US banks valuations now fully discounting Trump’s policy promises

Six weeks after Donald Trump’s inauguration, US banks valuations are looking stretched following the post-election rally. Based on our analysis of the potential impact of higher interest rates, corporate tax cuts and financial services deregulation on the earnings of US banks, current share price levels of US banks are already fully discounting a 1.5% parallel upward shift in the yield curve (we have had no more than a 0.5% shift so far), at least a 10% reduction in the effective corporate tax rate and potentially lower capital requirements and compliance cost savings for banks under a potential repeal or scaling back of the Dodd-Frank Act (which was introduced in 2010 in response to the 2008 financial crisis to make US banks safer via stricter regulation and supervision). However, the pace of interest rate hikes by the Federal Reserve may be slower than what is expected by the market as it will all depend on future inflation indicators while there is still no clarity regarding the Trump administration’s ability to reduce the corporate tax rate from 35% to 20% as promised due to the need to offset lower corporate tax revenues via higher taxes elsewhere, possibly via a proposed border tax that will tax US imports via higher tariffs. And at this stage there is no evidence that the new government can introduce the border tax due to the strong resistance from many US corporates (and particularly retailers) against this tax as it would significantly increase import prices and consumer prices. As for the impact of financial deregulation on banks earnings this is likely to be minimal at best for two reasons. First, it is highly unlikely that Congress and the Senate will agree to a major revamp or repeal of the Dodd-Frank Act as noone wants a repeat of the 2008 financial crisis which was triggered by lax bank regulation. And, second, the consensus amongst US banking analysts (us included) is that any changes to the Dodd-Frank Act will probably be cosmetic and will mainly benefit smaller US regional banks that are seen as possibly being overburdened with compliance requirements given their size and scope of activities. However it is unlikely that we will see a major rollback of regulations for US megabanks and especially those with substantial investment banking activities which entail higher risks.

Given that US banks valuations are now fully discounting a perfect scenario of much higher interest rates, significantly lower corporate taxes and a full deregulation of the banking industry, it is highly probable that actual events will disappoint investors and hence a pullback from current stretched valuations is likely in the short/medium term. Hence, a strategy of short term positions in US banks driven by government policy news flow is more preferable right now that a Buy Hold strategy.