A year after the mini-banking crisis, Ashok Bhatia, co-chief investment officer, fixed income at Neuberger Berman, sees the normalizing interest rate and yield backdrop generating tailwinds behind the Financials sector.
Investment grade spreads in the global Financials sector are almost at the same level as spreads in Non-Financials.
That is notable, given that the collapse of Silicon Valley Bank (SVB) triggered a mini-banking crisis a little over a year ago. But it could be just the start of a longer period of resilient performance by Financials sector credit, driven by the structural tailwind of a normalizing interest rate environment.
Rate cut expectations
As the collapse of SVB revealed, the initial rapid move to higher rates was a shock to those holding large amounts of fixed income with inadequate hedges, causing investors to worry about hidden holes in bank capital. An additional concern was collapsing net interest margins, as rates paid on deposits shot up faster than yields on asset portfolios could be refreshed.
Prompt interventions by the U.S. Federal Reserve prevented wider contagion. Later, in the fourth quarter of 2023, credit spreads in general tightened as investors grew confident that rates had peaked and started pricing for cuts.
More interestingly, Financials have outperformed Non-Financials so far this year, as those rate cut expectations have been dialled back. The sudden jump to high rates may have caused a lot of problems for the sector, but Financials generally benefit from higher rates for longer.
The stability that comes with the apparent peak in rates helps. It offers some assurance that deposit rates will go no higher, while also setting the foundations for an improvement in loan growth, especially in the key Real Estate sector, as borrowers start to see a cap on the current cost of their debt. In addition, in our view, managing balance sheet interest rate risk on a slow path lower should be easier than it was during a rapid and unexpected spike higher.
But stability at relatively high levels helps, too. The stability not only makes major losses on existing fixed income assets less likely, but as those assets mature, banks and insurance companies can substantially de-risk portfolios by reinvesting proceeds at yield levels unseen for 15 years.
Inverted curves
Yields levels may have normalized over the past two years, but yield curves remain inverted. Flat or inverted curves are traditionally regarded as headwinds to Financials because banks are thought of as using short-term debt to finance long-term lending.
Nowadays, however, that is a somewhat simplistic way to think about the sector. For example, consider the first-quarter reporting of Financials in the S&P 500 Index.
The earnings of traditional lending, personal, retail, business and regional banks, which are driven mainly by net interest margins, were indeed down more than 12%, on average, from a year ago. But banks with a focus on capital markets activity, whose earnings are more fee-driven, have fared considerably better. The Insurance sector’s earnings were up 45%. Other sectors, from asset management and custody banking to payments servicing, are also generally doing well. In aggregate, S&P 500 Financials earnings were up 7.7%, according to FactSet, beating analysts’ expectations for growth of just 2.3%.
We expect yield curves to normalize as inflation and central bank rates decline. That should help some of the current laggards in the Bank sector, and it’s notable that regional banks have been outperforming in the most recent credit-spread rally.
As curves steepen, the broader normalization of the rates-and-inflation environment is likely to leave us with moderately positive real yields. We think that combination improves the outlook for Property and Casualty Insurers, which have already been benefiting from high yields in their short to intermediate fixed income portfolios and, as inflation cools, may now start to get some relief from the rising costs of claims.
Structural tailwinds
Two weeks ago, there was a little flurry of excitement in the financial press when a regulatory filing revealed the “mystery” stock in which Berkshire Hathaway had been building a new, multibillion-dollar position. It turned out to be the insurance giant, Chubb.
Alongside other high-profile holdings, this investment may suggest that Berkshire sees structural tailwinds building behind the Financials sector. If so, that is likely due to the ongoing normalization of the interest rate and yield backdrop.
As credit investors, we share that outlook. Spreads have come in a lot since last October and are now very tight to Non-Financials, but these structural tailwinds limit the relative downside risk.
