Wall Street Series: Frederick Cannon & Christopher McGratty; Keefe, Bruyette & Woods

NEW YORK FOREIGN PRESS CENTER, 799 UNITED NATIONS PLAZA, 10TH FLOOR (Virtual)

MODERATOR:  Welcome, everybody, and good afternoon.  Welcome to the second installment of our Wall Street series.  Every year we provide our members exclusive access to financial experts, many of whom are chief economists and heads of research at U.S. banks and banking companies, and they share their views on the U.S. and the global economy.

Today’s briefers are Frederick Cannon and Christopher McGratty from Keefe, Bruyette & Woods.  In his dual role as global director of research and chief equity strategist, Mr. Cannon guides the research effort at KBW, which provides industry-leading research on the financial sector and research coverage to more than five – excuse me – on more than – over 540 financial services.  Christopher McGratty joined KBW in 2004 and was named head of U.S. bank research in 2020, and previously he led the firm’s SMID-cap bank research team.

Our briefers will share their analysis on and insights on the global economy and the 2021 outlook for the financial services sector.  Following prepared remarks, there will be an opportunity to ask questions.  We appreciate their time today.  This briefing is on the record and the views expressed by briefers not affiliated with the department or the U.S. Government are their own and do not necessarily reflect those of the U.S. Government or Department of State.  Participation in Foreign Center – Foreign Press Center programming does not imply endorsement, approval, or recommendation of their views.  We’ll post the transcript of this briefing later on our website, fpc.state.gov, and if you publish a story as a result of this briefing, please share it with us.

After their prepared remarks, we’ll open the floor for questions.  If you have a question, please go to the participant field and virtually raise your hand, or you can submit it in writing in the chat box and I will ask the briefers for you.  And with that, let me pass it over to Mr. Cannon.  Thanks for joining us.

MR CANNON:  Thank you, Daphne.  It’s a pleasure to be here today, virtually as it is.  It’s always great to get together in person, as we have for a number of years with this group, and talk about the financial service sector.  I’m going to share my screen, hopefully, and just talk through a few slides, but really just to highlight an overall discussion about the financial service sector.

Not surprisingly, financial service stocks got very hard hit early in the pandemic during the first months of 2020 as a result of concerns about economic collapse, about credit issues, and about what’s – what the response to that would be from the Federal Reserve and from Congress.  And if we look back, when stocks hit their lows last March, financial stocks were part of that.  There was a lot of concern about the depth of the recession, both – and this was about financial services sector not just in the United States but really globally, obviously, because the pandemic was global.

Since then, as the Fed reaction to the – Fed and other global central banks’ reaction to the pandemic was to put massive amounts of liquidity into the marketplace, we did see a recovery – and also Congress and countries throughout the world create fiscal stimulus – we generally saw recovery in stock markets globally.  Financial service sectors, however, lagged during much of last year, and the concern was a few things.  Number one is that there are still real credit issues, number one; number two, that the Federal Reserve’s actions to dampen interest rates were going to harm the long-term ability for banks and other large financial balance sheet financial companies to earn any money.  And the third was the impact on dividends and share repurchase programs, with a suspension of dividends in Europe and the suspension of share repurchase and capital return in the United States.

So that was – created a tough environment for banks and other financial services through much of last year.  Beginning in – at the end of last year, beginning late in 2020, we began to see a recovery.  What was going on?  A few things were happening.  Number one was that the disparity in valuations between the financial service sector and the rest of the market that was hitting new highs became extreme.  The second issue was that it appears increasingly that the balance sheets of financial service sectors, despite the pandemic, looked good.

And what do I mean by good?  Relative, but what I mean by that is that the balance sheets – the capital coming into the pandemic was in many cases three times as strong as it was going into the financial crisis, number one.  Number two is that a change in accounting rules allowed for the banks to take big reserves early in the cycle, which meant that there was less credit concern.  As a result, as we come into 2021, we have a fairly positive outlook both in the U.S. and globally for financial stocks, including some of the largest banks.

What is driving this positive view?  Number one is stimulus bills.  Here in the United States we got a stimulus bill before the turnover to the Biden administration, and now we have the prospects of an even bigger stimulus bill.  That’s putting money into the hands of consumers and businesses, which means credit issues are off the table and we can see some loan growth.  Secondly, we do continue to – obviously fits and starts, but expect by the second half of the year broad-based vaccine programs to allow for stronger economic growth, and that is of course critical.  And third – and I return to increasingly investors globally are looking at the balance sheets of the banks and looking at the balance sheets of the insurance companies and other financial service and say hey, while this can be difficult, these balance sheets look relatively strong.

