Shares sector review – financial services

• A higher rate environment, potential reopening of capital markets, adoption of new technology and depressed valuations are some of the factors supporting the investment case for financial services.
• Financials have outperformed in 2023, with higher interest rates helping banks in particular.
• Consumers and businesses facing higher costs mean potential loan defaults are posing a key risk to the sector.

The financial services sector is made up of banks, insurance, and asset management companies. It’s a cyclical sector, which means business performance is closely tied to the financial health of consumers and the broader economy.

How has the financial services sector performed?

The cyclical nature of the sector means it’s perhaps no surprise that over five years, UK financials have underperformed versus the wider market – it returned 11.6% compared to 21.8% for the market.

It’s not too hard to pinpoint exactly where that underperformance has come from. The pandemic sent shockwaves around the world and financials were hit hard.

Not only was there increased recession risk and a major halt in economic activity, but interest rates were at rock bottom levels. That’s not good news for banks, given that traditional lending operations are less profitable when rates are low (more on that later).

Five-year total return

Past performance isn't a guide to the future. Source: Refinitiv Eikon (UK Financial Services Sector represented by the Refinitiv UK Financial Services Total Return Index), 15/09/23. This chart gives an overview of the trends on these indices, but doesn't cover every data point.

Conditions have changed this year. As a result, financials have outperformed so far in 2023 – returning 8.6% compared to 3.7% for the market. That’s largely down to increased interest rates, which help profitability, as the Bank of England’s been fighting hard to battle high inflation. Although past performance isn’t a guide to future returns.

What are the opportunities?

Higher interest rates

We touched on this earlier, but interest rates heavily impact the profitability of banks’ borrowing and lending operations. Banks take deposits and pay interest, then lend cash out at higher rates.

When rates are low, there’s very little net interest margin to squeeze out – that’s a measure of how much extra the bank makes from lending compared to what it pays on deposits. The opposite is true when rates are higher, and banks see a boost to interest income.

Many UK banks think the benefits from higher rates have peaked, so we’re expecting net interest income growth to settle down from here. But if rates in the UK settle somewhere in the 3-4% range, we see that as a longer-term tailwind for banks compared to the near-zero rate environment we’ve come out of.

Higher rates also benefit insurance companies, who tend to see income generated from their investment portfolio rise. Higher rates pull down the value of their bonds, so on paper, it’ll look like a hit in the short term. But insurance companies tend to hold their assets until maturity, meaning changes in value over the bond’s life never get realised. When they roll onto new issues at higher rates, they can then earn higher returns.

Capital markets

It would be an understatement to say it’s been tough for those involved in making money from new IPOs or mergers and acquisitions (M&A). It’s felt like capital markets have essentially been closed for business for large parts of the past year or so.

Valuations have been compressed by a mixture of higher rates, inflation, and fears of global recessions – making it an unattractive place to try and raise capital. The same challenges also mean businesses have been hunkering down, focusing on their own operations rather than going on spending sprees in the M&A market.

However, green shoots are appearing. Global M&A by value was up 28% in the second quarter compared to the first. As it looks like we’re nearing the end of central bank hiking cycles, the outlook is starting to improve.

The IPO market is showing similar signs of a potential resurgence, with some significant activity in recent weeks. We don’t expect this to translate into a wave of action just yet, but it could mark a turning point.

New tech

The financial services sector is ripe for adopting new tech and artificial intelligence (AI) tools. Fintech businesses are popping up to change how we shop, spend, transact, and even invest – sometimes all through one app.

Legacy financial services providers have a battle to try and keep up. This presents ample opportunity for the new kids on the block and the established giants who are nimble enough to get on the front foot.

What are the risks?

Loan defaults

Higher rates help profitability, but the flip side is the impact on people and businesses facing significantly higher loan payments. Add in a cost-of-living crisis caused by rampant inflation and affordability becomes a real concern.

For now, default levels are creeping higher but remain relatively healthy. Banks are setting aside more money in preparation for higher levels of defaults, which is a hit to profit. We’ve not entered worrying territory yet, but it’s a risk worth watching. Look for banks with lower levels of unsecured debt to help reduce this risk.

Bank runs

Banks have always faced a risk that their depositors get the jitters, and all take flight at the same time. This risk has arguably been more prevalent in recent months with the high-profile failings of some US banks.

Since the financial crisis, capital positions have strengthened, and UK banks are sitting in a good spot. The UK’s recent banking stress test, which models how banks would withstand a set of horrendous conditions, came back with a strong set of results.

But that doesn’t mean there’s no risk. There’s also the potential for new regulations to upset the apple cart. We’re expecting some changes in the next few years, with the biggest impact likely to be an increase in the minimum capital level. It’s hard to say how much impact it’ll have, given banks are well ahead of the current minimums, but is something to watch.

Our view

Since the banking crisis, the financial services sector has faced an upward battle to restore investor confidence. To its credit, a lot had been done. Regulators put more stringent rules in place to help better protect against shock events, and UK banks are sitting on very healthy levels of capital.

Despite that, valuations have come back down to levels not seen since the financial crisis, as markets have been wary about the impact of potential recessions and high inflation.

Price-to-book ratio

Past performance isn't a guide to the future. Source: Refinitiv Eikon, 14/09/23.

We see pockets of the sector that offer good value, banks being one example. If interest rates stay higher for longer and banks remain prudent with their capital levels to absorb any shocks, valuations at these levels look attractive.

Should economic conditions play out better than expected, there could be a tailwind in sentiment acting as a further catalyst. We tend to favour those with particularly strong capital positions and less unsecured debt.

General insurance is another spot we like. It’s been downtrodden for a few years, as elevated claims levels and higher costs have weighed on performance. But conditions are turning, and we see some upside should things keep moving in the right direction from here. Of course, nothing is guaranteed, and keep in mind key figures shouldn’t be looked at on their own – it’s important to understand the big picture.

This article isn’t personal advice. If you’re not sure an investment is right for you, seek advice. Investments and any income from them will rise and fall in value, so you could get back less than you invest.

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Our last review looked at how the utilities sector has performed, what’s next for 2023, and the biggest opportunities for the sector.

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