To The Moon

This sector is well positioned for a series of rate hikes in the months ahead.

Growth to value rotation was one of the popular themes in 2021. The trend is evident especially in the middle of the year where we witnessed growth oriented sectors which led market returns since the start of the pandemic began to pull back – global economies’ recovery from the pandemic shifting a gear higher provided confidence for investors to initiate positions in businesses with a cyclical tilt that has been severely beaten down. On the back of the narrative, one of the sector that stood to gain was financials.

Coming into 2022, the key theme was elevated inflation across the globe which spurred central banks to embark on a policy tightening path – emerging economies have raised rates and the Feds later followed suit, signalling plans to wind down the bond buying program and laying out a road map for a barrage of rate increases. Such a macroenvironment has its boon and bane – on one hand, it challenges valuations of companies which have expanded meaningfully and on the other, it is a tailwind to sectors like the financials. In today’s article, we will delve deeper under the hood and discuss the outlook of the financial sector moving ahead.

Chart 1: Financials have registered losses on a year-to-date basis. Source: Bloomberg

A sanguine outlook for the financial sector

The financial sector which is poised to benefit in the macro environment has registered losses this year – MSCI financials delivered returns of -8.5%. We believe that the poor performance is attributed to the risk off sentiments of market participants that comes during a period of mounting uncertainty in the market place – the war that broke out in Ukraine in late February 2022 has rocketed prices of commodities, placing additional pressure on already-elevated-inflation, leaving central banks in a dilemma as to how aggressive they should tighten to curb price pressure without risking a recession

Chart 2: CPI YoY has risen to decade highs. The CPI, compiled on a monthly basis, is widely used as a consumer inflation measure.

Having mentioned that, investors should not look away from the financial sector as tailwinds such as i) rising interest rates, ii) an acceleration of FinTech trends and iii) attractive valuations will drive the sector’s return higher in both the medium and long term.

Higher interest rates sets a powerful backdrop for the financial sector

To begin, let’s look at some of the policy path of global central banks at the current juncture. In the Western world, US central banks have approved a first rate hike of 25bps in March and market participants are pricing in 6 more hikes this year that includes a mixture of 25-50bps hikes that will take the Fed Funds Rate (FFR) to roughly 3%. European Central Bank on the other hand is slated to end its hallmark stimulus scheme in the 3Q22 as officials fear that high inflation could become entrenched – the potential for a rate hike of 25bps appears likely. Shifting to the emerging market front, countries like Brazil have been on a yearlong tightening cycle, bringing to the table the most aggressive tightening cycle in the world – over the past year, Brazilian Central Banks has lifted rates by 975bps.

Chart 3: Feds rate hike projections over the course of the year. Source: Bloomberg

In a world where rates are on a upward trajectory, it spells positive for banks as higher rates can lead to higher net interest margins and therefore an expansion in profitability. Outside of banks, life insurance companies are also beneficiaries of an environment where interest rates are high as gleaned from Chart 5 – many life insurance policies involve guarantees and therefore a majority of the products are invested in treasury securities to avoid high risk or volatilities. In essence, higher interest rates allows insurance companies to yield more returns from the premiums. Additionally, consumers will also have an added incentive to buy a life insurance contract because of the larger returns received, contributing to the earnings of these companies.

Chart 4: Rates and performance of the financial sector moves in lock step. Source: Bloomberg

Chart 5: Insurance companies benefit in a rising yield environment. Source: Bloomberg

FinTech to experience top line growth in the years ahead

The pandemic has given us the impetus to move most of our daily activities online. In this vein, financial services was not an exception. Fintech adoption soared thanks in part to social distancing measures as consumers were encouraged to utilize digital financial solutions over in person services. According to a report by Plaid, the proportion of US consumers using FinTech grew from 58% to 88% from 2020 to 2021, with a whopping 93% of users indicating that FinTech brings about convenience to them.

Moving ahead, we believe that the trend of FinTech is here to stay, driven by i) the growth of digital payments, ii) increasing investment in the FinTech space and iii) digital banking adoption in emerging economies.