We’re not completely out of the woods by any stretch, though, as we all know for all of us living through the global pandemic.  First of all, we continue to see issues and potentially weaker economic growth here in the first quarter.  We know that there’re supply chain hurdles with the vaccine.  In addition, with these new variants, there’s concern that vaccines will take longer to have their positive effect.  And third, especially here in the United States with the Biden and Democratic administration coming in, concerns about higher regulatory impacts on the financial service sector, which we do believe is significant.  However, it is important to look back in history and recognize that if over a long period of time – and we looked back to 1952 – the stock market generally has done better under Democrats than under Republicans.  However, that’s dampened for the financial service sector a bit as a heavily regulated sector.

As you can see here, we do expect growth to accelerate here, obviously, after the significant downturn in 2020, but accelerate globally.  And the growth rate, at any rate, will be stronger in 2021 and certainly 2022 in most regions than it was in 2019.  At KBW, we have developed a restoration index, because for the financial service sector it’s not just growth rates that are important, but it’s when do we get back to the level of economic activity that existed prior to the pandemic.  That’s important because when we think about credit risk, whether people can pay their bills or not, we have to get back to that previous period of time so that we can continue to grow from there.

This restoration index, as you can see – and what we use here is also real-time indicators of the economy.  As many of us are aware, some of the traditional economic measurements, such as unemployment rate, lag what’s really going on in the economy.  And we have a number of new indicators to look at economic conditions, things like open table reservations, how many people were on airplanes during the past week, all – there’s numerous factors.  We chose 13 of those real-time indicators to put together in a restoration index, and this is where we’ve seen, as you can see, following the depths of lockdown last March we saw a recovery.  However, we haven’t really yet been able to break past that 80 percent of pre-pandemic economic activity level yet.  And I think it’s really getting that trajectory growing again which will be the key to continued growth, and there is expectations that we should start to move back towards that – back up towards that 100 percent level when we get vaccines more broadly distributed.

One of the concerns that we’re seeing – and it’s in many way helped the financial service sector – is that inflation expectations have risen (inaudible) – if you remember, bond yields were well below 1 percent in the United States – that is, a 10-year bond – through much of last year.  And now we’re – have moved back above 1 percent.  Still, historically, for most bank managers, 1 percent, even 1.1 percent seems extremely low.  But still, bond yields have moved up, steepening of the yield curve.  This has helped provide a somewhat positive backdrop for financial stocks really since last November.

However, we do believe that while bond yields have moved up and the yield curve is steeper, and we can’t necessarily forecast what bond yields are doing, we have to for the financial service sector look at a sector that is going to look at a recovery in the economy, but not one with reflation.  Because while even with stimulus bills there’s a lot of talk about deficits in the United States and globally, one of the things we’ve learned from Japan is that federal deficits and inflation – there’s really been no correlation for decades.  So as we look at the situation, we do expect to have to be in a period of time with very low interest rates and little inflation for an extended period of time and how that affects the financial service sector overall.

And that’s, as we talk about – I’m going to hand to Chris McGratty in just a minute – as we think about which stocks, which sectors we should be invested in in the financial service sector, it’s – which you should be invested in in a period of time that can go on for quite some time with a nice recovery and economic activity, but a continuation of very low interest rates.

And with that, thank you for listening to my broad intro.  We will have ample time for questions. But I really wanted to hand this off to Chris McGratty, who can talk specifically about the banking sector in the United States, which is, as we like to say, the bread and butter of KBW equity research.  Thanks, Daphne, and over to you, Chris.

MR MCGRATTY:  Fred, thanks for the intro.  And thanks for having us both today.  Just quickly, I lead KBW’s bank equity research efforts at the firm, which broadly covers north of 200 publicly traded U.S. financial banks.

Just to kind of carry the torch from the introduction from Fred, looking at the banks, in many ways this is the definition of a cyclical sector within the economy.  What we’ve seen, just to echo some of the comments from Fred, bank stocks were hit tremendously hard in early 2020, as again there were concerns with respect initially to the capital levels of the banks.  But as Fred alluded to, we came into this pandemic in a much better space, in a much better spot than when we did going into 2007 and 2008 and the global financial crisis.  The big difference is capital, and so how we view – how we viewed as a department, as a firm, the events of 2020 were more an income statement issue versus a balance sheet adequacy consideration.

And I think once we got comfortable with that and we stress-test the balance sheets, we knew that the industry, the recovery was going to look very different from 2008.  We weren’t going to see the failures that we saw last cycle.  And really we needed – there wasn’t as big of a capital-raising effort for the banks.  Now, the banks did – they did pause on share repurchases, which was a good tool.  And there was some periodic or episodic instances of dividend reductions.  But a year later, I think we feel really good about how well these balance sheets have been tested.  Again, we’re not out of the woods, but we feel good about the recovery that’s going on, and as the accounting has changed this cycle, the earnings impact and the earnings recovery is well underway.

Really, the background here is that because of CECL and the adoption of the new accounting standard in 2020, the front-ending pain from the income statement was felt last year.  And the charge-offs will eventually be felt, but we’re past a point where the earnings headwinds from credit are the most acute.

