Markets and headlines around the world are starting to reflect that interest rates may be at a turning point. While the future is hard to predict, and there are various scenarios that could play out, our global financials team believes that the balance of probabilities is starting to shift to the possibility of a lower interest rate environment. This would favour the financial sector (primarily banks but also insurers) and, based on what’s happened in the past, we expect this to result in good performance for investors in the sector. The current very low valuations of the sector reflect significant fear or pessimism, implying limited downside but very good upside.
On Friday, 3 November, the Financial Times featured two articles which highlighted that we might be at an inflexion point for interest rates. ‘Is this the turning point for interest rates?’ and ‘Slowing US jobs growth fuels belief that rate rise cycle is ending.’
This coincided with a US regional banks’ rally of 6-10% over 2 and 3 November – highlighting that the market also believes that we may be at a turning point. While there are various scenarios that could play out in the short to medium term, in this piece we cover one of them, as we look at the impact on the banking sector of interest rates starting to fall.
Being at an inflection point would be a game-changer for consumers around the world, and banks would benefit as a result.
When interest rates peak, the economic cycle clock moves on to the quadrant where banks traditionally outperform.
Figure 1: An illustration of the interest rate economic clock cycle
Source: Denker Capital illustration
*Net interest margins
A peak in the interest rate cycle has historically been followed by bank sector outperformance.
This is due to the following reasons:
1. A change in risk outlook:
In the previous part of the cycle, each further hike would risk increasing the eventual damage to the economy. In the new part of the cycle, the converse happens: lower interest rates mean more breathing space for struggling businesses and consumers.
2. A slowing economy is likely to lead to lower 10-year bond yields and, hence, capital gains.
– This brings about gains on insurer and bank bond portfolios.
– More importantly, for US banks it reduces the book losses on AOCI portfolios (‘accumulated other comprehensive income’, which includes unrealised gains and losses reported in balance sheets).
3. Lower interest rates mean credit becomes more affordable, eventually increasing demand for credit.
Eventually the factors above kickstart the economy back into the next growth phase. In the meantime, banks and insurers are using the high interest rates to roll over maturing low yielding portfolios into higher yielding investments – creating another boost to earnings in 2024.
The possibility of lower interest rates reduces macroeconomic fears.
The continued excessive US government spending, combined with a fairly healthy consumer, kept inflationary pressures high (and with this the risk of even higher interest rates). The latest economic releases, however, point to inflationary pressures subsiding and the US consumer spending boom nearing an end. Top publications and investment writers around the world have been writing about the risks banks are facing in the rising interest rate environment (losses on their commercial real estate lending, the potential AOCI losses mentioned above, etc.). A change in the direction of interest rates could have a big impact on risk perception and could cause a reduction in the risk discount markets have built into valuations of the sector.
One can wait for certainty, but history shows that the best time to invest is when investors are at their most negative.
This is when the cumulative selling pressure has forced share prices down. It is in periods of maximum uncertainty when low valuations provide certainty (i.e. the probability of earning returns from a low base). There is always the risk of the so-called value traps, which is one of the reasons why it’s important to do substantial research when investing (or to invest with a fund or manager whose process and philosophy you trust).
We believe that when you have a combination of three factors in place, the probability of good investment returns is high.
At Denker Capital three factors form part of our investment philosophy: Good business economics, quality management and attractive valuations. In a perfect world, a fourth factor would be a good environment, but you seldom get low valuations when the environment is good.
Below are a few examples of investments in our portfolios to illustrate the presence of the above factors.
Swedbank
Figure 2 below shows the unwarranted risk discount that has been built into bank valuations. Swedbank has a strong track record of growing shareholder value over many years. But over the past 10 years the market has ignored this, the share price is almost exactly where it was 10 years ago. But shareholder value has grown from 97 krone to 307 krone (shareholder value measured by adding the dividends paid over the 10 years to the tangible shareholder value).
