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The Financial Sector Could Be Poised For Significant Outperformance. Most investors understand and accept the theory that a rising interest rate environment usually boosts financial stocks to outperform. We believe it is the right time for all individual investors to begin a dialog with their advisors about being properly positioned in financials. The timing could be right for adding more exposure for a couple of reasons: 1) defensive posture and, 2) positioning for a rise in interest rates. For the purposes of this discussion, we will focus primarily on the latter reason. But the following questions and observations should be immediately discussed with your advisors:
- Are you properly exposed to financials? If not, why not?
- What are the advisor's thoughts on a potential rise in interest rates?
- Is it time to play more defensively and take recent gains in tech shares?
- Thoughts on the recent surge in the market? Overheated or not?
- Is there a sector rotation looming from tech stocks to financials?
Financials can be a defensive play. The 'defensive-posture" thesis is based on the theory that the market could be somewhat overheated at this point, especially the technology space. With the superior performance over the last several years and the recent surge in technology, some believe that the market could be poised for a correction, if not an outright bear market. I am not offering an opinion as to the validity of that thought, but merely mention the observation of many supposed "experts". Financials tend to be defensive when investors get skittish about the overall market or a crowded sector. Historically, investors tend to shift out of the crowded, overheated sector and into financials as a way to buffer any downside risk. However, given the fact that many banks now participate in a large way in the capital markets businesses (investment banking, securities trading, institutional sales…etc.), the insurance space could be a more defensive play if you believe the market may be due for a correction. On the other hand, a rising interest rate environment could allow you to continue to play offense in the market.
Rising interest rates are usually very good for financial stocks. There is also a lot of talk about the potential for interest rates to rise. The Federal Reserve is responsible for setting interest rates and during the financial crisis it eased rates at an extraordinary pace in an effort to save the economy. It might have prevented a complete meltdown of the economy, but the easing did not heat up the economy. Shortly thereafter the easing continued in an attempt to stimulate growth in the economy. We may now finally be seeing the growth benefits of a decade of easing by the Fed. Many observers believe that almost a decade later, the persistently low interest rates will rise as the economic outlook seems much better, buoyed by an overheated stock market, lower unemployment and a more robust housing market, among other things.
Now that we are in a post-financial crisis mode, it seems the Fed is poised to continue tightening. Moreover, as the economy continues to heat up, the Fed could raise rates to help offset the potential inflation associated with a more robust economy. There are many reasons rates could rise, but one thing seems quite clear: there is currently no reason to assume a lower interest rate environment. Hence, if that is the case, which sector is poised to benefit more? The answer is the financial sector (excluding REITs).
If interest rates rise, do we still want an S&P 500-mirrored portfolio? Financials make up about 16% of the S&P 500 index and Consumer Discretionary stocks make up about 10%. Together, 26% of the S&P 500 would be poised to outperform the rest of the group based on the assumption that economic strengthening could force higher interest rates. Usually interest rates are raised to help offset a growing and more robust economy that leads to higher employment and a surge in the housing market. As such, consumers tend to splurge on items beyond the realm of consumer staples. Hence, the plug for consumer staples.
Financials benefit in several ways but most of the financial sub-sectors benefit due to interest rate spreads getting much wider (More on that below). On the other hand, several other S&P segments, such as industrials, utilities and telecoms typically do not do as well in the rising interest rate environment. So while diversification through a SPDR S&P 500 ETF is usually a good diversification strategy, in a rising interest rate environment an overweight position in the SPDR Financials ETF (NYSEARCA:XLF) should allow an investor to outperform the broader markets. We suggest investors discuss an overweight strategy in financials at this point. Does your advisor believe interest rates are poised to rise in the near future? If so, how is she re-balancing your portfolio to take advantage of that new paradigm?
Why do financials benefit so much from higher interest rates? To answer this question, we will break down the financial sector into two main categories (although there are a few more) that make up the overwhelming majority of the sector - Banks and Insurance companies. Both of these industries generate income by playing the interest rate spread game.