So number one, we’re constructive on the recovery that’s going on, we’re constructive on the amount of stimulus that’s been provided to the banks.  And investors that we’re talking to today are really interested in banks that can benefit from a recovery in the credit conditions in economy.

The second challenge for bank stock investors is looking at just the pre-tax, pre-provision earnings power of the banks, which is effectively pre-tax earnings minus credit costs.  Here, as Fred alluded to, this is still a really tough interest rate environment for the banks.  You’ve got a 10-year Treasury at 1 percent, you’ve got, for most of last year, a pretty flat yield curve.  And what we haven’t seen is really much loan demand, so that’s really pressuring the top line growth for the industry.  And in response, what the banks have been doing is really taking a close look at expenses.  And we’ve seen over the past six months and we will continue to see a real commitment to reducing expenses in order to preserve ROEs going forward.

The third – and third topic that we’re talking about is capital return.  After, again, being off from buybacks for most of last year, the biggest banks got a really good sign in December with the thumbs-up from the regulators to – that they were able to repurchase stock beginning this quarter.  Now, this is a big – I think it’s important for two reasons.  Number one, it’s going to deploy some of that excess capital and protect ROEs.  But number two, I think it sends a really important and constructive signal to the market that the regulators have confidence in these balance sheets and investors should feel good about capital being returned to them.

So with all of this mind, we as a department decided the best way to play this recovery was through the largest banks.  In December, we moved to an overweight position for the largest banks really for a couple reasons.  Number one, we think the profitability will be stronger than the smallest banks due in part to scale.  Number two, we think the capital return will be significant.  And number three, the biggest banks, because they have such diversified business models such as capital markets, they were able to build reserves last year at a much faster pace than the average bank, and so the ROE wasn’t impacted nearly as much.  And all these factors, along with very inexpensive valuation, as Fred touched upon, lead us to be more constructive on the largest banks heading into 2021.

The last point I’d leave you with, and then Fred and I will be happy to take questions, is the – just a comment on the structure of the market and the growth-versus-value dynamic that we’ve seen really play out over many years.  Just by way of background, growth stocks have significantly outperformed value stocks for many years due in part to the growth outlook and the superior growth dynamics that they have.

What we’ve seen since the election is we’ve seen a slow rotation back into value.  Fred talked about the widening of the valuations between growth and value that occurred last year.  I think some of – some investors took the election and some of the stimulus that’s coming to say, “Hey, the reflation trade is going to be on.  How do we play it in the most inexpensive way with a cyclical bent?”   And so the financials have caught a bid over the last three or four months, which has helped relative performance.

So, Daphne, I think Fred and I are both ready to open up the lines.

MODERATOR:  Great.  Well, thank you for your introductory remarks.  We really appreciate it.  If you have a question, please raise your hand in the virtual room and – or type your question into the chatroom and I’m happy to ask it for you.  I think our first question is going to come from Nikhi.  Nikhi, please go ahead and introduce yourself and your outlet.

QUESTION:  Sure.  Can you hear me, Fred, Chris?

MR CANNON:  We can.

MODERATOR:  Yes.

QUESTION:  Great.  Thanks for doing this.  I enjoyed your comments.  But considering the timing of this meeting today, I just have to ask you how you think about the short squeeze?  And specifically, I mean, I don’t intend to get you into the political piece of this, but broadly when people like you – both of you have CFAs I noticed.  When you look at retail investors on platforms like Reddit, the mood there is wild, the kind of talk that goes on and the way they exchange memes and then decide to buy or not.  From where you sit, how do you understand this?  What are you thinking?  And a lot of people are saying they’re here to stay.  Sure.  I mean, if that’s the case, what is it that, say, the hedge funds might have missed entirely?

MR CANNON:  I’ll take a stab at that so I can give Chris a little time to think.  Well, first of all, I mean, in my view this isn’t a negative thing.  It’s part of the democratization of the marketplace, and the more people trading and involved in the market, that’s not a bad thing in any way, number one.

Number two is that the – I think it’s educational for a lot of people.  I mean, the one thing I’ve had to explain to people that I know casually is that, yes, a stock can have more than 100 percent of its shares short.  And in fact – but that even if 100 percent-plus is short, it doesn’t mean a stock can’t go to zero.  I happened to cover a stock in 2008 that had 120 percent of its shares outstanding short and it indeed went to zero as a result of the financial crisis.

The third point is that this is trading; this is not fundamentals.  We don’t have at KBW in my view – we don’t have a tremendous amount to add because as CFAs, as you’re suggesting, we look at fundamental value and believe that over time that the noise that’s created by trading will sort itself out and get back to fundamental value, number one.  Number two, though, we also recognize that these – this trading can occur for some extended period of time before fundamental value comes back in.  And this isn’t being driven just by retail investors on Reddit.   It’s being driven by what’s going on in the passive money.  It’s being driven by hedge funds battling it out between each other.  So these kind of dislocations in the market that aren’t based on fundamentals can last.

