Morgan Stanley gave clients its investing playbook for financial stocks during a higher interest rate environment and President-elect Donald Trump's economic policies.
The Financial Select Sector SPDR Fund rallied 11 percent since the Nov. 8 election as of Tuesday's close.
"Financials stocks, particularly US banks, have reacted quite positively to President-elect Trump's expected policies, particularly infrastructure spending and lower corporate taxes, which are clear positives for the banks and contribute to rising bond yields on higher inflation expectations," Ken Zerbe wrote in a note to clients Tuesday.
"Paired with hawkish Fed commentary, we have greater confidence in a near-term Fed Funds rate hike and are building a 25 bps hike in Dec 2016 into our models. ... US banks benefit the most from higher Fed funds due to their short-duration asset portfolios and high exposure to variable loans (i.e., floating rate C&I [commercial and industrial], HELOC [home equity line of credit], and card loans) and/or high levels of liquidity (cash and short term securities)."
The analyst forecasts a 2.7 percent increase in the industry's earnings per share if the Fed hikes by 100 basis points during the coming year. That boost can grow to 6.5 percent if the banks let the "entire benefit fall to the bottom line."
In addition, he sees potential earning-per-share upside of 20 percent if the Republicans and Trump can pass their economic agenda of lower taxes and reduced regulation.
Here are three top U.S. bank picks from Morgan Stanley with double-digit percent return upside to the firm's price targets.