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Financials: Potential opportunity in an unloved sector

Key takeaways

  • Financial sector performance in 2023 was hampered by the market volatility and bank closures that followed the failure of Silicon Valley Bank in March.
  • Looking to 2024, financial sector performance as a whole is likely to continue to be driven by the same broader macro concerns that have driven the overall market in recent years.
  • That said, the higher-interest-rate environment has shifted the sector landscape substantially, resulting in potential stock-picking opportunities.
  • I have found potential value in banks with high-quality deposit bases, capital markets-focused firms, and certain life insurers.

2023 may be a year financial sector investors would sooner forget—marked by the banking crisis and subsequent market volatility.

For 2024, macroeconomic issues like growth, inflation, and Federal Reserve policy may continue to be key driving forces for this sector and the broader market. Yet there could also be reason for optimism, given that many banks are actually on strong financial footing. Plus, rising rates have dramatically altered the landscape for the financial sector in the past few years—creating potential opportunity for bottom-up stock picking.

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Recovering from volatility

The defining month of 2023 for the financial sector was March, when Silicon Valley Bank suffered a bank run, triggering its closure. Regulators then closed Signature Bank and First Republic Bank—with JP Morgan Chase acquiring most of First Republic’s business. And UBS acquired Credit Suisse, as the latter saw depositors withdrawing funds and its share price declining in the aftermath of the Silicon Valley Bank closure.

News headlines around the time of these closures may have stoked investor fears and prompted memories of the many bank closures of 2008‒2009. But rather than snowball, the worst of the issues proved to be largely company-specific, and the market returned to greater stability as the year progressed.

Chart shows year-to-date price performance of the financial sector compared with the S&P 500. As of December 8, 2023, the financial sector had gained 5.10%, compared with the 19.92% gain for the S&P.
Past performance is no guarantee of future results. Financials sector performance is represented by the S&P Financial Select Sector Index. Data as of December 8, 2023. Source: S&P Dow Jones Indices, a division of S&P Global.

In terms of sector-level performance, financials fell behind the S&P 500® in March and never made up that lost ground as the year went on, although the sector showed positive year-to-date returns as of mid-December.

Looking ahead with cautious optimism

Looking ahead to 2024, there may be reason for cautious optimism. While the 2023 closures were unnerving, investors can take some reassurance that these incidents were triggered by a specific set of circumstances that may not apply across the board to banks and other financials.

The absolute level of returns for financials in 2024 may continue to be driven by the sorts of broad macro concerns driving the rest of the market. But the shifts and upheaval in the sector of the past few years may have also created opportunities for bottom-up research and stock picking to add to incremental returns.

A focus on deposit quality

The events at Silicon Valley Bank highlighted the importance of deposit quality in the current environment. For most of the past 15 or so years, interest rates have been so low that banks could pay nothing (or next to nothing) on deposits, with little risk that those deposits might walk out the door. But as interest rates have risen, depositors now may have higher-yielding options for their excess cash, such as money market funds and Treasury bonds, making deposits more vulnerable to potential flight. This is why a focus on quality deposits has become so important.

Fund top holdings1

Top-10 holdings of the Fidelity® Select Financials Portfolio () as of October 31, 2023:

  • 10.0% – Mastercard Inc. ()
  • 8.8% – Wells Fargo & Co. ()
  • 6.3% – Bank of America Corp. ()
  • 4.1% – Reinsurance Group of America ()
  • 3.0% – Chubb Ltd. ()
  • 2.7% – Moody’s Corp. ()
  • 2.6% – Marsh & McLennan Companies Inc. ()
  • 2.5% – US Bancorp ()
  • 2.5% – Citigroup Inc. ()
  • 2.4% – Morgan Stanley ()

(See the most recent fund information.)

A high-quality deposit base generally means one that is “stickier,” in that customers are more committed to their banking relationship and less likely to follow financial incentives (such as marginally higher interest rates) to another institution. This stickiness may give an institution 3 potential advantages. The first is stability, because in times of stress to the financial system, banks with sticky deposits have often been more likely to come through in relatively strong shape. The second is that this stickiness can enable lenders to fund loans at a lower cost, which has historically led to better earnings growth over time. And third, stable deposit accounts may generate more fee income for a bank. Wells Fargo (), Bank of America (), and M&T Bank ()2 are examples of banks that have illustrated this thesis.

Opportunities in turmoil from higher rates

Higher interest rates have been reverberating across the sector in other ways. For example, the level and volatility of interest rates have temporarily slowed the pace of corporate mergers and acquisitions, meaning lower fees for firms involved in debt issuance and other facets of putting deals together. However, if or when rates stabilize, such as if the Fed continues the pause it began this past fall, then deal volume could pick up again. Such a rebound in deal volume could be constructive for firms that serve capital markets, like investment banks and debt-rating agencies. Morgan Stanley () and Moody’s () have been portfolio holdings that have illustrated this thesis.

In the life insurance market, higher interest rates have allowed companies to offer products with more enticing rates. Although risks could increase in this segment if the economy weakens, in my opinion the risk-reward profile of some firms in this group looks more attractive than it has in some time. Corebridge Financial ()3 and Globe Life ()4 are life insurance providers that have illustrated this theme.

Potential value from stock picking

To sum up, a higher-interest-rate environment has considerably changed the playing field for firms across the financial sector. But a pause in rate hikes could set the stage for stock-picking opportunities in 2024, particularly among retail banks with high-quality deposit bases, capital markets-focused firms, and certain life insurers.

Headshot of Matt Reed.
Matt Reed, Fidelity Sector Portfolio Manager

Matt Reed is a research analyst and portfolio manager in the Equity division at Fidelity Investments. Fidelity Investments is a leading provider of investment management, retirement planning, portfolio guidance, brokerage, benefits outsourcing, and other financial products and services to institutions, financial intermediaries, and individuals.

In this role, Mr. Reed is responsible for the research and analysis of the financial sector. Additionally, he manages Fidelity Advisor Financial Services Fund, Fidelity Select Banking Portfolio, Fidelity VIP Financial Services Portfolio, and Fidelity Select Financial Services Portfolio.

Prior to assuming his current responsibilities, Mr. Reed covered a variety of sectors, including banks and diversified financials, global financials, financial services and tech, health care, and metals and mining. In this capacity, he was responsible for recommending securities across the capital structure for Fidelity’s High Income division.

Before joining Fidelity as a summer intern in the High Income division in 2008, Mr. Reed was director of Asia Pacific strategy and planning at MetLife, and director of finance at Travelers Group. He has been in the financial industry since 2008.

Mr. Reed earned his bachelor of arts degree in finance from Bentley College and his master of business administration degree from Harvard Business School.

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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. 1. 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. 2. Fidelity® Select Financials Portfolio (FIDSX) held a 1.54% position in this stock as of October 31, 2023. 3. Fidelity® Select Financials Portfolio (FIDSX) held a 0.92% position in this stock as of October 31, 2023. 4. Fidelity® Select Financials Portfolio (FIDSX) held a 1.55% position in this stock as of October 31, 2023.

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.

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. Investing in stock involves risks, including the loss of principal.

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.

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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