But to be honest, as a fundamental analyst, I don’t really have any idea of how long, what price it could go to, or where it will come out, but I don’t think that – my own kind of personal view, and I don’t think this is – I’m not speaking for KBW.  My own personal view is that this isn’t – more democracy in the marketplace is kind of a cool thing.  I mean, I thought it was kind of cool, the one article I read, which I think the journalists have done a really good article, that the guys who make all this money on Reddit – and they make like a lot of money, right; hundreds, thousands.  I guess some of them made a million bucks or something like that – they celebrate.  They call each other “trendies” and – or something like that – “tendies,” and they celebrate with Chicken McNuggets or something like that – or chicken tenders, that’s it.  That’s kind of refreshing relative to some of the hedge funds handing out $75,000 Rolexes to people.  So it’s – I don’t know, I’ve kind of enjoyed it.  I don’t think it’s a – personally, I don’t think it’s a bad thing.  I think that – I would hope that regulators don’t step in and this – again, this is speaking personally – that it’s important that investors like this can participate in the marketplace.

Chris?

MR MCGRATTY:  No, I mean, the only thing I would add is as an analyst, in a normal time, some of our corporate clients, the banks themselves, get frustrated with hedge funds because they’re betting against the company.  But I think what sometimes – and maybe this is – can tie into what Fred said.  Hedge funds do provide price discovery and they do provide deeper markets, and I think when you have depth to your markets, I think over the long term that is a good thing for markets.  When you see stocks go up 100 percent in a day, I mean, that’s just not – that’s just not sustainable.  And unfortunately, I think the only way to – for those investors that have fear of missing out, I mean, the only way to get them to not to do it is, unfortunately, to have a correction.  And I think we’re seeing that in some of these – some of these stocks.

QUESTION:  Thanks, Fred.  Thank you, Chris.  I have a follow-up but I’ll come back to it later when everyone’s done.  Yeah.

MODERATOR:  Thanks, Nikhi.  So we have another question coming in to the chat room from Federico Rampini, La Repubblica, in Italy.  “Commodity prices have staged a strong recovery, mostly due to Chinese demand.  Don’t you think that in the medium/long term this might lead to a resurgence of inflation?”

MR CANNON:  Well, I mean, I think that we have seen commodity prices over the past decade rally, fade, rally, fade, but we’ve seen very little pull-through from the commodity prices into sustained inflationary expectations globally.  Do we fully understand inflation?  Obviously not.  People have – I mean, the Federal Reserve itself has overestimated inflation for the past – I date myself – I would say for the – since 1980.  So what’s that?  Forty years.  If you look at what the Federal Reserve – which, remember, the Federal Reserve has 2,000 economists – has expected for inflation and what actual inflation has played itself out as, actual inflation has continued to come in lower.

So I think that when we look at commodity prices, select commodity prices, yes, that’s an issue.  I think the one area, however, that I would say is that if we actually saw sustained increases in energy prices for a period of time at very high levels, that is one historic indicator that suggests that that could stimulate a new round of inflation.  But commodities themselves – Bitcoin – I don’t see it as affecting underlying inflation.  What we have seen and what the Federal Reserve has been very clear on in inflation is that they’re going to err on the side of re-establishing their expectations and not act until inflation gets well above or meaningfully above their 2 percent goal.  And that’s one of the reasons we think – we think we’ll keep inflation down.

Now, the other issue I would raise, though, is inflation is so low today that the risk is asymmetric.  In other words, the risk to higher inflation because of where we are today is much greater than even lower – generally than low inflation, which is where we’re at.  So I think a lot of investors will continue to be concerned about – whether it’s because of deficits or commodity prices or other issues – of higher inflation, and that’s a legitimate thing that everybody should want to hedge against.  But right now I wouldn’t say commodity prices, I wouldn’t say government deficits.  Neither of those have – even though there’s a significant view that they will cause inflation, but there’s no empirical evidence over the past two decades to suggest that they will cause inflation in the foreseeable future.

MODERATOR:  Thank you.  The next question is coming in from Gabriel Mellqvist of Dagens Industri.  He writes, “Small business has suffered the worst in this crisis.  How do you look at defaults on bad loans for the banks?  Is the worst still to come or are we over the hump?”

MR CANNON:  Chris, you ought to talk about that, especially because between the PPP program and loan deferrals I think there’s some interesting data on that.

MR MCGRATTY:  Yeah, it’s – if you were to – if you were to ask me the question without the stimulus that we’ve gotten, I think we would have seen dramatically more bankruptcies.  And that’s not to say we’re not going to see a fair share of them in 2021.  I think what Fred was alluding to is the paycheck – paycheck protection plan, which provided short-term relief for small businesses.  It was fairly effective.  It kept payrolls at a level that were not dramatically different.  And the amount of stimulus that’s been provided with paychecks to personal individuals, I mean, that’s helped stave off some of it.

