OCEAN CITY — Financials have performed well recently, garnering attention as rapidly rising bond yields have hurt other segments of the market.
This week we take a deeper dive into the Financials sector to identify opportunities in the current interest rate environment. Selectivity is key, and we focus on banks, consumer finance companies and asset managers, where macroeconomic tailwinds coupled with improving fundamentals have led to positive momentum. We believe this can persist, despite ongoing regulatory and legal headwinds.
Financial services companies are tied to the overall economy, providing consumers with lines of credit and investment management, and businesses with financing and strategic deals. Since the global financial crisis, as the health of consumers and businesses has improved, banks have made progress in returning to profitability.
In fact, operating margins in the Financials sector are at all-time highs and above those of any other sector. Slightly positive revenue growth for the year is expected to translate into the strongest earnings growth within the S&P 500.
As the 10-year U.S. Treasury yield has risen from a low of 1.64% in January to nearly 2.3% this month, bond prices have declined, leading investors to ask what does well in an environment of rising rates. Our view that interest rates will rise gradually but remain below long-term averages for some time bodes well for some industries more than others.
Within the Financials sector, it is necessary to be selective, as certain segments — including banks and consumer finance companies — tend to do well when rates rise. On the other hand, stock prices for real estate companies can suffer significantly. As interest rates remain
low, investors have moved to riskier assets such as real estate investment trusts (REITs) as substitutes for fixed income, and accordingly their stock prices are acting more and more like those of bonds.
There’s another advantage for many of the companies better positioned for rising rates: They also tend to be the cheapest in the sector. Banks and consumer finance companies are trading well below their historical averages on the basis of both price-to-earnings and price-to-book value, while REITs and mortgage finance companies look expensive given their run up in the past six years.
With the labor market improving, expectations are that the Federal Reserve will raise interest rates later this year. However, we believe that when they do, it will be a slow and gradual process. Therefore, the heightened demand for income-generating alternatives to bonds is not expected to fade anytime soon.
BofAML U.S. equity strategists highlight the potential for dividend growth in the Financials sector, given better capitalized balance sheets and a focus on expenses and capital management. Cash balances held by banks have more than doubled in the last five years. In addition, the shares of many asset managers, particularly those running alternative strategies like private equity and hedge funds, offer dividend yields well above those of the overall market.
Certainly, the financial crisis continues to hang over the sector. Banks globally are still working to get bad loans off their balance sheets. Lending standards are still tight, as governments continue to refine their regulation of the financial services industry. As a result, the rising demand for credit has been increasingly met by nontraditional sources such as alternative asset managers that have stepped up with ample balance sheets to provide liquidity in the real estate market and financing for corporations. We expect this demand for nontraditional sources of lending to persist.
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)