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Written by Brad Tank and Ashok Bhatia, CFA
One year after the micro-banking crisis, we see the normalization of interest rates and yields generating tailwinds behind the financial sector.
Investment grade spreads in global finance The sector is almost at the same level as the non-financial sector.
This is noteworthy, because the collapse of Silicon Valley Bank triggered a mini-banking crisis just over a year ago. But we believe this may be just the beginning of a longer period of resilient financial sector credit performance, driven by structural tailwinds to the normalized interest rate environment.
Expectations of interest rate cuts
As the collapse of SVB Bank revealed, the initial rapid move toward higher interest rates came as a shock to those holding large amounts of fixed income with inadequate hedges, causing investors to worry about hidden loopholes in… Bank capital. An additional concern has been the collapse in net interest margins, as interest rates paid on deposits have risen faster than returns on asset portfolios have updated.
Rapid interventions by the US Federal Reserve prevented the infection from spreading more widely. Later, in the fourth quarter of 2023, credit spreads narrowed overall as investors became confident that interest rates had peaked and began pricing in cuts.
More interestingly, the financial sector has outperformed the non-financial sector so far this year, as interest rate cut expectations have been reversed. The sudden jump to higher interest rates may have caused a lot of problems for the sector, but the financial sector generally benefits from higher interest rates for a longer period.
The stability that comes with a clear peak in prices helps. It provides some assurance that deposit rates will not rise, while also laying the foundations for improved loan growth, especially in the prime real estate sector, where borrowers are starting to see a cap on the current cost of their debt. Additionally, in our view, managing balance sheet interest rate risk on a slow path down should be easier than it is during a rapid and unexpected rise.
But stability at relatively high levels also helps. Not only does stability reduce the potential for significant losses in existing fixed income assets, but as those assets mature, banks and insurers can significantly de-risk portfolios by reinvesting proceeds at return levels not seen in 15 years.
Inverted curves
Yield levels may have returned to normal over the past two years, but yield curves remain inverted. Flat or inverted curves are traditionally considered a headwind for financial services because banks are believed to use short-term debt to fund long-term lending.
However, nowadays, this is a somewhat simplistic way of thinking about this sector. For example, consider the first quarter financial data reports on the S&P 500 Index (SPX).
Earnings for traditional lending, personal, retail, commercial and regional banks, which rely primarily on net interest margins, fell more than 12%, on average, from a year ago. But banks focused on capital markets activity, whose profits depend more on fees, fared much better. Insurance sector profits increased by 45%. Other sectors, from asset management and banking to payments services, are also generally doing well. Overall, S&P 500 Financials earnings rose 7.7%, according to FactSet, beating analysts’ expectations of growth of just 2.3%.
We expect yield curves to normalize as inflation and central bank interest rates decline. This should help some of the currently laggards in the banking sector, in our view – and it is worth noting that regional banks have been outperforming in the recent rise in credit spreads.
As the curves steepen, we also believe that the broader normalization of rates and the inflation environment is likely to leave us with somewhat positive real returns. We believe this combination improves the outlook for property and casualty insurers, which were already benefiting from higher returns in their short- and intermediate-term fixed income portfolios and, with inflation subdued, may now begin to get some relief from rising claims costs.
Structural tailwinds
Two weeks ago, there was a small flurry of excitement in the financial press when a regulatory filing revealed the “mystery” stock in which Berkshire Hathaway ( BRK.B ) was building a new multibillion-dollar position. It turns out to be the insurance giant, Chubb.
Combined with other notable holdings, this investment may indicate that Berkshire sees structural tailwinds accumulating behind the financial sector. If so, we believe this is likely due to the ongoing normalization of interest rates and yield backdrop.
As credit investors, we share this outlook. Spreads have widened a lot since last October and are now very tight for non-financials, but we believe these structural tailwinds limit the relative downside risks.
In case you miss it yourself
- Existing home sales in the United States: -1.9% to 4.14 million units in Saudi riyals in April
- Japan Manufacturing PMI (preliminary): +0.9 to 50.5 in May
- Eurozone manufacturing PMI (preliminary): +1.7 to 47.4 in May
- US New Home Sales: -4.7% to 634,000 units in Saudi Riyals in April
- Japan CPI: National CPI rose 2.5% y/y, core CPI rose 2.2% y/y in April
- US Durable Goods Orders: +0.7% in April (excluding transportation, durable goods orders rose 0.4%)
What should you pay attention to?
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- Tuesday 28 May:
- Standard & Poor’s Case-Shiller Home Price Index
- American consumer confidence
- Thursday 30 May:
- US GDP for the first quarter of 2024 (second smoothing)
- Friday 31 May:
- Personal income and expenditures in the United States
- Eurozone Consumer Price Index (FLASH)
- Tuesday 28 May:
Investment strategy team
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