Financials Sector Flails as Coronavirus Sweeps Through

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Michael Wong: The financial-services sector has underperformed the overall market year to date, recently being down about 30% compared to the overall market at 25%. The underperformance of the financial sector is understandable given that two of the primary earnings drivers of the financial sector, interest rates and asset prices, have dropped sharply over the past several weeks. In terms of interest rates, short-term interest rates have decreased with the U.S. Federal Reserve cutting the federal-funds rate 150 basis points to a target range of 0% to 0.25% in March to deal with the negative economic impact of the coronavirus. This compared to a target range of 1.5% to 1.75% at the end of 2019 and a recent peak of 2.25% to 2.5% at the end of 2018. The 10-year U.S. Treasury yield that is representative of long-term interest rates has also fallen to about 0.6% from 1.9% at the end of 2019. Many financial industries are sensitive to changes in interest rates such as banking, insurance, and investment services.

We entered into a bear market for stocks, and corporate bonds are also in negative-return territory as credit spreads have widened. The decrease in asset prices, may not only affect financial-service industries whose primary business is managing client assets such as asset- and wealth-management firms, but other types of companies that hold assets on their balance sheet such as insurers and investment banks. In the near term, earnings for many financial-service companies may significantly fall and liquidity and solvency concerns may surface like they did in the financial crisis. There are also risks that will take several quarters or years to gauge such as loan losses, insurance claims, and duration of the low interest-rate environment. With all that said, we think financial institutions have entered this downturn with better balance sheets, better business models, and more-reliable regulators than they did a decade ago. So we don't believe there will be nearly as much value impairment in the sector. Consequently, we also assess that many financial-sector companies are trading below their long-term intrinsic value, with the median North American financial-services stock that we cover trading at a 27% discount to its fair value estimate and the banking industry looking the most undervalued. Several high-quality names currently trading at a discount to our Morningstar fair value estimates include Berkshire Hathaway, Broadridge, and U.S. Bancorp.