With the era of the ‘Zero Interest Rates Policy’(ZIRP) over, and long-term secular trends accelerated by Covid, we believe an active investment strategy focusing on the best-managed banks and insurers will be the way to take advantage of this opportunity.
Traditional banking franchises are already benefiting from rising net interest margins (NIMs) as policy rates rise, which will support earnings growth through 2023 and beyond if policy rates stay higher for longer. Moreover, after reinforcing their capital structure and undergoing an accelerated digital transformation during 2020 and 2021 as Covid hit, the best banks are very well-prepared for what seems an inevitable economic slowdown.
Higher rates will also drive increased investment income for life insurance companies, and allow them to match assets and liabilities more efficiently, improving solvency ratios. Higher future yields can help both product pricing and profitability, and with attractive dividends an overweight of life insurance companies makes sense at this point in the economic cycle.
To qualify this rosy scenario we are cognizant that the financial sector faces three major risks. First, the possibility of a deeper than expected global recession that hurts fee income for banks, increases NPL ratios, and reduces premium income for insurers. Second, the fear of contagion from some other kind of market shock related to tightening monetary conditions which then hurts the wider financial sector.1 Third, even if the top sector names perform well regulatory measures may restrict the ability to return capital to shareholders, especially in Europe.2 However, we believe the balance of risk-reward favors this opportunity, especially as the path of policy rates has been clearly marked.
Crisis hangover is no longer justified
In terms of valuation, the zero interest rate era since 2009 has been poor for financials with a strong argument to be made that investor confidence in the sector has never recovered from the crisis. Figure 1 shows that multiples have been consistently subdued for our Emerging Finance and Aging Finance trends. The Digital Finance trend traded into bubble territory through the Covid crisis but valuations are at much more realistic levels after a steep decline through 2022. As we exit the ZIRP era and face a likely global slowdown in 2023, is the persistent caution on the financial sector still justified? We think not.
Figure 1 | Valuation for our three investment trends
First, the sector is much better positioned to endure a downturn than it was in 2008. Banks entered the financial crisis overleveraged and with inadequate liquidity buffers, but since then a more conservative approach to risk management has resulted in steadily improving balance sheet quality. Capital adequacy measures reflect this with Tier-1 capital ratio well above Basel III3 minimum requirement of 10.5% across the Euro area as illustrated in Figure 2 below.
Figure 2 | Tier-1 Capital – Euro Area Banks
Source: ECB Statistical Data Warehouse (europa.eu)
Second, banks have just been through what was effectively a stress test in 2020 when the first pandemic lockdowns brought a sharp slowdown in economic activity. Provisioning for an economic downturn that didn’t last as long as anticipated has left banks well positioned to withstand an anticipated recession, with much of the debt associated with the pandemic borne by the governments. This is reflected in NPL ratios in Figure 3, which are also at historic lows.
Figure 3: NPL ratios (%) at lowest level since Euro-area formed
In addition, the pandemic period also accelerated the digitization of some traditional lenders, forcing both their internal operations and customer-facing functions into a more rapid transformation than previously planned. This is likely to keep operating costs increases below inflation, and support overall returns.
Picking winners: Performance dispersion and net interest margins
Our base case is that net interest margins will expand into 2023 as interest rates continue to rise (Figure 4) in at least the first part of the year and potentially stay higher for longer. This assumes that banks will see the increase in their cost of funds lag the increase in lending rates, as in previous cycles.4
Figure 4 | Market policy rate expectations
Source: Bloomberg, Robeco, change 12m ahead, based on money market futures and forwards; 19 October 2022
This relationship between policy rates and bank earnings changes over the economic cycle and the impact is always quite complex. With banks, for example, deposit beta plays an important role. As (short-term) interest rates rise, bank depositors may also demand a higher deposit rate. Competitors may try to take deposits away by offering higher deposit rates. If deposit betas are high almost all benefits from a higher interest rate will need to be passed to deposit holders. Large banks with a strong brand name and deposit base typically will have lower deposit betas. Right now, rising deposit betas seem to be mainly a problem for US banks and are yet to rise in emerging markets or Europe. In the US it’s especially a mid-cap banking problem but even for the biggest banks, deposit beta could be a drag if policy rates grind higher.
