Recently, financials have largely been shunned by investors, with the conflict in the Middle East reinforcing investor concerns around economic growth, inflation, and the interest rate outlook. However, the negative market sentiment exaggerates the headwinds this sector faces, given the resilient underlying growth environment, contained inflation pressures, and ample cushions against systemic risk. Yet the market may be overlooking an important second-order effect: banks are not only a potential diversifier away from today’s crowded technology trade, but also a beneficiary of the AI-driven capital cycle through stronger loan demand, debt issuance, and capital markets activity.

The financials sector has lagged the broader equity market since the start of the year. In fact, it has been the second worst-performing group within the S&P 500 on a year-to-date basis, returning 2.3% versus 9.8% for the overall market. 

Several macro, yield curve, and idiosyncratic factors have contributed to its underperformance:

• Macro: The energy shock tied to the conflict in the Middle East has lowered growth expectations and increased economic uncertainty, as questions remain on when energy and trade flows through the Strait of Hormuz will fully normalize. A renewed increase in gas prices could lead to further deterioration in household balance sheets. With consumer credit defaults already elevated, this has added another headwind to sentiment for financial companies, which are highly exposed to the business cycle. 

• Yield curve: As energy prices have remained elevated and inflationary risks have caught the attention of the Federal Reserve, markets have pivoted to pricing in a more hawkish policy rate path this year. With near-term hikes more likely than cuts, the yield curve has flattened since February. This dynamic has weighed on net interest margin, negatively impacting profitability for the financials sector.

• Idiosyncratic factors: Ongoing concerns of distress in private credit and potential contagion risks have cast a large shadow on financial companies exposed to this asset class. It has also led to fears that the linkages underpinning the growth of private credit in recent years have increased systemic financial risks that could negatively impact the sector.

While the challenges facing financials should not be dismissed, investors appear to be pricing in a much more adverse outcome than currently seems likely. In particular, underlying growth momentum remains resilient, the bar for Fed rate hikes is fairly high, and financial contagion risks are far from those seen during past crises. 

Growth momentum: Despite the overhang from higher energy prices, the economy has proven more resilient than expected. It has been lifted by buoyant consumer spending, which is supported by low unemployment and subdued layoff activity. Corporate earnings momentum has remained very robust amid a powerful AI-driven investment tailwind, with aggregate profit margins now at the highest level in history. 

Rate hike expectations: Markets have increasingly priced in a more hawkish Fed this year, yet the hurdle for additional rate hikes remains high. There is limited evidence of a problematic broadening in underlying inflationary pressures—inflation expectations remain anchored, and wage pressures contained. Moreover, with Fed Chair Warsh’s task forces reviewing the broader conduct of monetary policy, the Fed is likely to move cautiously while awaiting findings expected by year-end, reinforcing our view that policy rates will remain on hold throughout the rest of 2026.

Ample cushions: Ongoing distress in the private credit space is an idiosyncratic risk that warrants monitoring, but contagion risks to overall financial stability should be limited. Aggregate banking system leverage is much lower today than during the 2008 financial crisis, and the banking sector holds far wider capital buffers, allowing it to better absorb financial distress before reaching insolvency. Banks have been much more cautious in maintaining reserves for delinquent loans, with loss-coverage ratios for the overall banking system remaining higher than pre-pandemic averages, further reducing the risk of systemic distress.

Heightened, yet misplaced, fears about the financial sector may be causing investors to overlook a more interesting opportunity than headline sector performance suggests. For banks, the case rests on three reinforcing supports: improving earnings fundamentals, underappreciated exposure to the AI-driven capital cycle, and a portfolio role as investors look beyond increasingly concentrated technology leadership.

Fundamental backdrop: Positive earnings momentum for banks remains firmly intact, with the industry seeing upward earnings revisions for both 2026 and 2027. This trend is supported by optimism about net interest margin expansion, robust loan and capital market activity, and the move toward a more accommodative regulatory environment.

Net interest margins: Though the flattening yield curve has been a near-term headwind for bank earnings, this is likely to reverse as hawkish Fed expectations are reassessed. As the hurdle for rate hikes remains high, short-term interest rates should decline. With anchored inflation expectations keeping long-end interest rates stable, this should lead to a re-steepening of the yield curve that will help improve net interest margins. 

Loan and capital market activity: The investment incentives from the One Big Beautiful Bill have helped offset negative loan growth expectations since the start of the year. The impact of the AI capex boom on banks has also been underappreciated by the market. The nearly $2 trillion in AI capex spend over just the next two years implies increased debt issuance, which should be facilitated by banks. Combined with the robust M&A and equity issuance environment, this will provide an important tailwind for bank performance.

Deregulatory reform: With Chair Kevin Warsh now at the helm of the Fed, the path toward a more accommodative regulatory environment for banks has become clearer. His push to loosen capital and liquidity requirements should increase balance sheet flexibility for banks. Indeed, Vice Chair for Supervision Michelle Bowman has already proposed recalibrating unfavorable Basel III capital regulations. Overall, this should spur increased lending activity and enhance banks' ability to either return capital to shareholders or fund future growth. The push for faster regulatory approvals should also catalyze merger activity between banks, potentially leading to improved efficiencies within the industry. 

The overall market’s concentration remains a concern for investors, with technology now accounting for nearly 40% of the S&P 500 Index. In fact, between March 30 and July 13, ETF net buying or selling activity across the 11 major S&P 500 sectors points to investors having bought about $50 billion of Tech sector funds, significantly outpacing flows into other market sectors, which have been roughly flat. These dynamics leave investors acutely exposed if expectations for hyperscaler spending begin to soften. 

To date, financials are among the sectors used as a source of funds for investing in technology stocks. As a result, the sector could benefit if investors rotate away from crowded technology exposure and toward less-owned areas with improving fundamentals.

There are already early signs that a rotation trade may be emerging, with the latest tech-led sell-off benefiting financials. Moreover, as markets come to the eventual realization that there will be winners in the AI rollout beyond just the tech sector, banks, in particular, should stand to benefit. Together with a more constructive earnings backdrop, these factors suggest banks could participate meaningfully if market leadership continues to broaden.

Though sentiment toward financials has been overly negative since the start of the year, the sector has begun to quietly rebound in recent weeks. After months of being used as a source of funds for technology exposure, financials remain an under-owned area of the market—creating room for further upside if investors begin to rotate toward sectors with improving fundamentals and less crowded positioning.

Banks are the clearest expression of that opportunity. The industry is benefiting from both a better macro narrative, as well as several concrete earnings drivers, including the potential for net interest margin improvement, stronger loan demand, healthier capital markets activity, and a more constructive regulatory backdrop. At the same time, capital buffers and reserve coverage suggest the sector is better positioned to absorb stress than current valuations might imply.

For portfolios, banks can offer exposure to an industry where sentiment has lagged fundamentals, while also providing a useful counterweight to today’s unusually concentrated, technology-led market. If leadership continues to broaden beyond the AI trade, banks should be well positioned to participate, and potentially lead, the next phase of equity market performance.