Growth of digital payments: Based on a report by Mastercard, more than 100 markets saw contactless payment as a share of total in-person transactions grow by at least 50% from 1Q21 compared to the same period in 2020 – Mastercard experienced over 1 billion more contactless transactions, driven by superior growth in the US and Brazil where the combined amount of contactless transactions grew nearly 3-fold on a year over year basis. Another study of 1500 consumers by Marqeta has also found that 47% of those surveyed use a Buy Now Pay Later (BNPL) solution and over one third of BNPL users began using the solution during the pandemic. Truth is, the solution will continue to gain traction amongst consumer due to the appeal that consumers see their fixed monthly payments at the point of sale, for built in budgeting with no surprises and revolving interest.

Chart 6: Global digital payment usage is slated to increase. Source: Blackrock

Increasing investment in the FinTech space: Findings from KPMG have reportedthat 2021 saw a record number of FinTech deals that brought total investment to 210 billion – Global private equity firms were more active in the FinTech sector than ever before in 2021 and cross border M&A also saw strong activity. In our view, this trend is likely to remain resilient as companies in the FinTech segment seek to improve their business models over the longer term horizon.

Digital banking adoption in Emerging markets: Under a backdrop where adoption of digital banking services has grown significantly over the years as consumers, more specifically younger generations have a strong preference for digital offerings. This was further accelerated by the pandemic but there is still growth runaway especially in emerging markets. A report by Juniper Research concluded that over half of the world’s population would utilize digital banking services by 2026, representing a 68% in total users from 2021 levels.

Chart 7:Digital Banking usage will gain traction in the coming years. Source: Blackrock 

Valuations of the financial sector are attractive

In a market environment where inflation is sizzling hot and rates are being hiked to suppress inflationary pressure, valuations begin to matter. Growth as a whole which have enjoyed 2 good years of spectacular return are now trading at stretched valuations, making them susceptible to further correction – long duration assets are naturally more sensitive to changes in interest rates. On this note, the valuation of the financial sector stands out to us.

Currently, the sector trades below their 10-year average valuation multiple and a discount of 19% to the market on a price to earnings basis. This augurs well in a backdrop where market participants ditch high duration assets and rotate into segments that presents value.

Chart 8: The financial sector trades below its 10-year average P/E. Source: Bloomberg

Combine the attractive valuations that the sectors holds with a confluence of factors aligned to support a strong performance for the financial sector, we opine that there is an attractive long term entry point for investors who are looking for pockets of opportunity within a market place where volatility is high as market participants monitors the policy path of central banks closely.

Adding Financials into your portfolio

Investors who are looking to allocate some of your monies into the financial sector can look to the $Blackrock World Financials A2 USD(LU0106831901.USD)$  which invests at least 70% of its total assets in equity securities of companies who predominant economic activity is financial services globally. The fund is managed by Vasco Moreno who is a specialist with 28 years of experience investing in the financial sector and his team of more than 20 Financial and FinTech analyst worldwide.

What is interesting about the fund is its framework with 4 different stages that guides the fund’s stock selection process, focusing on relative value with re-rating catalyst. The first stage (Initial Company Selection) in the stock selection process uses different metrics through the quantitative value cycle for stock selection and re-rating catalyst to separate cheap stocks and value traps. Following next is Stress Testing which helps the team avoid weak businesses and sieve out stocks sieve simple business models and idiosyncratic attractiveness before moving to the third stage (theme overlay). After the first three stages, the team moves on to constructing the portfolio consisting of 30-50 stocks. Additionally, ESG is also incorporated into the stock selection process. This framework in essence allows the team to construct a strong portfolio to seek maximum returns for investors.

Performance wise, the fund has historically displayed stronger performance compared to its peers on a 3 year and 5 year basis. However, year to date, the fund has displayed the weakest performance amongst its peer group due to the notable difference in asset allocation – the fund has an overweight allocation to emerging markets. Having said that, we believe that investors should not shy away from the Blackrock World Financials fund as the narrative of a rotation into value remains well intact and emerging markets rates differential will act as a conducive backdrop for financials within the EM umbrella to perform.

Chart 9: The fund has outperformed its peers historically. Source: Bloomberg

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