That being said, I mean, there’s going to be defaults within the economy.  You looked at the retail industry.  If nothing else, I think we’ve learned that the world can operate remote and digitally, and if anything, I think some of the changes to the office – for example, Fred and I have been in New York, the New York office once in the last year.  I think the demand for office space is going to be – it’s going to undergo a structural change.  Now, this will take many years to play out versus a small business that might not make it in six months.  But some of the stimulus that’s being provided has artificially kept – and it’s a good thing – some of these defaults low.

The other thing I would mention is the way the regulators have allowed the banks to treat problem assets is different than it was during 2007.  So these deferrals, these loan deferrals that the banks have provided to their retail and commercial customers, have really allowed for a challenge for bank investors and analysts alike because the rules are different this cycle.  But the net – the net conclusion is the government’s done, I think, a pretty quick and significant response to the pandemic, and that should keep defaults lower than they would have been otherwise.

MODERATOR:  Thank you.  The questions are coming in fast and furious, so the next question comes from Jodi Klein of the South China Morning Post.  She is asking:  “How much is China’s opening up its financial markets to foreign firms going to affect U.S. financial service performance – U.S. financial services firms’ performance and their business models?”

MR CANNON:  Well, thanks for the question.  I would say when we look at the global institutions that are going to be involved in China, I think there’s kind of two views.  One is I think many firms continue to view China as a tremendous opportunity for growth, and especially with the opening of the financial sector further they continue to view that.

I think, however, both from a firm standpoint and from an investor standpoint, when we look at firms who have made major investments in Asia over the past 30 years, as all the Asian economies have really opened up, the profitability of those operations has been very mixed.  So I would say that I don’t believe at this point in time that investors – and Chris, maybe you could change that – view that China is going to create a tremendous profitability opportunity for U.S. financial institutions in the near term.  I think over time, though, obviously, as China integrates into the – more into the world economy, there’ll be many tremendous – more and more opportunities.

MR MCGRATTY:  Well said.

MODERATOR:  Okay.  The next question, we’re – I’m going to call on Alex.  Alex, can you introduce yourself and your outlet, please?

QUESTION:  Yes, good afternoon.  Thank you so very much, Daphne.  It’s great to see you.  This is Alex Raufoglu from Azerbaijan’s Turan News Agency, and I thank both briefers for their very helpful insight today.

Quick question, albeit this might be a far-fetched question.  I’m just going to try.  Can you please share your thoughts on how COVID-19 and the push to diversity is going to change U.S. investment strategy abroad, what it means for American investments in oil-rich countries such as Azerbaijan?  And what role do you see U.S. investors abroad can play in the clean energy transition?  For – I mean, it’s needless to say that some major American oil companies have already left oil-rich countries such as Azerbaijan long before COVID.

But I’m just wondering, when it comes to the broader picture, how U.S. investors can put both the pandemic and diversity in the rear-view mirror and move forward.  Thank you so much.

MR CANNON:  Well, thank you.  In terms of – regarding investments in global energy, obviously there’s still tremendous opportunities there.  As I mentioned earlier, I think that energy prices are a key to global economy inflation.

That said, I think especially with the move, the change in administration, we’re seeing kind of two issues from investors.  Number one is we’re seeing a renewed focus on ESG – environmental, social, governmental investment – investments.  That is already very strong in Europe.  It’s – it will expand rapidly in the United States, so there will be more investor focus on kind of where the environmental standards of their investment are.  What’s happening in that world is that more and more funds are kind of looking at the ESG of each of the companies they follow and scoring them and putting that ranking in.

So I would say the one area I would suggest we’re – that will change as we go forward, not just because of the pandemic but because of the changes in the administration, is there will be – and I think the pandemic has accelerated that – I think there will be an acceleration in ESG in focus for firms globally, especially coming out of the United States.

The second, which is something Chris alluded to regarding the pandemic – and I’ll let him perhaps add more – is that we are seeing the nature of transportation and transportation needs change, obviously, because of the pandemic.  We think there will be some lingering effects of that.  But I do think – again, my own view is that it’s likely to push more and more towards electricity and sources of electricity and not necessarily for fossil fuels.

Chris, I didn’t know if you had anything to add on that.

MR MCGRATTY:  Yeah, the only thing I would add is we’ve started over the last 12 months to really look at proxies for ESG disclosures, and I think a year and a half ago, many of us weren’t even in a position to fully appreciate the importance of ESG.  And so that’s something we’ve monitored as a firm.  There are certain financial institutions that have really good disclosures and really good policies, but I think that’s something that will evolve over the next several years.

MR CANNON:  Thanks for the question.

QUESTION:  Thank you.  Thank you.

MODERATOR:  The next question is from Takenori Miyamoto from Nikkei:  “President Biden is picking people who have more progressive agendas as their top financial regulators.  Examples include Rohit Chopra and Gary Gensler.  What does it mean for banking – what does it mean for the banking sector and the market?”

