When the bond market starts pushing interest rates higher, equity investors look for a silver lining. One is the financial sector.
Global 10-year interest rates are rising on stronger growth forecasts, putting pressure on expensive areas of equity markets such as technology. Higher rates reduce the value of the future cash flows of such sectors. However, financials have a history of outperformance in such an environment.
The sector experienced robust share price gains in the wake of the early 1990s recovery from recession and during 2003 when the dotcom bust and accounting scandals abated. Financials also led the equity markets higher from the low of March 2009, even after banks were the epicentre of the global financial crisis. The current rebound for financials dates from November when vaccines paved the way for the global economy to fully open up later this year.
That comes after a mostly difficult 12 years for the banking industry despite periods of stock outperformance such as in 2009. Those years have been marked by tighter regulation, increased capital requirements, cost-cutting rounds along with jaw dropping fines and penalties for numerous lapses.
Financial groups also suffered in this period from the prolonged period of negative and ultra-low interest rates. This has put a squeeze on the profits they make from effectively borrowing funds in the form of deposits and lending at higher longer-term rates.
Now things are looking brighter. In the longer term, financials are expected to benefit from greater consolidation and more cost efficiencies while the industry embraces and benefits from the digital revolution sweeping through finance.
In the short-term, banks benefit from a reflating global economy that increases demand for loans and pushes interest rates higher, boosting the profits on lending.
“Interest rates are crucial for the relative performance of financials,” says David Lefkowitz, head of equities, Americas at UBS. He says there is a reasonable argument that US 10-year rates will be higher than 1.5 per cent over the next 12 to 18 months.
For the past decade, UBS research found that 53 per cent of the share price performance in financials is influenced by a shift in 10-year rates, making them the most responsive group to the bond market.
Despite the recent jump in bond yields, bank stocks remain cheap in relative terms. Over the past 12 months, the MSCI All World index has gained 24 per cent, while the global bank index has risen by 10 per cent. In the US, the S&P 500 (.SPX) has risen 22 per cent, while financials are up 15 per cent.
In valuation terms, the constituents of the S&P 500 index trade on a multiple of price to expected earnings over the next 12 months of 22.1 times, according to data company FactSet. The financials are the cheapest main group within the index at 14.6 times.
“The catch-up trade still has a lot more room to go,” says Mike Mayo, a veteran bank analyst at Wells Fargo. Together with stronger growth prospects, buybacks, technology cutting costs and improving credit fundamentals, Mayo reckons, “banks will outpace the broad S&P 500 over the next two years”.
In contrast with previous recessions dating back to 1990, the pandemic slump has not left banks exposed to a welter of bad loans. After US banks amassed large loan loss provisions last year, Mayo says there is a good chance that two out of every three dollars set aside will go unused and are eventually released.
An important swing factor this year is the degree to which the broader recovery in activity prompts stronger loan demand. “An improving economy and stronger loan growth from small businesses will boost bank profitability,” says Lefkowitz. “That lack of top line growth has been a problem for banks over the past decade and a material change in lending would be a big deal.”
Given the speed at which markets have priced in the 2021 rebound, investors may well start trimming their exposure to financials before the end of the year. This is more likely if a hotter economy openly challenges the easy policy stance of central banks.
However, there are grounds for arguing that the case for investing in banks will become more compelling in the next few years. A wave of consolidation beckons as traditional lenders seek greater scale as they adapt to a more digital economy.
“What’s really different for financials in this recovery is the secular story and we think US banks will ultimately be the big winners of this business cycle,” says Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management.
“The demands of cyber security, technology, and contactless payment systems over the next three years requires scale and large US banks will acquire fintech businesses and transform their models.”
So banks have a brightening fundamental story that could soak up money coming out of recently hot areas of the share market. Could we see a repeat of what happened in 2013? Then US financials rose by one-third and shrugged aside a bond market tantrum that saw a doubling of the 10-year interest rate to 3 per cent.
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