Yellen as Federal Reserve chair, and also dive into rising interest rates and what consumers and investors need to know. Finally, they'll discuss the Consumer Finance Protection Bureau's "class action rule," which won't be taking effect in 2018 as planned.

A full transcript follows the video.

This video was recorded on Nov. 6, 2017.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, Nov. 6, and we've got a bank news trifecta for you today, and none of them have anything to do with bank earnings. There are actually lots of interesting, broad things happening across the financials sector right now. I'm your host, Michael Douglass, and I'm joined by Matt Frankel. Matt, thanks for coming back!

Matt Frankel: Always good to be here!

Douglass: Fantastic. Folks, before we get into these three really interesting pieces of news, you're going to hear us talking a lot about cycles today. Cycles of regulation and deregulation, cycles of easy credit and tough credit, and interest rate cycles. To really get a full understanding of where we are today, we need a historical perspective. That can really explain where we are and why we're here. A couple of years ago, John Maxfield, one of our premiere banking writers made a chart covering the history of American banking since the Civil War. It's the sort of thing that, at least for me, took two minutes for me to read and brought my understanding forward by at least several months. So, I think it's a really cool piece of content. I would love to share it with you. If you would like a copy, just drop us a note at [email protected]. With that, let's turn to our first piece of news. It looks like we have a new Fed chair.

Frankel: We do. Donald Trump picked Jerome Powell, just as expected. He will take office in February.

Douglass: Donald Trump was looking at a lot of different potential Fed nominees. You had Kevin Warsh, you had Janet Yellen herself, you had a number of different possibilities. Jerome Powell is a stay-to-the-course candidate. There isn't a lot of daylight between him and Yellen in terms of their viewpoints in how to do Fed policy, and how things work from here.

Frankel: Right. This was the least controversial pick Trump could have made while still making the Fed his own. Powell is unlikely to deviate from Janet Yellen's trajectory at all. He's actually always voted with the majority since he's been on the Fed board of directors. He's the path of least resistance to what's going on right now. There's a small difference between him and Yellen in that he's a little more in favor of looser financial regulations, especially when it comes to smaller banks. So, you can kind of see why Trump would align with him a little bit more than Yellen.

Douglass: Sure. We'll talk more about financial deregulation, or at least, fighting back against financial regulation a little bit later with another of our news pieces. But, this is certainly one of those broad cycles that you tend to see in finance, where something will happen, there will be a panic or a crisis or something a la, hopefully not as bad, of course, the 2008/2009 financial meltdown. But when that happens, usually the government will step in with a lot of regulations that will depress bank profitability, but also help them better control risk, force them to control risk a little bit. Then, over time, that'll get taken down, and there will be a deregulatory cycle. So this might -- and, emphasis on might -- be one of the signs that begins to signal some of that movement toward looser regulations for banks.

Frankel: Right. First, you see a knee-jerk reaction to a crisis, or tough economic environment. Then, over time, you'll see them realize that they might have gone a little too far, that some of the regulations might be doing a little more harm than good, costing a little more than they're worth, excluding certain people from credit who should be able to get credit. So that's the argument in favor of winding down some of these regulations.

Douglass: But for me, and I think for anyone watching this story, the key thing here is, Donald Trump had a chance to make a big change and he chose not to. That's good news for people who think that the economy is generally heading in the right direction. And certainly, the stock market reacted positively. So, at least in the short-term, that's very good news for investors, too. Any other thoughts on that, Matt?

Frankel: No. I think if he had chosen any of the other nominations, we would have had a lot more to talk about.

Douglass: Yes, that's extraordinarily true. Let's turn to news piece No. 2, rising interest rates. And we're not talking about U.S. interest rates this time. For the first time in a decade, the Bank of England raised interest rates by 0.25%, with plans for two more hikes by 2020.

Frankel: Interest rate hikes are generally a sign that the government is confident in its economy. The U.K. is kind of a special case, because the economy is kind of a mixed bag. Generally, the two main reasons that rates are increased in the first place are, either inflation is getting a little too high, or unemployment is lower than the target range. Both of those are true in England right now. Inflation is at about 3%, and we expect that to go up a little bit with the next reading. Unemployment is as low as it's been in a few decades. But, the flip side of that is, economic growth is slower than it's been in five or six years, since pretty much right after the financial crisis. So, it's kind of a mixed bag. This increase was widely expected. It was a very small increase. England's benchmark interest rate is 50 basis points, 0.5%. This is worth pointing out, this is undoing the emergency rate cut that was done right after Brexit last year. So, don't read into this too much in terms of how well England's economy is doing.

