COF: 2 Stocks and 1 ETF to Buy if You Think the Yield Curve Will Continue to Steepen

A notable development in the last few months is the strength in long-term interest rates. The 10-year Treasury yield has moved higher from 0.55% in August to a high of 1.2% this week.

The primary reasons for this strength are increased fiscal stimulus and the successful development of a vaccine, which is starting to be distributed. The latter development means that we should be returning to a “new normal” in 2021, which will lead to the unleashing of massive amounts of pent-up demand.

While long-term rates have strengthened, short-term rates have remained depressed due to the Fed’s policy of keeping rates at zero until at least 2022.

The Fed has also adjusted its framework to increase the threshold at which it will raise rates. This means the Fed is likely to look past any surge in inflation until its 2% target is achieved on a “symmetrical basis.”

This combination of long-term rates rising and short-term rates remaining flat has led to the steepest yield curve we’ve seen in years. A steepening yield curve is a bullish sign for the economy, as it reflects that investors believe that there will be stronger growth and inflation in the coming years.

The banking industry will likely benefit the most from this. That’s because banks borrow money at short-term rates and lend at long-term rates. The wider the steeper the yield curve moves, the wider the spread between show-term and long-term rates, which means increased profits for banks.

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Therefore, you should consider adding top-rated bank stocks to your portfolio, like Capital One (COF) and Ally Financial (ALLY), and bank ETFs like SPDR S&P Bank ETF (KBE).

Before we discuss these tickers, let’s take a look at the broader market:

Market Commentary

The current interest rate environment is also supportive of stock market strength. Goldman Sachs’ Jan Hatzius increased his 2022 GDP projection to 6.8%. Growth expectations are rising due to expectations that the economy will reopen in the second half of 2021.

Low short-term rates mean that borrowing costs will be low for corporations. Recently, Apple (AAPL) sold $14 billion worth of bonds for 95 basis points above Treasuries. Currently, the average investment-grade company can borrow at a rate of 1.8% for a length of nine years.

This translates into higher profits and more share buybacks – boosting EPS. At the same time, higher levels of economic growth will lead to increased profits for cyclical stocks. Usually, there’s a tradeoff between rates and growth as the Fed hikes to prevent the economy from overheating. This won’t be the case until sometime in 2022.

Given this positive backdrop, the stocks should continue to move higher. The stock market is in a “goldilocks” situation, where “bad economic news is good” as it increases the scope of fiscal stimulus, while “good economic news is also good” as it indicates a stronger economy. This is leading to a relentless bid under the market. Some evidence of this is the market moving to new highs in a matter of days following its 5% dip from late January. Similarly, the market remained higher on Friday following the slight miss in the January jobs report.

Capital One Financial (COF)

COF is one of the leading consumer finance companies with various products including credit cards, consumer credit, auto financing, and banking. This industry should be strong in 2021 for multiple reasons – household finances are in good shape, the steepening yield curve means that lending will be more profitable, and lower default rates due to an improving economy.

The pandemic depressed spending since so many outlets was unavailable. It increased incomes, on an aggregate level, due to the stimulus payments. This has resulted in household savings hitting multi-year highs, while people also paid off their debt. This means that as the economy returns to normal, demand for credit is likely to increase which will benefit COF.

Given the favorable macro environment and looming catalysts, it’s not surprising that COF is rated a B by the POWR Ratings which equates to a Buy. These ratings are compiled by weighing 118 different factors to help you identify the highest-quality stocks.

COF has a B for Growth. This is consistent with analysts’ expectations for EPS to go from $5.17 in 2020 to $13.56 in 2021. A big contributor to this growth will be fewer defaults. The company set aside $7 billion in loan-loss reserves, however, default rates have been lower than expected and should decrease further with more stimulus and improved growth.

In addition to an overall rating and Growth grade, the POWR Ratings assesses the stock based on Value, Stability, Sentiment, Quality, Momentum, and Industry. Find out more here.

ALLY Financial (ALLY)

ALLY is another consumer finance company, although it has slightly more exposure to auto financing than COF. Some of its other offerings include insurance, online banking, mortgages, and brokerage services.

Auto sales are expected to be strong in 2021 and 2022 following multiple years of lower than normal car sales. ALLY is very attractively valued with a forward PE of 7.6 which is significantly cheaper than the S&P 500’s at 22. ALLY also pays a 1.8% dividend.

The yield curve is at the steepest it’s been since 2011 which means that lending will be more profitable. Loan demand should be high as the economy returning to normal should unleash new business activity and formation.

The POWR Ratings rate ALLY a B which equates to a Buy. ALLY also has a B for Growth. Next year should bring earnings growth of 50% according to analysts’ forecasts as it puts aside less money for defaults and sees increased loan demand. Many of the catalysts for ALLY are shared by its competitors so it’s not surprising that it has a B for Industry grade.

SPDR S&P Bank ETF (KBE)

While the consumer finance companies are one way to benefit from the current economic and interest-rate climate, another option is to buy a well-diversified, low-cost bank ETF like KBE. KBE’s major holdings include First Republic Bank (FRC), JPMorgan (JPM), and Bank of New York (BNY). The ETF has a nice mix of exposure between regional and global banks.

The banking industry will benefit from the economic climate which should see strong loan demand, low defaults, and a steepening yield curve. Thus, the loans on bank balance sheets will appreciate in value, while new loans will be more profitable.

Another positive sign is that all the banks passed the Fed’s recent stress test. During the coronavirus crisis, the Fed put limits on share buybacks and dividends to ensure that banks have enough capital on their books to withstand any spike in defaults. The Fed wanted to ensure there was no repeat of 2008 when credit froze which exacerbated the downturn.

Remarkably, most banks remained profitable even during the crisis despite putting up significant amounts of money in reserves. In Q4, banks reduced reserves due to lower than expected defaults. This should continue in 2021 and lead to impressive earnings growth. Since they passed the recent stress test, banks are once again allowed to buy back shares and hike dividends which could also benefit stock prices.

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COF shares fell $0.57 (-0.49%) in after-hours trading Thursday. Year-to-date, COF has gained 18.52%, versus a 4.50% rise in the benchmark S&P 500 index during the same period.

About the Author: Jaimini Desai

Jaimini Desai has been a financial writer and reporter for nearly a decade. His goal is to help readers identify risks and opportunities in the markets. He is the Chief Growth Strategist for StockNews.com and the editor of the POWR Growth and POWR Stocks Under $10 newsletters. Learn more about Jaimini’s background, along with links to his most recent articles. More...