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Financials: Finding value in an unloved sector

Key takeaways

  • While financials have generally benefitted from rising interest rates, they have remained an out-of-favor sector ever since the Great Recession.
  • Although an economic slowdown in 2023 could hurt the sector, I have found companies that could nevertheless show resilience, and in some cases have recently had low valuations.

As an economically sensitive group, the financial sector's performance in aggregate in the coming year is likely to be tied to the broader economy.

Yet despite the storm clouds of a potential slowdown on the horizon, I think that certain well-positioned financial stocks could represent solid value for long-term investors.

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A better-than-feared 2022

The financial sector declined along with the rest of the market for much of 2022. However, the group outpaced the broader market over the latter part of the year, accompanied by a fresh surge in bond yields. Rising interest rates tend to boost bank profitability by widening the differential between what banks earn (on loans they make) and what they must pay (on deposits they hold).

Chart shows 2022 year-to-date performance for the financial services sector and for the S&P 500.  As of December 9, financial sector stocks had lost 10.23% at the index level, compared with the S&P 500's 16.17% loss year-to-date on a total return basis.
Past performance is no guarantee of future results. Financial sector performance is represented by the S&P Financial Select Sector index. Data as of Dec. 9, 2022. Source: S&P Dow Jones Indices, a division of S&P Global.

Although credit performance has continued to show strength (meaning, borrowers have generally continued to make their required loan payments to banks), rising recession risk has called into question whether that strength will continue through 2023. While banks' third-quarter results continued to show the benefits of higher rates, they also included evidence of some banks preparing for the possibility of a weakening economy—by setting aside capital to cover potential losses on future credit defaults.

Still an out-of-favor sector

Ever since the bank bailouts of the Great Recession more than a decade ago, the federal government has closely monitored the capitalization of the largest US banks through a series of "stress tests" designed to simulate a variety of worst-case scenarios. The banks have passed these tests, indicating reduced risk in the group.

But despite banks' improved financial standing, some investors still seem to be avoiding the sector. As of late 2022, financials were one of the cheapest sectors in the S&P 500®, and also very cheap relative to the sector's own historical valuation patterns.

Of course, there's no way to know exactly how the current economic cycle will play out, or whether 2023 could bring an outright recession or a soft landing. But if banks are being cautious in setting aside capital for loan losses, it could mean that they are better positioned than the market expects. That could bode well for banks' ability to navigate a variety of economic scenarios that may arise, while staying positioned to benefit from any potential subsequent recovery or extension of the current economic cycle.

Areas of potential opportunity

One group I have focused on in this environment is banks with strong deposit bases and conservative credit profiles, which—along with fee income—can help them weather macroeconomic turbulence. Although banks can borrow from other banks to fund loans, it's cheaper for them to do so with their own deposits. As long as they continue to maintain credit standards on loans, such banks could prosper, even if higher rates dampen overall loan growth or trigger a spike in defaults or delinquent loans. Meanwhile, fee income tends to be recurring and can provide stability for earnings if there is an economic downturn.

Recent portfolio holdings Wells Fargo & Company () and US Bancorp () are examples of banks with long-term franchises that may have been undervalued by some investors. The former has a strong deposit base, and has the potential to see its outlook and valuation improve if it's able to move beyond the various regulatory challenges it's faced in recent years. US Bancorp similarly has a strong deposit base, and also has substantial fee income for a bank of its size. Additionally, the company recently received permission from regulators to move ahead with its proposed purchase of MUFG Union Bank's core regional banking business, which has the potential to provide opportunities for synergy.

I have also favored investments in insurance, which tends to be less economically sensitive than some other segments, because people and business by and large maintain their insurance policies even if there's an economic downturn. For example, Reinsurance Group of America (), has recently benefitted from rising industrywide rates for reinsurance, higher interest rates (which increase what insurers earn on cash), and an improving health landscape as we move beyond COVID.

Fund top holdings*

Top-10 holdings of the Fidelity® Select Financial Services Portfolio () as of October 31, 2022:

  • 6.5% – Wells Fargo & Company ()
  • 4.9% – JPMorgan Chase & Company ()
  • 4.9% – Bank of America Corp. ()
  • 3.4% – Morgan Stanley ()
  • 3.1% – Citigroup Inc. ()
  • 3.1% – State Street Corp. ()
  • 2.8% – Marsh & McLennan Companies Inc. ()
  • 2.8% – Arthur J. Gallagher & Company ()
  • 2.8% – Reinsurance Group of America ()
  • 2.8% – US Bancorp ()

(See the most recent fund information.)

These themes typify my current thinking—emphasizing company-specific drivers that could enable some firms to prosper, despite the uncertain economic outlook for 2023.

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Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully. * Any holdings, asset allocation, diversification breakdowns or other composition data shown are as of the date indicated and are subject to change at any time. They may not be representative of the fund's current or future investments. The Top Ten holdings do not include money market instruments or futures contracts, if any. Depository receipts are normally combined with the underlying security. Some breakdowns may be intentionally limited to a particular asset class or other subset of the fund's entire portfolio, particularly in multi-asset class funds where the attributes of the equity and fixed income portions are different. Under the asset allocation section, international (or foreign) assets may be reported differently depending on how an investment option reports its holdings. Some do not report international (or foreign) holdings here, but instead report them in a "Regional Diversification" section. Some report them in this section in addition to the equity, bond and other allocation shown. Others report international (or foreign) holding as a subset of the equity and bond allocations shown. If the allocation without the foreign component equals (or rounds to) 100%, then international (or foreign) is a subset of the equity and bond percentage shown.

Views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.

References to specific securities or investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. This information must not be relied upon in making any investment decision. Fidelity cannot be held responsible for any type of loss incurred by applying any of the information presented. These views must not be relied upon as an indication of trading intent of any Fidelity fund or Fidelity advisor. Investment decisions should be based on an individual's own goals, time horizon, and tolerance for risk. This piece may contain assumptions that are "forward-looking statements," which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Past performance is no guarantee of future results.

Investing involves risk, including risk of loss.

Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Because of its narrow focus, sector investing tends to be more volatile than investments that diversify across many sectors and companies. Sector investing is also subject to the additional risks associated with its particular industry. The financials industries are subject to extensive government regulation, can be subject to relatively rapid change due to increasingly blurred distinctions between service segments, and can be significantly affected by availability and cost of capital funds, changes in interest rates, the rate of corporate and consumer debt defaults, and price competition. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks. The S&P 500® Index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent US equity performance. The S&P Financial Select Sector index comprises those companies included in the S&P 500 that are classified as members of the financial sector, with capping applied to ensure diversification among companies within the index.

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