As Rates Rise, Financials Can Shine

As Rates Rise, Financials Can Shine

Summary

The pandemic forced central banks to slash rates and restart the quantitative easing measures first rolled out during the financial crisis.

Near-zero interest rates in the United States and negative rates in Europe have compressed net interest income.

After several years of strong markets and large volumes of equity and debt issuance, the US and European banks with significant capital markets businesses may struggle.

KanawatTH/iStock via Getty Images By Andrew Dinnhaupt, CFA, Portfolio Manager, Research Analyst, Franklin Mutual Series & Luis Hernandez, Portfolio Manager, Research Analyst, Franklin Mutual Series

Mutual Series’ analysts see value opportunities in the financials sector as the interest-rate environment turns more favorable in the United States and European banks see greater clarity about the impact of the Russia-Ukraine war.

It has been a bumpy 2022 so far for the financials sector, and value stocks more broadly. As a major part of the value indexes, the sector’s performance can influence how the style performs. With the US Federal Reserve (Fed) raising interest rates again, the environment for both financials and value may be turning more favorable, in our view. After a lengthy period of historically low interest rates, rising rates can help boost earnings for financial companies, particularly for those that lend or invest their premiums in fixed income. Banks are also seeing a sharp pickup in loan demand, further supporting more positive industry fundamentals, and creating new opportunities in both the United States and Europe. The longer the war in Ukraine rages and energy prices remain high, however, the greater the potential for a sharp deceleration in global economic growth, which may abruptly end this tightening cycle. Author Lower for (Not Much) Longer

It seems like a lifetime ago that 30-year fixed-rate mortgages were above 15% and money market yields were measured in actual, whole percentage points. Financial stocks across the developed world have been coping with a historically low interest-rate environment for over a decade. In response to the 2008 financial crisis, global central banks slashed interest rates. It was only when the recovery was well underway in late 2015 that the Fed began raising rates again, ending the tightening cycle in 2018.

The pandemic forced central banks to slash rates and restart the quantitative easing measures first rolled out during the financial crisis. As a result, some financial companies have seen their profitability suffer, dragging down stock prices. Near-zero interest rates in the United States and negative rates in Europe have compressed net interest income (NII), or the difference between the income banks generate from their lending and their funding costs, like the interest rates they pay out on deposits.

For banks, as rates rise, they are generally able to boost the interest they charge on newly originated loans and existing loans with floating interest rates faster than they increase what they pay out on deposits. Loan origination is picking up, as people burn through the money they saved during the pandemic and companies borrow more amid the healthy economic environment. Eventually, higher rates will lead to higher deposit rates, but we believe it may take several hikes before banks feel any pressure from the pinch of higher funding costs.

For life insurers, rising rates mean they can invest their premium income at higher rates, improving the yield on their investment portfolios. Other areas of the sector that make money from interest-rate differentials may also see a profit benefit from higher rates. Author Location, Location, Location

Globally, we see clear valuation discrepancies between the United States and Europe. Europe remains behind the United States both in terms of economic recovery and when the first interest-rate increase might occur. Some US bank stock prices are already baking in a more favorable rate environment. We think large-cap US banks that have been improving their businesses offer some good opportunities for value investors.

In Europe, banks have become even cheaper following the Russian invasion of Ukraine and resulting weakness in the sector as investors assess the impact. Although the greater economic uncertainties in Europe stemming from the spike in energy prices and any exposure to Russia and Ukraine may temper the outlook in the near term, particularly if banks are forced to raise their provisions for bad debts, we expect any jolt is likely to be to bank earnings and not banks’ capital. Moreover, we view the recent selloff in banks across the region as overdone given the potential impact.

Among the large-cap banks, European valuations look more attractive to us than US valuations, mirroring a similar […]

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