MR CANNON:  Yeah, I mean, I – so first of all, throughout the previous administration, we did see a relaxation of regulations across the board, and now we’re seeing a reversion to that.  I think the important thing is to keep in mind that most of – firms, especially large financial firms, never really made an adjustment to the new regime.  They kept the kind of compliance processes they had in place during the Obama administration pretty much in place – with concerns that this was probably only short-term.

So that’s – overall, therefore, I don’t think people should think that the financial service sector has to kind of go from a Trump regulation to more – super-progressive regulation, right?  Really, what it’s more – it’s adjusting to kind of a probably more progressive than Obama-era regulation, number one.  Number two is a lot of the primary regulators of financial services are going to change slowly, not rapidly.  For example, when the SEC does shift, as was suggested and CFPB will shift.  If we look at the Federal Reserve, given the timing of it, that’s going to be more for a slow change over the next couple of years.  And number two is that promulgating new regulations takes time.

So where does all that leave us?  Number one is that what doesn’t take time is enforcement.  So I think the financial service sector firms have to be very focused on potential enforcement actions by regulatory agencies that might not have been in place during the past four years, and those, because of those progressives, could be much more – much more significant.

The second is that the – that the firms have to kind of make sure and readjust back to where they were before, if they had reduced some of their activities.  And number three is selectively they may want to get things done quickly.  One of the things that we’re seeing this year is we do think we’re seeing a real acceleration in bank mergers during this year, and the reason is is the vice chairman for bank regulation will be in place until the end of 2021.  And if we look at the change that occurred of bank deals under the previous vice chair or acting vice chair Tarullo took about twice as long as they have in the most recent time period.

So I do think in select cases you’ll see more activity in anticipation of future changes.  But especially on Bank M&A, maybe that’s a good lead into – maybe Chris could comment on that situation regarding regulation.

MR MCGRATTY:  Yeah, thanks.  The one change – the big change after the 2016 U.S. election was, again, looser policies, but also they raised the bar for which a bank was determined systemically important.  So that went from 50 billion, which was in hindsight a very arbitrary line, to 250 I believe.  And so what that did is it allowed for a more free-flowing M&A environment, which is I think healthy, more healthy for markets.  And I think we see a pause in M&A activity in 2020 because of the credit concerns in the economy, but I think the pieces are in place absent a real sharp change in the regulatory environment towards banks specifically.  We should see pretty good activity, especially with markets and valuations recovering.

MR CANNON:  I would just add that it is important to recognize that if the Fed had been under more Democratic leadership and Janet Yellen perhaps had been in place at Treasury, we might not – we might have seen the dividends suspended in the U.S., because you have to remember that both Lael Brainard on the Fed, which is – she’s the sole Democrat at this point in time, as well as Yellen, and Summers and most Democrats had come out against U.S. – had come out for suspension of dividends.  So that kind of does underscore some of the concerns that investors are going to have as we see this new regulatory environment.

MODERATOR:  Thank you.  Gerben, can you introduce yourself and your outlet, please?  Go ahead.

QUESTION:  Thank you very much.  My name is Gerben van der Marel, and I want to start the video but I’m not sure, I think you don’t allow me to, Daphne, but – you have to unlock me.

MODERATOR:  You should be able to.

QUESTION:  Yeah, there we go.  Thank you.  Christopher, I think you said – you – your universe contains, like, about 200 financial institutions in the U.S.  That’s quite a lot.  Still, I wanted to ask you a little bit about Europe, since I’m from the Netherlands and following Europe a little bit more than U.S.  What we’ve seen the last five, 10 years, of course, is that European banks have been suffering.  Businesswise in the U.S., they have had trouble actually staying there or keep business, but more importantly probably on the stock market, they have been hammered, and the valuations – people compare U.S. valuations to European valuations in the financial sector, and there’s a huge gap.  What do you tell investors?  What – how do you explain that?  Is that – could you just give me an overview about what’s wrong with the European banking sector?  Thanks.

MR MCGRATTY:  Maybe I’ll start, and Fred can correct me.  I mean, I think you hit it right that the valuations are sharply lower.  As a firm, we actually are constructed on European banks, so we share your concerns.  The low interest rate environment here is perhaps even more pronounced than Europe, and what that’s doing is that’s having an effect on ROEs, return on equities.  So there is a correlation over time between the level of a bank’s profitably as measured by ROE and the valuation the market assigns.

So the other one would be the – as Fred alluded to, the U.S. didn’t go as far as Europe in terms of restricting dividends, and that’s a big – I think that’s a big change between the two markets, is the dividends and sustainability, as investors typically look to a financial institution or bank for yield as part of their total return.

MR CANNON:  Yeah, just to kind of underscore Chris, when we look at the valuations differentials, it really goes back to profitability.  If you look at the profitability of the European banks, they’re roughly half of the profitability of the U.S., and the valuations are about half on price to book as the U.S.  So that’s where it comes from.  The European banks, as you alluded to, provide a cautionary tale for the U.S. insofar as if you look over the past five years, call it, the – or really since the kind of European crisis, the – as interest rates came down to very low levels, the expectations for bank earnings continued to ratchet down almost every year as the banks had to adjust to those much lower interest rates being sustained.

