Financials sector

Financial stocks have had an excellent 2024—ranking as one of the top-performing sectors year to date and riding strong post-election momentum into year-end. 

I see this dynamic potentially extending into 2025, particularly for diversified banks as well as transaction and payment processing firms.

2024: A banner year for financials

Buoyed by a post-election surge, the financial sector was up more than 30% as of mid-December on a price-return basis, as measured by the S&P 500 Financial Sector Index, outpacing the S&P 500^® by nearly 5 percentage points. That followed positive but lagging performance in 2023, when the sector posted double-digit returns but trailed the broader market's stronger gains.

Many of the prevailing concerns at the start of 2024—including the collapse of several small-to-mid-sized U.S. banks that proved to reflect specific issues at those banks, rather than a sector-wide crisis—were overwhelmed by a relatively strong economy and improving sector fundamentals.

2025: Financials on much firmer footing

Heading into the new year, I see companies in this sector being on sturdy ground. A primary reason for my optimistic view has been steady economic growth for the U.S. economy.

The financial sector is cyclical, meaning that the sector's performance is largely a function of the strength of the broader economy. The U.S. economy continues to show momentum and a path toward the desired “soft landing.” This would alleviate fears of a mild recession that could cut into many financial stocks.

A notable difference in market dynamics heading into 2025, compared with recent past years, is the interest rate outlook. The second half of 2024 kicked off a new rate cycle, with the Federal Reserve cutting rates for the first time since the early days of the pandemic. For banks, rate changes can present pros and cons. Banks can benefit from higher interest rates because of an increase in net interest margins (the difference between what they pay on deposits and what they earn on loans).

While declining interest rates may cut into the net interest margin for some banks, I think falling rates and a Fed in easing mode is a big reason to like financial stocks going forward. Lower rates could help boost confidence and reduce the pressure on economic growth, which would be good for virtually all industries in this sector. Falling rates may also relieve some credit risk for financial companies and potentially increase economic activity, which can lead to better deposit generation.

One cautionary note: Since the Fed's September rate cut, market-driven interest rates (particularly for longer-term borrowing) have risen. A temporary rise in market rates has occurred early in some other rate-cut cycles, and we will be watching to see if this recent increase moves beyond normal limits. Regardless, interest rates will remain an influential factor for financial stocks.

Potential opportunities

Among financial stocks, I like both diversified banks (which are larger players in the sector) and regional banks (representing mid-sized and smaller institutions). I see a bright outlook for some diversified and regional banks with strong fundamentals that appear to be well-insulated from the concerns that brought down the banks that failed during the 2023 regional banking crisis.

The prospects for certain firms in the transaction and payment processing services group look appealing to me as well. These firms are sensitive to the broad level of economic activity, including the health of consumer spending. Consumers have been remarkably resilient during the recent period of relatively higher interest rates. Now that the Fed has embarked on lowering rates, the outlook for this group could be even brighter.

An optimistic outlook for financial stocks

Of course, there are risks to financial stocks. In addition to a potential drop in net interest margins if rates are cut further, commercial real estate holdings for some financial companies remain a source of concern for lenders. If the U.S. economy were to weaken, some banks could see weaker loan demand and an increase in nonperforming loans.

But I believe the tailwinds for financial stocks appear stronger than the risks. 

With the 2024 U.S. election in the books, the likely impact for financials includes a less aggressive regulatory agenda for banks, along with a more conducive backdrop for mergers and acquisitions and other capital-market activities. And if policymakers can manage inflation while growing the economy, it should bolster confidence among businesses and consumers. That could benefit the entire financial sector, which is already heading into 2025 with a lot of momentum.