Industry Focus: Financials host Michael Douglass and Fool.com contributor Matt Frankel take a look back at the five most newsworthy financial sector stories of 2017, and what each one means to investors. Here's what you need to know about the new Federal Reserve chair, rising interest rates, bitcoin and other cryptocurrencies, Wells Fargo (WFC -1.40%), and the Equifax (EFX 1.42%) data breach.
A full transcript follows the video.
This video was recorded on Dec. 18, 2017.
Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, December 18th, and you're listening to the Banking and Financials show. We're kicking off an Industry Focus-wide "year in review" theme week. For each sector, we're recapping the major stories and headlines from 2017. In addition to this, the Industry Focus team is continuing in a long tradition of offering the best content of Fool.com from this year. That's 2017 in this case, though we've done it in past years as well. If you're interested in that content, send us an email at email@example.com, and the team will reply with the list of some of our best content of Fool.com this year. I'm your host, Michael Douglass, and I'm joined by Matt Frankel. Matt, welcome back!
Matt Frankel: Always good to be here!
Douglass: Fantastic. Let's hop right in. We're going to be talking about five major stories in financials this year. Story No. 1: Jerome Powell as the new Fed chair.
Frankel: This was not unexpected. President Trump did not renominate Janet Yellen, which set off a big wave of speculation -- is he going to nominate somebody more conservative or dovish, I guess you would say. But he nominated Jerome Powell, who's pretty much, it was his best choice for making a change without actually making a change, is the best way I could put it. Nothing really changed in terms of expectations. Before he was nominated, the markets expected three interest rate hikes in 2018, for example. They still expect that. Not much has changed, which is a good thing. If it's not broke, don't fix it. But this was President Trump's way of putting a little bit of a change at the Federal Reserve without actually making too much of a ruckus about it.
Douglass: Yes. Yellen and Powell, I think they can best be characterized as centrist and a little dovish. And by that what I mean is, doves tend to be very measured about raising interest rates, sometimes even want more fiscal stimulus, whereas the hawks tend to be more in favor of raising interest rates to keep up with American economic growth. So Yellen, and now Powell, have tended to say, yes, we're going to do some interest rate increases, but they're going to be very slow and very measured. We do not want to disrupt this economic recovery.
Frankel: Yeah, definitely. Basically, they don't want to add to any uncertainty that already exists. Between tax reform, things like North Korea, there are a lot of things that could cause volatility in 2018, but the Fed probably won't be one of them.
Douglass: Right. And when thinking about this story, that's probably the key investing takeaway: The Fed is not going to be contributing to volatility next year, as far as we can tell. Of course, no one can predict the future, etc. But we have no reason, based on Jerome Powell's history, to think that the Fed is going to be anything but a stabilizing force next year and in the years to come.
Story No. 2: interest rates. Because, of course, it ties right into the Fed. The Fed increases interest rates when the economy is doing well, so they control inflation. Of course, they tend to drop interest rates when the economy needs a little bit of an extra nudge. The Fed has raised interest rates three times this year, and it's now going to be up to a range between 1.25% and 1.5%. And they have signaled three more interest rate increases next year, two in 2019, and two more in 2020.
Frankel: That's really the key story. The interest rate hike that just happened and the few that have already happened to this year were pretty expected. There were no big surprises anywhere. The real thing that can move markets is what the Fed expects to do in the future. For example, if we wind up getting four rate hikes next year instead of three, things like that could really move the market, because these tend to be priced in ahead of time. One of the key sectors this could move is banks, which tend to profit more when interest rates get higher. And the stock prices from an investment standpoint are based on what the market expects to happen. Right now, for example, we're expecting three interest rate hikes next year, two more in 2019, and two more in 2020. This is somewhat reflected in stock prices right now. If we get surprises, that's when you're going to see changes.
Douglass: Yes. Also, it's worth noting, we're in a historically low interest rate environment, even right now, even with this year's three increases. And that's been because the global economic recovery and the U.S. economic recovery have looked, in a lot of ways, pretty fragile. But Janet Yellen, at her most recent press conference, gave us this quote. She said, "The global economy is doing well. We're in a synchronized expansion. This is the first time in many years we've seen this." I think, if you're concerned about the American economy -- and I suspect that if you're listening to this or if you're anyone in the world, you're probably concerned about the American economy, given how much of a driver of the global economy it is -- that's good news, and that speaks well to the overall global recovery. I think one of the other things that's worth noting is, this historically low interest rate environment is likely one of the reasons we've seen so many acquisitions in the last few years. A lot of folks are locking in low interest rate debt while they can. And frankly, also because the economy hasn't been doing that well, in a lot of ways, one of the easier ways to get growth has been to buy it.
Frankel: Yeah, definitely. Like you said, this is more of a normalization than it is interest rate hikes. You've also seen companies in a rush to refinance existing debt for this reason, to take advantage of the low environment. And the recovery has looked kind of fragile recently, but not over the last year or two, which, to tell you the truth, kind of makes me nervous as an investor, that things aren't looking like we need to maintain quite as much. But, generally, this is good for banks, bad for high-dividend stocks, and bad for anyone who wants to take on debt as interest rates are rising.