In Europe, such as in the U.S., I think there’s – there was a continuing expectation for a return to normal of interest rates, and it kept being dashed.  And that’s one of the reasons in the – as we look at the – Chris studies this – is we don’t want to get caught up in a situation with our earning estimates that we’re forecasting higher interest rates in the U.S., therefore it’s going to get better.  Because I think Europe has taught us not to do that, and I’m kind of hopeful in the U.S. that that adjustment to lower interest rates won’t take five years, it’ll take one or two years, and we’re well into that.  So that’s kind of one of my hopes.

The second issue, I think, is to remember – is that the structure of banking in the U.S. is quite different than the structure of banking in Europe.  In particular, as you know, in the U.S. most banks do not hold fixed-rate mortgages on their balance sheets, especially adjustable-rate mortgages on their balance sheet, because we have Fannie Mae and Freddie Mac, an investor community to take those off.  So those low-returning assets aren’t on the balance sheets of the U.S.  And number two is the corporate loans, because of our capital markets, top-rated corporate loans are also not on the bank balance sheets in the U.S. to the extent they are in Europe.

So as a result, those two factors, those two structural factors in addition to the very – the low interest rates keep the profitability of the European banking sector below that of the U.S.  So while we do think there is – and we’ve seen the pressure on the U.S. – we don’t see, even if we do sustain a long period of very low interest rates, that we would drop the valuations of the European banks because of that structural difference.

QUESTION:  I have a quick follow-up question.  Consultation is expected in the European banking sector the coming years.  Is there any chance that an American bank will be interested to buy a European bank?

MR CANNON:  Chris, correct me if I’m wrong, but I think if – I think most investors would want to sell on that news, to be honest.  I think that, I mean, perhaps a Spanish bank or something niche-y, but in general, I think two things: number one is that U.S. banks do not have a good history of certainly retail and SME bank purchases in Europe or most anywhere else in the globe.  Number two is I think the U.S. banks feel very strongly that they can compete very effectively in the capital markets without buying, they can do it with building.  If we look at the – kind of the market share that JP Morgan’s been able to garner in the capital markets, I think they’ve been able to do it without buying, so I would think that’s a second factor.

And third, I mean, banks are going to – are looking for growth.  And so I think if there was a FinTech firm in Europe that was showing growth, I think there would be a number of U.S. banks, and maybe that would be a preferred partner for a European FinTech.  So I would think – this is just my own view, and I’ll let Chris opine – that if we see U.S. banks investing in M&A in Europe, it would be in the FinTech area, not in the traditional financial service sector.

MR MCGRATTY:  The only add I would make here is some of the foreign banks are shedding their U.S. operations.  And so PNC, I believe, bought the operations of BBVA.  There’s a rumor that HSBC is looking to exit the U.S. retail, and I think there would be demand for that asset here.  But a whole – to Fred’s point, a whole U.S. buying a foreign is not probable.

MODERATOR:  Thank you.  So we’re going to take one – we have time for maybe two last questions and we have two journalists in the queue.  So let’s go back to Nikhi for her follow-up.

QUESTION:  Sure, thank you.  And Daphne, thank you for doing this.  I forgot to thank you earlier.  Thanks so much.

Fred, Chris, what about the fee structure?  I know there’s been chatter for a long time about how hedge funds are not regulated, and the fee structure that exists currently is such that it leads to bubbles bursting.  And we’ve seen a tiny microcosm last week, we’ve seen a much bigger one in 2008, but what’s your view from where you sit?  What’s the word on the street?  How is it when you actually work with these instruments?  What are the inefficiencies in the system?

MR CANNON:  What are the inefficiencies in the system regarding kind of the trading?

QUESTION:  The fee structures, yeah.

MR CANNON:  The fee structures?  Well, I mean, the fee structures are pretty efficient from my standpoint, right.  I mean, basically everybody can trade for zero today.  I think there are some fee structures that institutional clients don’t like that could come under regulatory pressures, such as the ability for some hedge funds to pay for order flow.  In particular, I think that area is probably ripe for regulation.  In other words, if I’m a large mutual fund, the idea that some hedge fund can pay somebody to find out my order flow has forced me to go into these different markets to hide my order flow, right?  That’s kind of maybe – and is the order flow information the property of the broker or is it the property of the – a mutual fund?  I mean, those are big questions.

And I think when you start moving towards having, say, a Gary Gensler at the SEC, there’s going to be a fresh look at that kind of fee structure in the system, as opposed to the previous administration where I think it was just, whatever, whatever’s out there is out there.  I think some of the – look, we have a guy named Kyle Voigt, who was – to be an expert that we can put you in touch with to discuss that in much more detail.  He follows the exchanges and understands kind of a lot of the dynamics of it that is well beyond my capacity.  But I would say just as that example, is there’s some kind of philosophical questions about some of these fees and some of the things that are going on that are going to get – those kind of questions are going to get asked in the next four years that really weren’t asked in the previous four or 12 or 20.