There will also be performance dispersion as some banks get more net interest income (NII), rather than net fee and commission income, as a proportion of total income. We are focusing on picking the winners in this space that will benefit from rising NII. Strong NII will provide a healthy operating buffer, and coupled with high loan loss provisions, operating results are likely to be better than expected for these select stocks in our Digital Finance and Emerging Finance themes through 2023.
There is precedent for this in previous economic slowdowns. During the Volcker recession of 1980-1982, EBITDA for the US financial sector actually grew 22%, the only sector to enjoy earnings growth through that period.5 Like the current period, the 1980-82 recession was triggered by rising policy rates aimed at cleansing persistent inflation from developed economies.
Life insurers a complementary overweight
A complementary strategy to buying banks’ sensitivity to policy rates is to overweight life insurance which is part of our Aging Finance trend. Life insurers will benefit from higher rates at the long end of the yield curve and this will translate to earnings growth in the medium term. Life insurer valuations are pricing in the short-term negative of the reduction in the value of their bond and equity portfolios through 2022, which has hurt book values. Valuations are comparable with banks trading at P/B multiples below 1.0 in Europe, and we would argue long term risk/reward is even more attractive in overweighting this sector.
Solvency ratios for the life insurance sector are strong (Figure 5 below) with the sector well prepared for an economic slowdown in 2023. Higher rates at the long end of the yield curve lead to improved solvency ratios as the duration of insurers’ assets is generally shorter than the duration of their liabilities. Higher solvency ratios mean more capital to grow new business and pay dividends, or conduct buybacks. With long yields at a higher level (even if they have peaked) and with better solvency ratios for many corporate pension funds, life insurers will have significantly more opportunity to undertake pension buyouts. We have already heard of a significantly bigger pipeline in the US, UK and the Netherlands, and expect this will be a strong tailwind for select life insurers that we are invested in.
Figure 5 | Average Solvency II ratios (%) for European life insurers at healthy levels in 2022
Source: Morgan Stanley
Despite the gloomy economic consensus we should also be aware that life insurance policy benefits are defined at inception so sensitivity to inflation is limited compared to other insurance sectors, and premiums are projected to grow 1.9% in real terms in 2023, according to Swiss Re.6
In addition, the real kicker for life insurance exposure is that higher earnings are likely to be passed on to shareholders directly in the form of dividends, and there is little chance of regulatory interference with that process. This effect is apparent regardless of geography, with dividend yields for the top-50 life insurers globally averaging nearly 5% in 2022.7
The landscape has fundamentally changed for the financial sector now zero interest rate policies are in the rear view mirror. How this plays out depends on your macroeconomic outlook, but we don’t believe the positive impact of higher interest rates has been priced in. The major reason for caution is the looming recession, but the financial sector has been through slowdowns before and the best-managed players are much better placed than in 2008. There are opportunities to gain exposure to growing, high quality, long-term profit streams before financials re-rate, and the real risk might be to just wait and see. We believe we are very well positioned with investments in leading banks, life insurers and asset managers across the globe.
1 “Banks Need to Worry About Shadow Banks”
2 “Shareholder payouts at risk as ECB tells banks to hold capital - sources”
3 “History of the Basel Committee”
4 “In line with conventional wisdom, at the median, NIM has tended to increase when short-term interest rates increase and decline when short-term interest rates decline.” “The historic relationship between bank net interest margins and short-term interest rates”
5 “Mapping decline and recovery across sectors
6 Projection published in April 2022 - “sigma 4/2022 - World insurance”
7 “Highest Dividend yield of Life Insurance stocks”