Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

WE’RE moving headfirst into a new economic cycle, one that’s likely to see higher inflation and the prospect of rising interest rates in its wake.

That’s prompting plenty of concern from investors, who are worried about preserving their assets’ value as prices start to rise.

Fortunately, there are some sectors out there which have traditionally performed better under such conditions. Banks, whose entire business models are inextricably tied to interest rates and therefore ultra-sensitive to any rises, are chief among them.

Today’s rising share prices reflect investors’ expectations that banks are about to enjoy better times ahead - global bank stocks are on track to record their best year since the end of the Financial Crisis.1

Here’s a look at why stock pickers are getting excited about banks, and how you can invest in them.

Making sense of banks

A bank makes money in two ways. The first is through something known as ‘net interest margin’ (NIM). This reflects the difference between the money a bank borrows at a lower interest rate - through customer deposits such as current accounts - and the money it lends at a higher interest rate - through mortgages, loans, overdrafts, etc.

NIM isn’t an easy concept, but it’s here that the special relationship banks hold with the prevailing interest rate comes to the fore.

What banks ideally want is something that resembles the ‘yield curve’ of a healthy economy. The yield curve reflects the difference on the yield available between short-term and long-term bonds.

In a healthy economy, in which interest rates aren’t low and people are confident in the present, shorter-term bonds offer a lower yield; long-term bonds, which are seen as riskier because of their greater time commitment, should offer a higher yield to compensate for that risk. In other words, the ‘spread’ between short-term and long-term widens.

Banks’ NIM relies on a similar relationship between short and long dated loans. The maturities on their assets (e.g. mortgages) tend to be longer dated than those on liabilities (e.g. customer deposits) - they ‘lend long, borrow short’.

A rise in rates means a larger spread for banks, as the interest they charge on assets tends to increase at a sharper rate than what they lose on short term liabilities. In other words, banks increase the rates they charge more quickly than the rates they pay.

Alex Wright, manager of Fidelity Special Situations Fund and the Fidelity Special Values investment trust, recently told the Financial Times that markets are factoring in “maybe [0.75%] to 1% interest rates” next year - a fair step up from their current levels of 0.1%. Wright reckons that such a scenario would boost NatWest’s profits by 24% and increase earnings at Lloyds and Barclays by 12% and 8% respectively.

Banks also make money through fees and charges on accounts. In times of economic prosperity, borrowers are less likely to default on loans, while consumers are more willing to borrow to finance their own growth, meaning banks earn more through fees and charges. When confidence is low, consumers borrow less, while the risk of default can increase in an unstable economy.

Better times ahead?

Banks have proved one of the best ‘recovery’ buys since the start of the pandemic.

Nevertheless, they’re still looking cheap. If you look at the price-to-book (P/B) ratios for the UK’s leading banks, the traditional measure for valuing banks, all of the FTSE 100 names - Barclays, NatWest, HSBC, Lloyds and Standard Chartered - have a P/B below 1, suggesting the stocks are trading at a discount to their net asset value.

Moreover, the sector is also home to many of the UK’s big dividend payers. While many banks were forced to cancel payments last year when COVID struck, those five have since resumed. Most are offering now a decent looking dividend in the region of 1.5 - 3%.

The outlook for banks’ dividends going forward look positive as they shore up their balance sheets and begin to make use of hoard of cash set aside during the pandemic.

Lloyds recently revealed its pre-tax profit of £2 billion over the three months to the end of September, nearly double that posted for the same period last year.

Lloyds was aided by a release of cash that it had been ordered to set aside for bad loans last year when the pandemic struck. The added £84 million puts the bank in a far stronger capital position than was expected - something that bodes well for future dividend payments and perhaps share buybacks further down the line.

It’s a similar story with some of the UK’s other big names. NatWest’s profits tripled in the third quarter as demand for mortgages grew and cash set aside for the pandemic rolled onto the balance sheet, while HSBC’s results exhibited similar rises. Barclays, meanwhile, benefitted from continued strong performance from its investment bank branch, driven by a boom in dealmaking. It’s an area that sets Barclays apart from some of the other, more traditional, UK banks.

HSBC is another that stands out, due primarily to its international exposure. Regions like Asia and Emerging Markets, with their expanding middle classes, represent serious growth opportunities for financials in these regions.

The company’s dividend also catches the eye. Its interim dividend announced in August takes it just shy of an enticing 4%, while a $2 billion share buyback announced in October will certainly whet investor’s appetites.

Standard Chartered sets its sights abroad too, focussing primarily on Emerging Markets. It also saw pre-tax profit jump over the third quarter, from $435 million a year ago to $996 million this time around.

Of course, spare cash won’t be on the books for ever. Investors shouldn’t get distracted by eye-catching payments. However, the combination of rising interest rates and revigorated dividends do suggest positive times ahead for a sector that’s had little to offer in recent years. We’ll see over the coming months whether banks have finally turned a corner.

Source:

1 Financial Times, 22 November 2021

Important information: Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. When you are thinking about investing in shares, it’s generally a good idea to consider holding them alongside other investments in a diversified portfolio of assets. Investors should note that the views expressed may no longer be current and may have already been acted upon. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.

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