Chris, do you have anything else on that?

MR MCGRATTY:  Nope.  I think, yeah, that’s a good answer.

QUESTION:  Just to understand this, tell me if I’ve gotten it right.  Essentially, the crux of what you’re saying is who does this knowledge belong to – that question is being interpreted differently by different players, and how much of that information is yours and how much is mine, correct?

MR CANNON:  Right.

QUESTION:  Okay, sure.  I’ve got it, thank you.

MR CANNON:  Is it – is there a kind of a right to privacy to a mutual fund to their order, right?

QUESTION:  Sure, sure.  Got it.

MR CANNON:  Or is it —

QUESTION:  Thank you.  Thanks.

MR CANNON:  Sure.

MODERATOR:  We have one question coming in from Dorothea Hahn.  She would like to know more details about the slow rotation into values since the November election that Mr. McGratty mentioned.  Secondly, “I would like to understand what makes stock markets do better under the Democrats, as Fred mentioned, and whether he anticipates the same phenomenon to happen this time with the Biden-Harris administration.”

MR CANNON:  Chris, do you want to take the first one?

MR MCGRATTY:  Yeah, I’ll start.  I’ll give you some perspective.  So after the 2016 election, there was great enthusiasm for financial stocks under the Trump administration.  And from the election in 2016 through March of 2020 there were approximately $23 billion that came into financial exchange traded products.  From that point through this election, we lost 95 percent of it.  So a big rush into financial stocks and then there became some concerns about the economy and late cycle and interests rates, and so all those investors that came in left.

Since the 2020 election with Biden, we’ve seen about 10 billion come in, so a little less than half of what came in last time.  I think the reason for the renewed enthusiasm to financial stocks is, number one, stimulus – right – stimulus in a cyclical economy; and number two, the search for value in a market that was pretty expensive on an absolute basis.  So those are the dynamics that have occurred.  And the banks would be the proxy as a way to play that.

MR CANNON:  Oh, yeah, it’s interesting on the – you might have seen The New York Times wrote a piece about how the economy both in terms of GDP and employment has actually performed better under Democrats than Republicans since FDR.  We did a piece that looked back to 1952, and the overall market has tended to perform better under Democrats than Republicans.

I think that says a couple things.  I think number one is that the market and the economy – the role of politics in terms of its impact on the economy and the market are overstated.  I mean, the traditional kind of view is that, “Oh, you get Republicans in there, they’re going to be great – let everything go crazy and that’s going to be all good,” and I think the George W. Bush administration was a classic example.  If you end with a financial crisis, it’s not going to be good for returns of the economy during that time period.  So that kind of underscores – we can all debate about the causes of the and the timing of the financial crisis, but things happen.

As you saw in the paper today, relative to the economy, Trump ranks last in terms of economic performance, but as much we can – whatever we believe is the pandemic had a lot to do with that.  So I think the number one lesson is that the link between politics and economics and the market is overstated, and I think most of us CFAs, as we were alluded to, in terms of financial analysis, it’s a pretty minor effect as we look at how we evaluate most of our companies and the returns that get created.

The second thing is the timing is hard to figure out, right, because a lot of times – the old adage in the market was that – is that what happens is that the market rallies on Republicans winning and then they’re never as good as the market expects.  Conversely, the market always sells off before the Democrats and the Democrats are never as bad as expected.  So the timing of – as you compare it to administrations is important.

And the third issue is is that any – for the market as a whole, what we have seen historically is any benefit of laissez-faire economics can be more than offset by aggressive government investment in the economy.  And so ultimately, those two factors, if you generally ascribe that latter one to the Democrats and the former one to the Republicans, they both have provided pretty strong economies since World War II, and neither one of them has clearly dominated.  And in fact, if anything, the more the government investment in the economy has tended to be, and I think, again, statistically it would be very difficult to say it’s statistically significant, but it’s tended to be more – shown more benefit.

MODERATOR:  (Inaudible) to unmute myself.  Well, I think that concludes today’s briefing.  I want to thank both of you so much for your time, imparting your knowledge with all of us today.  Today’s briefing was on the record.  The transcript will be posted and shared as soon as it’s available.  I’m told likely tomorrow morning.

I want to also plug two events we have coming up in this Wall Street series next week.  We will be doing two independent briefings, one with Bank of America and the other one with The New York Stock Exchange.  So we hope that you will join us for those as well.  And again, Mr. Cannon, Mr. McGratty, thank you so much and have a great day.

MR CANNON:  Thanks for having us, and I hope everybody stays safe.

MR MCGRATTY:  Thanks, Daphne.

MODERATOR:  Thank you.  You too.