Banking Sector: In simple terms, the "net interest spread" for banks is the difference between the amount of interest it pays for borrowing funds and the interest it receives for lending funds. A loan from a bank generates income in the form of the interest rate paid by the consumer on that loan. That is the income generated by that asset (the loan). On the other hand, banks also pay out interest on "borrowed funds", or deposits, (savings accounts, Certificate of Deposits…etc). The difference between what a bank earns on its earning assets and the borrowed funds is a primary way it makes money. For example, if a bank generates a mortgage loan to a customer at 7% while taking a deposit from a customer and paying that customer 2% on that deposit, the net interest margin is 5% to the bank. However, when interest rates rise, that spread expands (say from the net spread of 5% to 7%), giving a significant boost to earnings for the bank.
How does this happen? As interest rates rise, there is always a greater spread between the federal funds rate (the rate at which the bank borrows money from the Fed) and the rate the bank charges its customers. The bank borrows from the Fed on a short-term basis (lower interest rates charged) and lends on a long-term basis (higher interest rates charged). Hence, the bank will charge the customer a much higher interest rate than what it has to pay to borrow the funds and, thus, increase the interest margin. In simple terms, if interest rates rise 1% and the bank is required to pay 1% to the Fed for funds, it will charge an additional 2% to its customers; thereby increasing its interest rate spread by an additional 1%. Of course, this assumes a normal yield curve.
Generally speaking, we suggest that most individual investors take advantage of this potential sector play by investing in a Financial ETF or index fund in order to diversify your exposure. However, for those more inclined to do a little more research, we suggest looking into individual names that are most poised to benefit. I do not endorse any particular stock or ETF, but I do believe ETFs are better for your longer term returns than by utilizing a financial broker, who adds very little value. Some names that you should discuss with your advisor (if you use one) include, but are not limited to:
- ETFs or Index Funds to discuss with an advisor:
- Bank Stocks to consider in a discussion with your advisor:
Insurance Sector: The insurance sector is another segment that benefits significantly from a rising interest rate environment. In fact, we believe that the insurance sector is poised to be the main benefactor of the rising rate environment and, accordingly, we like this space more than the bank sector. To be sure, banks' fundamentals are poised to benefit but they still have excess regulatory pressure and other baggage in the aftermath of the financial crisis of 2008-2009. The bank sector has outperformed over a one-year period, but the insurance sector has experienced better overall performance the past three, five and ten years - primarily because the insurers climbed out of the financial crisis depths much more quickly than the banks as a result of having much stronger and more resilient balance sheets (AIG notwithstanding). The one-year outperformance for the banks is certainly a positive sign that they are viewing the financial crisis in the rear view mirror. That said, it is clear from the 10-year performance that the insurers have come out of the past crisis in much better shape than banks. Prior to the economic crisis, the banks were poised to outperform the insurers. But each segment got knocked down harshly as the economic crisis emerged, but with the banks having to dig out of a deeper hole. The insurers have recovered more quickly and more prominently as evidenced by recent past performance of the SPDR S&P Insurance ETF (NYSEARCA:KIE) vs KBE (Bank Sector ETF). On a 3-year performance (through November 2017), the KIE was a slight outperformer, while on a 5 and 10-year basis, the outperformance was much more significant.
How do insurers benefit from higher rates and why do we like insurers now? Insurers flourish when interest rates rise. Some observers would even say that there is a linear relationship. Others have argued (unconvincingly) that insurers are simply "bond surrogates" since so much of their invested assets are in fixed income securities. With regard to that argument, nothing could be further from the truth. Property/casualty insurers, like Travelers (TRV), Chubb (CB), and AIG (AIG), make money two ways - on its underwriting margins and through net investment income. The investment income portion is by far the greatest contributor to overall earnings and is generated through the interest-spread strategy. The spread business for an insurance company differs somewhat from a bank. An insurer will charge a customer a premium in exchange for risk protection that is expected to be paid out in the future. For example, one pays car insurance for protection against an accident. The insured pays a premium annually and that premium is invested in fixed income producing securities (mainly bonds). The spread for that insurer is the difference between what the insurer earns in investment income from your premiums and what it has to pay out in a future claim. Hence, an insurer with longer term liabilities (like Chubb, AIG, or ProAssurance Corporation (NYSE:PRA)) will tend to benefit more in a higher interest rate environment.
