Financials Stocks Should Handle Rising Interest Rates Better Than Other Sectors

The Morningstar US Financial Services Index has outperformed the Morningstar US Market Index over the previous year, returning 60.9% compared with 58.4%, and significantly outperformed in the previous quarter, up 14.3% compared with the market, which is up 6.0%.

Financials outperformed in the first quarter - source: Morningstar

After the recent increase in stock prices, the median North American financial sector stock trades at a 10% premium to its fair value estimate compared with about a 6% premium at the end of the fourth quarter and a 27% discount at the end of the first quarter of 2020. Many financial sector stocks are fairly valued according to our assessment, with the few North American financial sector stocks that we cover that are trading at meaningful discounts to our fair value estimates having company-specific issues and are turnaround stories.

While there are few bargains in the financial sector, many stocks should outperform other industries in a rising interest-rate environment. We currently rate less than 10% of the North American financial sector stocks that we cover as undervalued 5- and 4-star stocks, about 60% as fairly valued 3-star stocks, and over 30% as overvalued 2- and 1-star stocks.

Most financials are fairly valued - source: Morningstar

While short-term interest rates as represented by the effective federal funds rate have remained near 0.08% over the previous couple of months, longer-term interest rates as represented by the 10-year U.S. Treasury yield have dramatically increased. The 10-year U.S. Treasury yield has recently climbed to over 1.6% from an average of 0.86% in the fourth quarter of 2020.

Long-term interest rates have dramatically risen - source: Morningstar

Some people have attributed recent stock market movements and shifts in the performance of sectors to prospects for higher inflation and interest rates.

Many financial sector business models benefit from higher interest rates. Banks and companies with banking operations, such as retail brokerages and wealth management firms, benefit from investing client deposits into higher-yielding assets, such as loans and fixed-income securities. Net charge-offs of bad loans have remained low so far but will likely tick up later in 2021. Insurers may also benefit from higher yields on their investment portfolios, but their profitability also depends on insurance pricing and loss rates.

Charge-offs are low but expected to increase later in 2021 - source: Morningstar

Top Picks

American International Group (AIG)
Star Rating: ★★★★
Economic Moat Rating: None
Fair Value Estimate: $60
Fair Value Uncertainty: High

American International Group announced upcoming changes to its management team and its intention to separate its property/casualty and life insurance operations. At the start of March 2021, Peter Zaffino took over as CEO, with former CEO Brian Duperreault moving to executive chairman. Arguably, Duperreault’s work as CEO remained unfinished, but Zaffino has been a key lieutenant in the company’s turnaround efforts, and we see this move as confirmation that AIG will maintain its positive course. From a strategic point of view, we also like AIG’s announced intention to separate its life insurance operations.

Berkshire Hathaway (BRK.B)
Star Rating: ★★★★
Economic Moat Rating: Wide
Fair Value Estimate: $293
Fair Value Uncertainty: Medium

We are impressed by Berkshire Hathaway's ability to generate high-single- to double-digit growth in book value per share. Believing it will take some time before Berkshire succumbs to the impediments created by the size of its operations and that the ultimate departure of CEO Warren Buffett and Vice Chair Charlie Munger will have less of an impact on the business than many believe, we are always looking for opportunities to put money to work in the name. Berkshire currently has a ton of cash on hand and a disciplined share repurchase program, making it an ideal defensive name in a slowing economy or down market.

Wells Fargo (WFC)
Star Rating: ★★★★
Economic Moat Rating: Wide
Fair Value Estimate: $52
Fair Value Uncertainty: Medium

We think Wells Fargo offers unique upside. It comes with a lot of baggage, which is one reason we believe the stock is so cheap. The risks are real, and the company is still in turnaround mode. If rates stay at zero forever, we think Wells is roughly fairly valued. If Wells gets the benefit of the doubt for future rate hikes, like its peers, we see material upside for this rate-sensitive name. We also see the asset cap being lifted and future expense cuts as further catalysts for Wells that could drive additional outperformance.