Douglass: Yeah. One of the key things that I think it's also good contacts for this is, the Bank of England, part of their mandate is to target a consumer price index, or CPI, growth of about 2%. As you noted, it hit 3% in September, so it makes sense that they were going to try to tamp that down a little bit. I think it's good news for people who don't like radical change, sort of like how Jerome Powell is good news for people for don't want radical change with U.S. Fed policy. It's good news for people who don't want radical change that the Bank of England raised things by 0.25%. It wasn't a huge change, it's really just trying to tamp things down a little bit to nudge that growth in inflation down to get them closer to their benchmark.

Frankel: Right. Like you said, they're only expecting two more rate hikes within the next three years, which is probably about third of the pace that we're expected to raise interest rates.

Douglass: Right.

Frankel: I would take that more as a sign of uncertainty in the economy than anything else. The numbers themselves look pretty good right now, but Brexit is still in the background, and growth is a little higher than it should be given such high inflation and good unemployment. So, it's more of a sign of caution than anything else.

Douglass: Yeah, there's a lot of uncertainty for our friends across the pond right now. Let's take a step back and talk about, in general, a rising interest rate environment and what that means. Let's face it, U.S. interest rates are definitely increasing, and they'll actually be increasing, as you noted, probably a good bit faster than the U.K.'s. I think the first group we should talk about are consumers. If you are a consumer, a rising interest rate environment primarily affects you because, when you borrow money, you're going to be paying more interest. On the flip side, you're going to get a little more interest when you open a savings account or a CD. So, when you deposit money in the bank, maybe instead of, I'm making this up here, 0.01%, you might be getting 0.5%, or even one day 1% or 2%. That's not historically unreasonable to see, at some point in the relatively distant future. So, that should help some of those yields for consumers.

Frankel: Definitely. It's also worth pointing out that some things are directly related to rising benchmark interest rates while some aren't. You mentioned savings accounts. So far, savings accounts really haven't risen proportionally to the [benchmark] interest rates.

Douglass: Not at all! [laughs] 

Frankel: Not at all. But some things have. Credit cards will rise immediately after the rates are increased. Any kind of loan that's tied to a benchmark, like an adjustable rate mortgage, for example, would rise immediately. Whereas things like non-adjustable mortgage rates, savings, CD rates, they tend to move with rate hikes, but it's not a perfect correlation.

Douglass: I think that's a great point to make. The other thing to consider is, one of the other groups that's said to be affected by interest hikes are banks themselves. Banks make their money by taking in money, usually through checking accounts, savings accounts, money markets, things like that, and then loaning it out at a higher rate. So, as rates go up, they can theoretically put that money out at an even higher rate, and that will juice their returns. So, banks in general should benefit substantially from interest rate increases.

Frankel: That's especially true that, when rates rise faster than rates on deposits are rising, like we just mentioned with the savings accounts, generally the effect is, when rates rise, borrowing rates tend to rise a little bit faster than deposit rates, which is what's called margin expansion for banks. So, banks tend to make a higher percentage as they're loaning money out for a higher rate, and not paying quite as much more on deposits. So, that's why in the past quarter, you've seen pretty much every bank other than Wells Fargo (WFC -0.20%) make higher interest margins by about 10 to 12 basis points. So, you'll see this as interest rates continue to rise, a little bit more margin expansion, which is very good for banks.

Douglass: Absolutely. Then, for investors, one of the interesting things about rising interest rates is, usually it'll drive down bond prices, which will then improve bond yields. If you have -- I'm making this up -- a $10 bond that yields $1 per year, that would be a 10% yield. That would be insane, by the way, much higher than we get right now. But if the price of that bond drops to $5, then suddenly that $1 yield becomes a 20% yield, even though it hasn't changed any, it's just that with the price lower, that yield is then better. What's interesting about this to me is that if bond yields improve substantially -- right now, you see a lot of bonds paying 3% to 4%, if that starts getting up into 5%, 6%, maybe even 7%, I think a lot of your income investors, these are folks who are at or near retirement, who have been in dividend stocks because they're paying a similar yield to these bonds and you get some potential capital appreciation out of it, might head over to bonds instead of income stocks, which could have some really interesting effects on the dividend stock market. Most of them, let's say not terribly positive for those who are already invested there. Of course, we can't predict the future, but that's just one possible outcome here.

Frankel: Right. A good example I always use, I invest a lot in real estate stocks, REITs, which pay, generally, 4% to 6%.

Douglass: Yeah, they do pretty well.

