The improving economy is great news for banks

The stock market has been volatile, but it’s been a very solid year on -— and for — Wall Street.

Stocks rebounded Monday after a big tumble last week, but the Dow remains up a robust 10% in 2021. Goldman Sachs is the top stock among the blue chips, surging 35%.

Goldman isn’t the only financial giant that’s thriving: American Express is the second best Dow performer, rising more than 30%, while JPMorgan Chase has gained 18%.

And over in the S&P 500, big banks Capital One, Wells Fargo, SVB Financial and Fifth Third are all up more than 30%.

Why are these and other bank stocks doing so well?

The market rally is obviously good news for the Wall Street side of banks’ business. Companies like Goldman Sachs and JPMorgan Chase both generate revenue from trading commissions as well as investment banking fees for advising on mergers and initial public offerings.

But it’s also the strong economy, bolstered by an improving job market, that should boost demand for loans and the creditworthiness of borrowers. Housing is still red hot too, and that’s good for regional banks that have big mortgage lending businesses.

Economic rebound bodes well for the banks

Add all that up and it means the banks are now among the biggest profit-generating machines in Corporate America. According to FactSet Research, earnings for the financial sector are expected to more than double in the second quarter and estimates continue to rise, led by gains at Wells Fargo, Capital One, Discover Financial Services and Bank of America.

Bank stocks are also getting a lift due to the fact that they pay big dividends that yield more than boring bonds. That makes them more attractive to conservative investors looking for steady income.

The 10-year Treasury yield is currently hovering just below 1.5%. Citigroup’s dividend yield is double that. Major regional banks Truist, Citizens Financial, KeyCorp and Comerica all pay dividends that yield north of 3% as well.

“Banks have cleaned up their books since the great financial crisis and have proven their business strength in the pandemic crisis,” said Anu Gaggar, senior global investment analyst for Commonwealth Financial Network, in a recent report.

“Even at low absolute interest rates, they can make money. Strong economic and capital market activity is very pro-financial stocks. Financial strength gives them the flexibility to reward investors through dividends and share buybacks,” she added.

Inflation may not be the worst thing for financials

But what about inflation? Fears about rising prices and higher interest rates from the Federal Reserve sooner than expected have hurt stocks in the past week, including the top banks.

That might be an overreaction, though. Some experts note that the financials should actually benefit from a so-called reflation trade as the economy rebounds from the depths of the coronavirus recession.

“We expect loan demand to pick up as businesses begin to invest for growth again. During the pandemic, corporate and small business borrowers limited drawdowns and tapped capital market sources of funding instead of commercial borrowing,” said UBS Global Wealth Management analysts Laura Kane and Michelle Laliberte in a report this month.

“Commercial and industrial lending should tick higher as capex picks up, and the potential for rising interest rates on the back of stronger economic growth should be supportive of financials,” they added.

So it might be a Goldilocksian time for the banks. The economy is growing just enough to give a lift to their lending and investment banking businesses but the stocks don’t reflect all the good news just yet.

The financials remain the cheapest sector in the market right now, trading at just 14 times earnings estimates for the next 12 months, according to FactSet.

That’s a huge discount to the broader market. The S&P 500 is now trading at 22 times earnings forecasts — well above its 5-year and 10-year averages.