Franklin Equity Group Vice President and Portfolio Manager Matt Quinlan explains why he thinks US banks could benefit from a more favorable economic and regulatory environment. Given this healthy backdrop, he believes select large-cap bank stocks may increase dividends and stock buybacks in the next two years.

Although valuations appear stretched in certain pockets of the US equity market, we see value in specific sectors. In particular, we like the prospects for US banks.

In our view, select large-capitalization US banks are likely to benefit from a growing US economy, higher interest rates and a less-restrictive regulatory environment. As a result, we think they have room to increase dividends and stock buybacks as earnings improve and capital is freed up.

Favorable Economic Backdrop

At this time, US economic growth appears to be on solid footing, with tailwinds from tax reform as well as some near-term fiscal stimulus. As the US economy continues to grow, we think select banks are likely to see increased loan and capital markets activity.

In addition, we think the upward momentum in US interest rates is likely to lead to higher bank net-interest income growth, and as a result, greater profitability potential. The US Federal Reserve (Fed) has said it plans to continue to raise interest rates as the economy improves. At its March monetary policy meeting, the Fed reaffirmed its projection of three interest-rate hikes in 2018, which would put the federal funds rate at 2.1% by the end of the year. Also, the Fed projected the fed funds rate will rise to 2.9% by the end of 2019.

Improving Regulatory Environment

In the past year, the regulatory backdrop for the US financial sector has improved for the first time since the global financial crisis (GFC) a decade ago. President Donald Trump’s administration has proposed rule changes that would allow banks to hold less capital, based on how much leverage they hold.

US banks have worked to build up their capital ratios since the financial crisis. Now, we think regulators seem generally confident that bank capital ratios are sound. These institutions performed well in government-mandated stress tests last year, which allowed them to return capital to shareholders. We believe they are likely to continue to perform well.