Morgan Stanley says US bank stocks will do well even when Fed pauses interest rate hikes

The U.S. Federal Reserve is widely expected to temporarily stop raising interest rates in the middle of 2019 — but Morgan Stanley predicts that stocks in the financial sector will still do well.

A rising interest rates environment is typically beneficial for banks because it boosts profitability on loans. But bank stocks in the U.S. have done poorly this year despite the Fed raising rates three times, with a fourth hike expected to come next month.

Morgan Stanley expects the Fed to take a break from raising rates in June next year.

“The irony is that financials didn’t do well this year when rates are going up, it may be the case that financials do better in 2019 as the Fed backs off,” Mike Wilson, Morgan Stanley’s chief U.S. equity strategist, told CNBC’s Sri Jegarajah.

“The financials figured out that the Fed was tightening too rapidly and so rates were going up, sure, but they realized that that was going to lead to slower growth. Now, if the Fed pauses, financial stocks may actually sniff that out and say ‘hey, that’s a good thing’ and they may actually outperform in 2019,” he said at the Morgan Stanley 17th Annual Asia Pacific Summit in Singapore.

Morgan Stanley earlier this week said it maintained an “overweight” stance on U.S. financial stocks for 2019. But the bank downgraded U.S. equities as a whole to “underweight.”

It explained that the call for an outperformance in financial stocks is partly due to the sector’s relatively cheap valuation compared to others. Some banks also have the ability to control costs better than companies in other sectors, which would allow them to register better earnings.

“We admit that retaining our overweight in Financials seems odd in the context of the slowing growth environment we are calling for next year. After all, why should intermediaries for economic activity work in a slowing growth environment?,” the bank said in a report dated Nov. 26.

“The overweight call for us really comes down to earnings achievability and relative valuation driving relative outperformance in the absence of a recession,” it added.

Share prices of major U.S.-listed banks have recorded losses so far this year: Citigroup was down 14.72 percent, Wells Fargo declined by 12.33 percent and Bank of America fell by 6.03 percent. J.P. Morgan Chase bucked the trend with a 2.6 percent increase.

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