It’s been a tough few years for financials. Having been the cause of one of the steepest global recessions in living memory, the operating environment for most financial businesses has been about as difficult as it can get.
Regulatory scrutiny fuelled by political and public distaste at the way banks and their like have been operated has significantly increased the cost of doing business. Barely a week passes without global banks somewhere incurring yet another fine for one form of malpractice or another. Many of these indiscretions have actually occurred since the crisis, doubling the public ire and bringing even more regulatory burden onto their businesses.
On top of this, not only has the cost of business increased, but central banks’ zero interest rate policies have crushed their returns. Net interest margins at banks have fallen relentlessly over the years. In the past, banks would compensate for a lower return on assets by increasing leverage, but in the post-crisis world with higher capital requirements this source of juicing returns is no longer available. The insurance sector has also suffered through low investment returns on its large pool of customer assets, potentially creating problems between assets and liabilities further down the line.
Unsurprisingly given this, the financial sector has not been a particularly rewarding place to invest. While global markets have soared, the depressed returns achieved by the financial sector have seen their performance lag. Indeed, with the S&P 500 about 35 per cent higher than its pre-crisis levels, the US banking sector is yet to regain previous levels. Worse, since US house prices began to fall in 2006, an event deemed impossible by most risk models at the time, the US banking sector has underperformed by almost 60 per cent relative to the S&P 500.
The insurance sector has not really fared much better with 35 per cent underperformance. And don’t even get started on the European financial sector. With little to no economic recovery and saddled with huge debt levels, the sector is languishing almost 70 per cent below its pre-crisis levels.
However, things are beginning to change. While being a bond investor has been extremely painful of late, as government bonds have sold off aggressively, the prospect of higher interest rates, particularly in the US, has seen financials burst to life for the first time in many years.
US banks are closing in on their previous pre-crisis levels and are now at a 52-week relative high compared to the wider market. Life insurance names have also rallied strongly of late after treading water for the past couple of years. In fact, fully 27 per cent of financials in the large and mid-cap sectors in the US are now at 52-week highs, far more than any other sector across the market.
All of this has been driven by the rapid rise in 10-year treasury yields from less than 2 per cent to almost 2.5 per cent in the past few weeks. This significantly boosts the earnings outlook for all financials if higher rates are here to stay. After an extremely lacklustre first quarter, the US economy appears to be back on track with some better economic reports more recently. This, coupled with more hawkish rhetoric from the Fed, has led to expectations for the first interest rate rise in almost a decade coming sometime this year rather than waiting until next.
Because of the financial sector’s long underperformance, valuations also remain compelling despite the recent moves. US banks on average are only trading at a slight premium to book, in stark contrast to as much as two-times book pre-crisis. Life insurance names look even better value as they remain at a discount to book compared to a significant premium pre-crisis. In the context of a market that is trading towards the top end of its historic range of valuations, then even if returns will never climb to previous highs the sector still appears to offer very good relative value; and with a recovering economy and rising rates, a healthy overweight in US financials looks like a must.
European financials look even better value, but warrant some caution given the different economic and monetary conditions. Trading well below book, as a value play they also look quite compelling. However, unlike the US, the banking system has not been properly recapitalised and banks are continuing to deleverage.
Many banks’ balance sheets continue to hide some extremely poor quality loans – a situation made viable by rock bottom interest rates. The ECB will be in no hurry to raise interest rates and the recent back-up in government yields will probably not persist unless economic growth really starts to pick-up rapidly. In Europe it is worth sticking with the higher quality plays in the financial sector, if having any at all, but the case for US financials appears incontrovertible.
Jake Robbins is senior investment manager at Premier Asset Management.