“You'll notice I brought a prop to the lectern. It's a jar with the word ’transitory’ written on it. This has become a swear word to my staff and me over the past few months. Say ’transitory’ and you have to put a dollar in the jar.”
Raphael Bostic, President and CEO of Federal Reserve Bank of Atlanta. 12 October 2021
The recent uptick in inflation has been seen by the market as if not transitory then something that will subside over the coming 6-12 months, as concerns around supply-chain issues start to subside. Nevertheless, central banks globally have started raising interest rates at the fastest rate since prior to the global financial crisis. Against this background, financials, particularly bank shares, have been outperforming as they are one of the biggest beneficiaries of rising interest rates as it boosts their profitability. If interest expectations continue to rise, then we would expect the sector to follow.
How should investors be positioned if inflation does not prove to be transitory, or “episodic” as it was described by Bostic. Many have hedged with a variety of assets such as index-linked bonds despite the negative real returns they offer. Gold is often cited; equally commodities, real estate or equities, each with their own idiosyncratic risks and rewards. A few have started to consider financials, specifically banks, as an insurance policy as one of the biggest beneficiaries of higher inflation as it would lead to higher interest rates.
A 1% increase in interest rates over the course of a year would, all things being equal, result in the average earnings of US banks rising by 13%. However, as not all loans reset immediately when interest rates rise then the impact in the second year would be a 20% rise in their earnings.
For example, a 1% increase in interest rates over the course of a year would, all things being equal, result in the average earnings of US banks rising by 13%. However, as not all loans reset immediately when interest rates rise then the impact in the second year would be a 20% rise in their earnings. For Japanese and some European banks, the impact would be even greater reflecting their lower level of profitability due to the current low or negative interest rate in their countries.
As recently highlighted by John Authers, of Bloomberg and formerly Financial Times fame, in a recent article, US household deposits are by some calculations over $3trn more than they would otherwise have been if not for the pandemic. More importantly, as a consequence of the fall in interest rates and sharp fall in the levels of household debt since 2007, debt service ratios are at 40+-year lows. Equally, corporate cash levels over the past year have hit levels not seen for 70+ years. Thanks in part to government and central bank largesse, consumers and corporates are in incredibly robust health which means defaults will not be rising in any meaningful way in the short term.
Furthermore, financials are also one of those sectors that has been tarred with the brush of being a value investment, namely it trades on a low valuation relative to earnings or book value. Those investors whose investment strategies have been focused on buying value stocks have done poorly in recent years relative to growth-focused investors. In fact, in a recent research paper called Did I miss the value turn? Rob Arnott of Research Affiliates argues that value stocks as of June 2021 had almost never been cheaper, using data going back to July 1963 for the US, suggesting significant upside in share prices1.
As JK Galbraith said about forecasting: “There are two kinds of forecasters: those who don’t know and those who don’t know they don’t know”. We believe the next 10 years for financial markets will be as unlike the past 10 or the 10 before that, albeit no doubt just as volatile. Until the outlook for inflation and interest rates is clearer, having a slightly more diversified portfolio and one that includes some exposure to global banks and other financial companies that benefit from higher interest rates make sense.
1 For the US, it was estimated that value stocks were between the 95th and 99th percentile of cheapness while UK value stocks were in the 93rd and 97th percentile of cheapness.
Nick joined Polar Capital in September 2010 following the acquisition of HIM Capital, and is manager of the Polar Capital Income Opportunities Fund and co-manager of the Polar Capital Global Financials Trust Plc.
Prior to joining HIM Capital, Nick worked at New Star Asset Management. While there he managed the New Star Financial Opportunities Fund, a high-income financials fund investing in the equity and fixed-income securities of European financials companies, which outperformed its benchmark index in all six years that Nick managed it. Previously, Nick worked at Exeter Asset Management and Capel-Cure Myers. At Exeter Asset Management, Nick managed the Exeter Capital Growth Fund from 1997 to 2003 which over this period was in the top decile of the IMA UK All Companies Sector.
John joined Polar Capital in September 2010 and is fund manager of the Polar Capital Financial Opportunities Fund and co-manager of the Polar Capital Global Financials Trust Plc.
Previously, John worked for HSBC as a banker based in Hong Kong and was the head of Asian research at Fox-Pitt, Kelton. In 2003 he joined Hiscox Investment Management which later became HIM Capital. John has won Lipper awards in the equity sector banks and other financials sector in 2010, 2011, 2012 and 2013.
George joined Polar Capital in September 2010 as an analyst on the Financials Team. He is a co-manager on the Polar Capital Financial Opportunities Fund, with John Yakas, and the Polar Capital Global Financials Trust, with John and Nick Brind.
He has over 10 years’ experience analysing Europe, Asia and emerging markets. Prior to joining Polar Capital, he was an analyst at HIM Capital from 2008 where he completed his IMC.