December was a big month for consumer finance stocks. Capital One (COF 0.16%) rose 17.4%, Ally Financial (ALLY 0.41%) rose 19.5% and SoFi (SOFI 3.69%) charged 36.5% higher during the month, according to data provided by S&P Global Market Intelligence.
The financial sector got a huge boost following the Federal Reserve's Open Market Committee (FOMC) meeting on Dec. 13. The Fed's commentary indicated that it is likely done with its aggressive interest rate hikes, and that rate cuts are a strong possibility in 2024. SoFi, Capital One, and Ally stocks all launched higher following the central bank's statements. Increased interest rates have curbed demand for their consumer financial products, so the latest news on monetary policy was a welcome signal that conditions are likely to improve over the next few quarters. The stocks rallied on that optimism in unison.
Why was the market so focused on the Fed's report?
The Federal Reserve took decisive action to help slow runaway inflation in 2022 by implementing one of the most rapid interest rate hike campaigns in its history. High interest rates discourage corporate growth initiatives, consumer spending, and riskier investment decisions in capital markets. As a result, rate hikes hinder demand -- and price growth -- for goods, services, and labor across the economy.
Inflation was creating serious issues for consumers and businesses alike, suggesting that the economy was "overheated" to an unsustainable level. The Fed's rate hikes were considered a necessary evil to control inflation, even if it hurt unemployment or caused a recession in the near term.The financial sector is an important cog in the economic wheel, and banks' results tend to fluctuate with the broader economic cycle. These companies were particularly jeopardized due to the specific products that generate most of their revenue and income.
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SoFi, Capital One, and Ally are much more heavily exposed to consumer lending products than the major banks and diversified financial institutions. Most of SoFi's revenue comes from its consumer loans, which include mortgages, student loans, and personal loans. Personal loans, such as refinanced credit card debt, make up the biggest portion of its interest revenue. Capital One leans much more heavily on credit card business, which generated more than 60% of its net interest income last quarter. Consumer debt, such as auto loans, contributed an additional 35% of the bank's revenue. Ally has an enormous automotive finance business, which contributed 90% of its revenue in its most recent quarter. This was supplemented by its smaller corporate finance and mortgage businesses.
These three consumer finance companies all occupy different niches, but they share many of the same catalysts. They rely on consumer spending, financing, and refinancing activity. That activity really dries up when layoffs make people uncertain about their future income, or when interest rates are high enough to discourage refinancing, homebuying, and big-ticket purchases.
SoFi, Capital One, and Ally can be contrasted with the major banks, which are more diversified institutions with different growth drivers. The results of major banks like Bank of America or Wells Fargo are less influenced by the performance of any individual product category. The consumer finance stocks should be highly correlated to other members of the sector, but they are more sensitive to investor expectations on automotive sales, credit card utilization, and consumer loans.
What's next for these consumer finance stocks
If we really are on the cusp of rate cuts and the desired recession-free "soft landing," then conditions are likely to improve for SoFi, Capital One, and Ally. There's a clear bullish narrative for all three companies, but it depends on economic outlook and consumer behaviors. Rate cuts and strong economic data are likely to send the stocks higher. If high rates linger longer than anticipated or we wind up plunging into a recession, these stocks are likely to sustain losses.
SoFi has a reputation as a fintech company, going back to its operations before it commenced banking operations. That reputation, combined with an enormous opportunity associated with the return of student loan refinancing demand, leads to loftier investor expectations and a premium valuation. This gives SoFi some dynamic growth stock traits, but it can also create extra downside risk. The stock has already lost most of its December gains, thanks to an analyst downgrade.
Capital One and Ally are more similar to other mature bank stocks. They pay dividends and their market caps closely reflect their book values. Both stocks are priced reasonably enough to provide upside potential if rates are indeed slashed in 2024 and consumer spending is resilient. Ally and Capital One probably won't fluctuate as much in price as SoFi, be it higher or lower.
