Published in the Financial Post, June 3, 2015 – by David Pett

U.S. bank stocks have already climbed more than 300 per cent on average since markets bottomed from the financial crisis a little over six years ago, and that might just be a sign of things to come if interest rates finally rise south of the border in the coming months.

“It could be explosive,” said Joel Clark, chief executive of K.J. Harrison Partners Inc. “Financials thrive in a rising interest rate environment.”

It remains to be seen exactly when the U.S. Federal Reserve will begin its rate hiking cycle, but the net effect when it does will be a huge tailwind for the banks on several fronts, Clark said.

For one, they will earn incrementally more as short-term rates rise on the money they have sitting at the Fed currently earning next to nothing. Their net interest margins on loans will also increase as the yield curve gets steeper and rates rise.

“For money that is being lent, they’ll now be lending at six per cent, for instance, as opposed to five per cent, and that extra one per cent goes straight to the bottom line,” Clark said. Beyond rising rates, he believes loan growth will improve in lockstep with the U.S. economy.

Clark is also encouraged by the group’s low valuation relative to the broader market and that the regulatory and legal settlements that have dogged the group since the financial crisis are finally dwindling.

“The combination is a potent cocktail for earnings growth out of the banking sector,” he said.

Clark said U.S. banks have become much easier to analyze since the financial crisis, largely because government stress tests provide greater clarity on potential risks.

His top pick in the group is JPMorgan Chase Co., which trades at a price/earnings multiple of roughly 10 based on forward estimates and is expected to grow earnings at 10 per cent to 12 per cent over the next few years.

The company is a market leader on several fronts, including credit cards, investment banking and private banking, and it has a “fortress-like” balance sheet, he said. It also offers investors a compelling dividend yield of three per cent based on a 30-per-cent payout ratio that is expected to reach 50 per cent over time. “That is a big jump and as earnings grow, you are going to have a big string of increases,” he said.

Analysts who cover the bank group are also mostly bullish on JPMorgan, with 29 of the 40 rating the stock a buy and 11 rating it as a hold, according to Bloomberg data.

Even a small rise in interest rates could deliver a big boost to bank earnings, BlackRock said in a recent paper.

But the group is doing fine even in the existing environment of low rates, said Russ Koesterich, the asset manager’s chief U.S. investment strategist. “Financial firms with large capital market operations and merger-and-acquisition desks are thriving,” he said in late April commentary following U.S. bank earnings season. “We see the favourable environment for this sector continuing, and accordingly, we would remain overweight large, global financial firms.”

Republished with the express permission of: “National Post”, a division of Postmedia Network Inc.

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