Financials: A Rising Rate Environment Helps, but Don’t Look Past other Opportunities

In the post-election equities rally, financials were among the top returning sectors in the U.S. Since their early March peak, however, the sector has incurred greater losses than those of the broader market.

The initial optimism was premised on the anticipation of a friendlier regulatory environment and rising interest rates. While the Federal Reserve (Fed) delivered on the latter, details on culling the regulatory overhang faced by financial firms have yet to materialize. Indeed, the sector’s recent volatility – along with that of broader equities – has, in part, been driven by investors reassessing the likelihood that all the pro-growth initiatives already priced into stocks actually materialize. Despite recent volatility, we maintain a favorable view toward financials, not only in higher-profile segments such as banking, but in other, often overlooked, pockets.

With regard to banks, the Trump administration’s promised regulatory rollbacks could ease capital constraints and encourage lending. That, in turn, would boost banks’ earnings growth, and a number of firms are well positioned to benefit from rate hikes. The extended period of low interest rates weighed on banks and other financial intermediaries. That headwind could become a tailwind if the Fed sticks to the rate-hike path it put forth at its March meeting.

We recognize the benefits higher interest rates would have on banks’ net interest margins – a key measure of banking profitability. We also see the relief higher rates would provide to balance-sheet driven financial firms, such as insurance companies, in helping them meet future liabilities.  Yet, more goes into a bank’s success than macro factors. We like banks that will not only benefit from rate hikes but also have strong management teams, high or improving returns, and revenue streams that could see accelerating growth. Examples of these revenue streams include fees from wealth management, payments, investment banking and trading.

More than banks and insurance companies

It is in this sometimes- neglected space that, in our view, lie some of the most attractive opportunities with the most robust secular tailwinds. Providers of data, analytics and technology services to financial companies are an increasingly attractive area of growth. Demand for these services is rooted in a wide variety of functions, including trade execution, index construction, risk management, payments and loyalty programs. We believe that the ongoing transition to electronic payments remains one of the most attractive areas in financials. The winners in this space will have advantaged business models that will continue to offer clients value-enhancing products throughout the business cycle.

The outlook for the U.S. economy has grown more positive but depends, in part, on still-unknown government policies. While recognizing that the climate may swing in favor of banks, we believe investors will also be rewarded by focusing on innovative financial firms that rely upon more than a sturdy macro environment to grow.

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