Two ways to benefit from interest rates - reinvestment yields and current cash flow yields. Insurers will invest the cash flow proceeds from premiums in fixed income securities, such as bonds, that generate investment income. Roughly 80% of a P/C insurer's earnings come from investment income. Hence, that component is very important for earnings growth. Roughly 70%-75% of all invested assets for a P/C insurer are invested in bond securities that have yields based on year 1 interest rate environment. Since interest rates have been declining for many years now, the overall yield on that portfolio has been declining as well. Of course, the opposite happens when interest rates rise. The new cash flow from current premiums is invested at a higher yield, generating growth in investment income. Moreover, with an average duration of only about four years (meaning insurers only hold the bonds on average for four years until they mature) that means one-quarter of the portfolio will turn over and be reinvested when they mature. Hence, not only is the new cash flow being invested at higher rates, but the reinvestment yield on one-quarter of the asset portfolio will rise as well. Hence, there is a two-pronged benefit - the reinvestment yield on the existing, maturing bond portfolio and the higher yield on the new cash flow - that allows insurers to flourish in a rising interest rate environment.
The insurers are poised to benefit in two ways (pricing power potential and interest rates), creating excellent upside potential for the stocks. We like the potential for banks and most financial segments based on a more positive fundamental outlook for interest rate sensitive financials. In a more robust economy, banks benefit in their capital markets business as well through increased lending activity and lower incidents of loan defaults. For commercial property/casualty insurers (AIG, TRV, CB, Hartford Financial Services Group Inc. (NYSE:HIG), XL Group plc (NYSE:XL)) a more robust economy usually means a better business environment and growth in risk exposure. That growth in exposure usually means more demand for insurance. Hence, rising rates bodes well for banks and insurers as spreads widen but also benefit from a more robust economy as demand for their products typically increases as well.
But the second, less obvious, reason we prefer the property/casualty insurers right now is the potential for increased future earnings power as a result of the near-record catastrophes of 2017. The last two hard markets (robust premium growth for insurers) were in the 2002 - 2003 time frame and 2012 - early 2014. Throughout 2002 into 2003, the stocks significantly outperformed as did the stocks in 2012 to 2014. Both of these time frames were immediately on the heels of extreme catastrophic years that allowed the industry to raise prices. (Think of what happens if you get into a car accident - insurer raises your rates upon renewal). 2002 followed the year of greatest catastrophic loss that included losses associated with 9/11, while 2011 was the next greatest catastrophe-impacted year with roughly $45 billion in losses (New Zealand earthquake; Hurricane Irene; Japan earthquake & tsunami). Of course, some observers are saying that 2017 could become the most expensive year on record as a result of Hurricanes Harvey, Irma, and Maria. This should bode well for pricing for the insurers (if not for consumers) and, thus stock outperformance.
It should be noted that 2005 was also a major catastrophic year (Hurricanes Katrina, Rita, and Wilma) that merely experienced stabilization in rates after some negative growth years. However, the reason there was not more of an upward slope in pricing was due to the extreme price increases in the 2001- 2004 timeframe that experienced an average of over 15% rate hikes. Pricing had simply risen to extreme levels leading up to 2005 and, thus, the forces were against any more hikes. On the other hand, the last 4 years have seen the rate of change declining and/or stabilized for the past several quarters. Hence, the force against price increases is not nearly as great as it was in 2005. So, if 2017 turns out to be a record catastrophe year (as many expect), we would expect to see that second derivative in pricing (the velocity of the rate of change in pricing) turn upward and benefit the stocks significantly.
Bottom Line: Price increases are usually the most important determinant of performance for insurance stocks. In this regard, we believe that the major catastrophic events of 2017 could play a role in helping to temporarily boost the rate of price increases. In addition, if the interest rate environment also begins to shift favorably, we believe there could be a rotation out of some of the sectors of the S&P 500 and into the financials. This, again, would be a boost for insurance stocks as well as banks and other financials.
Some insurance names that you should discuss with your advisor include, but are not limited to:
- ETFs or Index Funds:
- Insurance Stocks to consider in discussion
- Travelers Group
- Chubb Limited
- American International Group
- The Hartford
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I do not endorse any of the stocks or funds mentioned in the article. They are included merely for example and informational purposes only.