This has resulted in Swedbank trading at its lowest P/tNAV (price to tangible net asset value) for as long as we’ve been visiting and following the company (since the late 1990s). Only once was the valuation more attractive. That was in December 2008 when bank balance sheets were geared, and filled with bad lending, and questionable products and fears about a 1930s type depression were the order of the day.
Figure 2: Swedbank characteristics
Source: Denker Capital research and forecasts, 30 September 2023.
BAWAG, Erste Bank, ING and One Savings Bank
Figure 3 is an extract from a presentation we did on Thursday, 2 November 2023. BAWAG, Erste Bank and ING had just released (good) Q3 results, whilst One Savings Bank (OSB) had released a trading statement. While we were presenting, the OSB share price jumped 16%, and then another 5% the next day supporting our point of low expectations built into current valuations. Our upside calculations showed 226% upside to our fair value and a 9.8% forecast after tax dividend yield.
Figure 3: BAWAG, Erste Bank, ING and One Savings Bank characteristics
Source: Denker Capital research and forecasts, 30 September 2023.
Since then, markets have continued to re-rate the sector gradually, supporting our thinking: As the uncertainty created by the sharp increase in interest rates reduces, the sector’s risk premium should unwind. Figure 3 highlights how big the discount to reality is.
How much upside could we see from here?
The sharp interest rate increases over the past few years were a good test of the quality of the lending books and balance sheets of the large banks. They’ve reported solid Q2 and Q3 results with little sign of deterioration in credit quality. In addition, even during the past 10 tough years they’ve continually grown shareholder value and increased their dividend payouts (we can’t recall a time over the last three decades when US regional banks EVER traded on the current high dividend yields). So, from the current low valuations we could easily see a doubling in share prices over the next two to three years. The 13% gain since 1 November should be but the beginning. Many US regional banks are still down 20-35% (and more) from December 2022 prices. Figure 4 highlights the de-rating over especially the past two years.
For the financial sector we tend to use the price/net asset value (P/NAV) as a valuation metric. But in figure 4 we used the price-to-earnings (PE) ratio which investors are more familiar with. A low PE ratio indicates that a company is attractively priced, and a high PE ratio indicates that it’s expensive. Figure 4 shows how the PE ratio of the US banks (S&P 500 Banks) has swung between 8x and 15x with the average around 11.5x. From the current PE of around 8x, that gives 50% upside if the sector simply re-rates back to ’average’.
The graph shows how worried investors were in 2008 (global financial crisis), 2011 (European sovereign debt crisis) and 2020 (Covid-19), but how each time markets re-rated them back afterwards (from normal back to above average).
Figure 4: PE ratio of the S&P 500 Banks Index since 2003
As another example, figure 5 shows how JP Morgan has grown earnings per share (EPS) over the past 20 years, despite the periods of significant upheaval and recessions (the company has grown EPS at a compound rate of 8.9% in USD over those 20 years). Yet, despite outperforming the S&P 500’s total return handsomely, JPM trades on a PE of 8.2x vs. the S&P 500’s PE of around 15x.
Figure 5: JP Morgan’s earnings, price and dividends over the past 20 years
Source: Denker Capital research, 20 November 2023.
*Compound annual growth rate
The total return of 8.5% is calculated by adding the total dividends paid to investors over the 20 years to the 2023 share price. This calculation significantly understates the value created – a dividend paid in 2003 re-invested has significant value, but we did not try to be fancy and calculate the value of a 2003 dividend in 2023.
We can’t predict what the future holds, but hopefully we’ve highlighted how much fear there is built into bank valuations.
The change towards lower interest rates might be the catalyst to convince investors of the value available in the financial sector.
If you’d like to access opportunities in the sector through the financial funds that we manage, please speak to your financial advisor or contact us on investorrelations@denkercapital.com. These funds are diversified across different types of financial companies (not only banks) and countries. You can access the latest minimum disclosure documents (fund fact sheets) at the links below.
Denker Global Financial Fund (USD)
