Higher Interest Rates Could Lift Financials Stocks

The Morningstar US Financial Services Sector Index underperformed the Morningstar US Market Index over the previous year, returning 12.61% compared with 14.43%, but outperformed in the previous quarter, down 0.89% compared with the market's decline of 5.16%.

Exhibit 1: Financials outperformed in the first quarter.

- source: Morningstar

The median North American financial sector stock trades at a 1% discount to its fair value estimate compared with about a 2% premium at the end of the fourth quarter of 2021. We currently rate about 28% of the North American financial sector stocks that we cover as undervalued 5- or 4-star stocks, with about 56% being rated fairly valued 3-star stocks and 16% rated overvalued 2- and 1-star stocks.

Exhibit 2: Financials are looking attractive. - source: Morningstar The relative outperformance of the financial sector recently is likely due to an increase in interest-rate expectations. At the end of 2021, the median Federal Open Market Committee member believed that three interest-rate hikes in 2022 to a range of 0.75%–1% would be appropriate. However, actions and expectations have dramatically shifted, with the FOMC increasing the federal-funds rate to 0.25%–0.50% in its March meeting, and the median FOMC member expecting the federal-funds rate to rise to 1.75%–2% by the end of 2022, according to the FOMC dot plot.

Exhibit 3: Federal-funds rate expected to rise to 1.75%–2% in 2022.

- source: Morningstar

Long-term interest rates have also increased, with the 10-year U.S. Treasury's yield increasing to over 2% from around 1.5% at the end of 2021. Higher interest rates are a positive driver of earnings across much of the financial sector from banks that charge more for loans to insurers that earn more on their investable float. The positive effect of higher interest rates on financials contrasts with many other sectors where higher interest rates increase their cost of funding or could limit their ability to finance new projects.

While there is much to be currently worried about in the world, the FOMC is focusing on reining in inflation. In February, core inflation was about 6.5% and inflation including energy and food was nearly 8%. While raising interest rates won't directly relieve some drivers of inflation, such as disruptions in oil supply, it could tamp down demand to bring the overall demand and supply of goods and services into a better balance. We don’t see an immediate recession risk for the U.S., but the European situation and progress toward a "soft landing" must be monitored.

Exhibit 4: Higher interest rates are being used to rein in inflation.

- source: Morningstar

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