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Wall Street’s favorite trade has been battered by the bank stock meltdown

Wall Street's favorite trade has been battered by the bank stock meltdown

Equity investors who piled into financial stocks to ride out the Federal Reserve’s harshest tightening cycle in four decades are learning that rising interest rates aren’t always a good thing.

Investing in lenders when yields are rising is standard Wall Street practice — higher rates often mean higher interest income, which boosts financial-firm earnings.

However, the equation is being rewritten as rising money market rates send depositors scrambling for better deals elsewhere, while saddling banks with losses on bond holdings that investors now fear they may need to sell.

The result: financial companies, which provided a modicum of shelter in the 2022 bear market, are taking serious lumps in an otherwise up year for US stocks. Cascading losses Thursday laid low a group that for mutual fund managers was among the most-favoured trades this year.

Banks tumbled everywhere last week, pushing the cohort in the S&P 500 down more than 4 percent, the worst drop since June 2020. Losses ran the gamut from big to small, with JPMorgan Chase & Co sliding 5,4 percent while SVB Financial Group — whose securities firesale to shore up liquidity ignited the paranoia — plunged 60 percent.

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“Today’s news highlights a risk that likely wasn’t on the radar of most investors,” said Adam Phillips, managing director of portfolio strategy at EP Wealth Advisors. “This might be an isolated event, but the concern is that it will open the door for other banks to report similar issues.”

Thursday’s bleeding was likely a blow for mutual-fund managers, which according to a Goldman Sachs Group Inc study owned financial shares at 138 basis points more than would be dictated by benchmark index weightings at the start of this year, on average. While hedge funds were generally underweight the industry, they still counted Wells Fargo & Co among their top picks, according to data compiled by Goldman strategists led by David Kostin. Shares of Wells Fargo dropped for a fourth day, sinking more than 6 percent.

Sparking the rout was a double-shot of bad news from two small lenders. SVB Financial, a Silicon Valley-based bank, took steps to buttress liquidity by selling securities and raising capital. Meanwhile, Silvergate Capital Corp announced plans to wind down operations and liquidate after the crypto industry’s meltdown sapped the company’s financial strength.

While the selloff in financials reflects tectonic forces that have been at play in the economy for months, its arrival was stunning in its suddenness. The group was still up on the year as recently as last week amid stories that commercial deposits fell in 2022 for the first time since 1948.

That lending was likely to slow as the economy buckled under the Fed’s inflation-fighting campaign had also been apparent before this week’s downdraft. Investors have also been on edge with Friday’s February jobs report set to inform officials’ thinking on the central bank’s next policy decision. Troubles at smaller lenders did nothing to calm nerves.

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“You get two of them back-to-back with enough trepidation about how aggressive the Fed might get with tomorrow’s jobs number in an environment where markets are jittery anyway, there was a pretty good excuse for a risk-off day,” said Art Hogan, chief market strategist at B. Riley Wealth. “No one was going to step in front of that freight train.”

Sudden sell-offs in financial shares are unlikely to sit well with investors at large after the 2008 financial crisis. Because of their role as capital providers, bank stocks are often assumed to hold signals for the broader market, and this week’s drama will to embolden recession doomsayers who have been warning the runup in the S&P 500 since November would cave in on itself. Banks’ gravity-like force was apparent in Thursday’s trading, when spiralling losses in regional banks went mostly ignored for the first half of the equity session, only to drag major benchmarks to their biggest drop in a month as nervousness about the industry spread.

“I don’t think this is a canary-in-the-coal-mine moment but I certainly feel as though the market is reading it that way,” Hogan said.

Bonds in US banks also weakened Thursday after SVB sold equity to shore up its capital position. The moves were generally the sharpest in a few months, but not big enough to signify serious fear just yet. Spreads, or the extra yield that bonds pay compared with Treasuries, widened by 0,08 percentage point, or 8 basis points, for Bank of America Corp.’s 5,015 percent bonds due July 2033.

Optimism among investors that banks could deliver interest income gains can be seen in expectations for industry profits. Companies in the S&P 500 Financials Index is forecast by analysts tracked by Bloomberg to rise 9,4 percent in 2023, the second-highest of any industry group. It’s also visible in their valuations, with the group’s price-to-book ratio hovering around the highest level in two decades.

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That optimism is now put to test, according to Michael O’Rourke, chief market strategist at JonesTrading.

“The broad tape has consistently ignored the reality that the higher interest-rate environment will create headwinds for businesses going forward,” he said. “I would say it illustrates that rising interest rates do matter.”

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