Douglass: Right. The reason this is bad for high-dividend stocks is because those dividends come with some risk. When interest rates increase, bond rates also increase, meaning that, let's just say, for example, you have a stock that yields 5%, and you're in that stock for 5% because bonds are all yielding lower than that. Well, if bonds suddenly started yielding 6% or 7%, then from a stock-price standpoint, it's not going to be so great for those dividend stocks, as many of their income investors flee to bonds. But, from an underlying-business standpoint, and I think this is the key investing takeaway for any Foolish investor, that doesn't matter. What really matters is what this is going to do to underlying businesses. This is going to be great for banks, as you pointed out, Matt. They're going to be able to arbitrage more effectively the higher interest rates are. We'll all see, hopefully, our savings account yields increase a little bit -- won't be by nearly as much as [banks] are increasing yields on their loan book, so they'll be doing just fine. It's going to be a little bit troublesome for REITs (real estate investment trusts), which basically take on a lot of debt so they can purchase properties and lease them out. You're probably going to see them suffer, and their spreads narrow, and therefore their businesses be a little bit more threatened. And of course, as you noted, any business looking to take on a lot of debt or that has a lot of variable debt could also be affected.
Let's turn to story No. 3: cryptocurrencies. Now, you might question putting this in financials, but frankly, most of the companies that are really involved, and I'm talking about the Cboe [Futures Exchange] and options and futures and such, those are usually considered financials companies. Plus, we're the Financials show -- I think that means anything financial could be considered Financials. So I'm just going to lead off with this one stat, which is just crazy to me. Bitcoin started the year at just under $1,000 for its price. It's now over $19,000 as of our taping here on December 18th. That's just enormous growth.
Frankel: Yeah. And it's actually worth pointing out that this has been bitcoin's third best year. This isn't even the highest performance percentage-wise. I could tell you from personal experience, I wish I had back the 20 bitcoins I owned in 2015 when they were worth $200.
Douglass: Yeah, oof. [laughs]
Frankel: Wouldn't we all? I also wish I would have played the winning lottery numbers last night. But that brings me to the point I wanted to make for investors. This is very much a speculative investment at this point. Bitcoin and any other cryptocurrency for that matter, or any company that's involved in cryptocurrencies, any financial firm that's placing big bets on cryptocurrencies in their technology, these are all very speculative things at this point. Don't confuse a long-term investment with gambling.
Douglass: And I think this is an important point. It's been very interesting, particularly in the last month, watching so many people who have never thought much about investing suddenly get really excited about bitcoin and talk about trading bitcoin and making money in bitcoin. It brings back to me that timeless bit of wisdom from Warren Buffett, "be fearful when others are greedy and greedy when others are fearful." I'm seeing a lot of greed, and I'm seeing a lot of people really really excited about this, and I think excited beyond what is reasonable, and that as an investor makes me afraid. So that's why I'm very firmly outside of the cryptocurrency space and likely to remain so.
Frankel: If you think back to the dot-com boom, the point when you really needed to start worrying was when people who, like you said, never were interested in investing before were suddenly buying mom and pop's dot-com. And just like any other boom, like the tech boom, a lot of money will be made here, a lot of money will be lost here. They just recently started trading bitcoin futures on two major futures exchanges. This should help bring a little stability, theoretically, to the price of bitcoin, but it also adds an interesting dynamic in that it allows institutions to short bitcoin, which has never been an option before. So this could be kind of a stabilizing mechanism, as well as downward pressure at the same time. It'll be interesting to watch how the bitcoin futures introduction plays out. That might be one of our big stories of 2018.
Douglass: I suspect so. I've received a few emails from folks who are interested in having us do a couple of deep dives on cryptocurrencies. I want you all to know that I have a book, and I'm planning to read it and do some more research, and definitely very much on our list for 2018. Matt is actually one of our big cryptocurrency writers, so we'll have a lot to talk about. But I want to make sure that we have the time to really put together some really great episodes before we hop into that. So, just to let you all know, it's coming. It'll come sometime in 2018, probably in the first quarter.
Alright, story No. 4: Wells Fargo. This is not a particularly happy story, because Wells Fargo has had a pretty darn rough 2017.