Frankel: Right, they're some of the highest dividend stocks on the market. And one of the examples I always use is, say, if a 10-year Treasury is paying 3%, and a pretty solid REIT is paying 5%, it's worth taking the extra risk to get that extra yield. However, if the Treasury is now paying 6%, but you can only get 5% from a riskier asset, you lose the incentive to take that extra risk. That can create selling pressure on the stock to jump the yield up, as you were just describing.

Douglass: Of course, on the flip side, when great businesses go on sale, that's a great time to potentially buy in. We've talked a fair amount about dividend stocks and Dividend Aristocrats, and some of these other companies that have really shown their ability to raise their dividends and really reward investors long-term. So, this might create some really great buying opportunities. I know, me personally, I'm looking forward to and hoping for that outcome so that I can pick up some great companies on sale.

Frankel: Me too. It can be painful in the short term to watch the dollar value of your portfolio go down, but in the long term, it's actually a really good thing for people who still have time.

Douglass: Right. So long as it doesn't go down for forever, right? [laughs] 

Frankel: Right. Short term, it's OK.

Douglass: Right. And we always have a long-term mindset here. Anyway, that's one of the possible outcomes of this. So, let's turn to our third story. In late October, the United States Senate voted to overturn a rule that had been made by the Consumer Finance Protection Bureau, or CFPB, to make filing class-action lawsuits a lot easier for consumers. Again, thinking of this from a deregulatory cycle standpoint, this is a pushback against a bank regulation.

Frankel: Right. It's worth mentioning, this rule hasn't gone into effect yet. Nothing is changing.

Douglass: Right.

Frankel: So, the rule would have made it difficult for banks, credit card companies, other financial companies, to prevent class-action lawsuits if they did something wrong. A good example would be the Wells Fargo fake account scandal. When customers opened accounts at Wells Fargo, they signed what are called arbitration clauses that prevent them from joining in with other investors to sue the bank, and instead requiring them to solve their disputes through arbitration. Now that this rule has been thrown out, that's pretty much the only option. The Supreme Court ruled that these arbitration clauses are legal, but the Consumer Finance Protection Bureau was trying to amend that in the cases of banks, credit card companies, and such.

Douglass: Sure. And there are some interesting effects, knock-on effects, of this sort of thing with things like the Equifax (EFX -0.35%) data breach, for example.

Frankel: Right. When the Equifax data breach came out, they offered consumers a year of credit protection, but there was a clause in the sign-up form that said that consumers were not allowed to join class action lawsuits against Equifax if they accepted the help. They later wound up taking it down after there was a big backlash about it. But this is the type of thing that is not uncommon. These are just two high-profile incidents that we talked about. Actually, most people listening to this probably signed something saying they wouldn't join a class-action lawsuit when they open to their own checking account. So, this isn't new, it's just new protection that was going to go into effect.

Douglass: Right. And, again, it's interesting, because it's not clear that we've begun a real deregulation. Certainly, there's been a lot of talk about it, and, again, the appointment of Jerome Powell, this turn back on the CFPB could be the very beginnings of a push back against what might be perceived to be some overreach. But it's hard to tell exactly whether that's actually beginning, or we're still going to stay where we are on regulation for a while.

Frankel: I was talking about how you can make a case toward removing certain regulations, but this is a good case to be made. A lot of frivolous class-action lawsuits are filed against these companies. I know somewhat related example. I invested in a stock years ago and it wound up going down by 40% because I was wrong about the company. And I got 10 emails asking if I wanted to join a class-action lawsuit against the company, even though they hadn't done anything wrong. The argument against it is, the only people who are benefiting from this are these trial lawyers who are suing. And there is some evidence that says through arbitration, consumers generally get better settlements than through class-action lawsuits. So there's an argument to be made either way. I'm not saying whether it'll be a good rule or a bad rule. Just, there is an argument to be made that some regulations might be overstepping a little bit.

Douglass: Yeah, totally. And that's definitely part of this whole conversation. It's hard to predict whether one of these regulations would or wouldn't have been the right answer, because frankly, there's lots of real-world data and, as you pointed out, a fair argument to be made either way. For me, I'm more interested in seeing this within a broad landscape of banking. Again, I'll just do one more plug for this: I do think this conversation is a lot more enriched if you have a better understanding historically, in terms of thinking about how the banking system has really developed over the last 150 years, and what some of those different cycles have looked like. So, again, if you want that chart that John Maxfield made, drop us a note, [email protected]. We'll be happy to provide that.

That's it for this week's financials show. Questions, comments, you can always reach us at [email protected]. We love to hear from listeners. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Matt Frankel, I'm Michael Douglass. Thanks for listening and Fool on!