Frankel: This is technically a 2016 story, because that's when the news of their wrongdoing -- in Elizabeth Warren's phrase, a scam -- first came to light. Whether you think the bank was completely at fault or it was a bunch of rogue employees, that's another discussion for another day. But one of my favorite Warren Buffett lines is, "you'll find that when you turn the lights on, there's not just one cockroach in the kitchen." And this really applies here. First of all, the number of people affected by the fake-account scandal during 2017 grew from the 2 million that were originally disclosed to about 3.5 million. Not only that, there were a bunch of other mini-scandals that were brought to light. In one, Wells Fargo was charging 800,000 customers for auto insurance they didn't need. In one they were caught improperly raising mortgage rates for certain customers that they hadn't properly disclosed that they were going up for a rate increase. And there were a couple more. They were making unauthorized changes to people's mortgages. So you see all of these scandals snowballing, and it's pretty much because regulators, the investing media decided to take a closer look at Wells Fargo and scrutinize them a little more. So even though this was brought to light in 2016, it turned into a bad 2017. 2016 was OK for Wells Fargo in that they did initial damage control, in my opinion, pretty well. But in 2017, it's just been one thing after another, and it's really been weighing on the company's results and, as a result, its stock price.
Douglass: Right. I think when we take a step back, one of the things that Wells Fargo was really well known for was its aggressive sales culture. [Former] CEO John Stumpf used to say that "eight is great." What that meant was, let's try and get each Wells customer into at least eight products. With that being the expectation, employees were under a great deal of pressure and pretty clearly cheated. Not saying, to be clear, that all Wells Fargo employees cheated. That's certainly not the case. But a significant proportion did, and we're seeing issues across a number of different departments. So that's been a really rough drip-drip-drip of bad news for Wells Fargo. And as you noted, across the board the bank is reeling. Their efficiency ratio, which is a measure of core profitability and their ability to control expenses, has climbed. That's bad. You want a smaller efficiency ratio. It's above 65% in the most recent quarter. Historically speaking, Wells Fargo has generally been in the mid-to-upper 50s, and that's kind of where you want to see a big bank. And revenue and earnings per share are both down year over year, because frankly, there's a trust deficit, and I think understandably so.
It's interesting. I don't know what I think about Wells Fargo going forward in a lot of ways. What I do know is, the sales culture was supposedly the one thing that really made Wells really different from the other big banks. And sure, there were other things too, to be clear. But that was one of the really big pieces of any investing thesis. Now that that is, at least for the moment, gone -- and again, to be clear, rightfully so. Is the stock undervalued? Possibly. But by the same token, for me, when I'm looking for investments, I'm looking for companies that can distinguish themselves in some way. And I don't see a lot in Wells that really breaks it out differently, at least for me as an investor. And frankly, I want to beat the market. I'm not looking to match the market's return, or buy, essentially, a high-cost ETF of big bank stocks. I'm looking for the best investments. And Wells just doesn't fit that criteria for me.
Frankel: Yeah. As Buffett would say, they lost one of their most durable competitive advantages in terms of the cross-selling ability. They never really stopped to think whether or not people needed eight different baking products. I read somewhere that the average person has less than 10 banking products total between all the banks and credit card companies and everybody they deal with. That was a pretty lofty goal, so it's not surprising that it led to wrongdoing.
Douglass: No. 5, and perhaps in a lot of ways the biggest story of the year, the Equifax account hacking scandal. 143 million accounts hacked, yours truly potentially included. It's been quite the year for Equifax.
Frankel: Yeah. I look at this as kind of the biggest story of the year from a consumer point of view, not necessarily from an investor point of view. I personally wouldn't touch Equifax's stock. But I don't really foresee this affecting their bottom line on a long-term basis, simply because consumers aren't the ones who generate most of their revenue. They depend on consumers and their personal information for the revenue, but generally speaking, they're paid by companies. So I don't see this as a big investing story. I do see this as a big story from the personal side, as in the three main credit bureaus, their existence is predicated on the fact that they're good at handling people's personal information. So this highlights the need for people to protect their own identity, not necessarily by taking advantage of the credit monitoring service Equifax is offering customers as compensation, but just in general, monitoring your own credit, knowing how to freeze your credit if you need to, putting out a fraud alert. We actually had a lot of coverage come out about this around that time. I'm sure Michael would be able to send you any of our tips lists if you're concerned about your own -- what to look out for and what to do, what it means that your identity was compromised. But, like I said, I see this as the biggest story of the year from a consumer standpoint.
Douglass: Yes, I would be perfectly happy to send it along. If you have any credit concerns, drop us a note -- firstname.lastname@example.org -- and I'll be happy to send you along some of the content that we have. I think, thinking about this from a really broad standpoint, we've all known to some extent that companies and governments have been waging a defensive war against hackers for years. And frankly, the hacks are getting bigger and more frequent. It's been a real struggle for Equifax, for plenty of insurers and hospital systems. This is a problem that really crosses industry boundaries. And I suspect that it's going to get worse before it gets better. Of course, no one can predict the future, but it looks pretty rough. Personally, I was never that excited about Equifax as a business, so I'm a stay-away. Certainly, the hacking scandal didn't really endear them to me any extra.
So those are our top five picks for the biggest stories in financials this year in 2017. Again, if you want the "best of" list, that's the best content on Fool.com, in 2017, drop us a note at email@example.com, and a member of the team will get back to you. That's it for this week's Financials show. If you have questions or comments, you can always reach us at firstname.lastname@example.org. 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!