- While financials have generally benefitted from rising interest rates, they have remained an out-of-favor sector ever since the Great Recession.
- Although an economic slowdown in 2023 could hurt the sector, we have found companies that could nevertheless show resilience, and in some cases have recently had low valuations.
As an economically sensitive group, the financial sector's performance in aggregate in the coming year is likely to be tied to the broader economy.
Yet despite the storm clouds of a potential slowdown on the horizon, certain well-positioned financial stocks could represent solid value for long-term investors.
A better-than-feared 2022
The financial sector declined along with the rest of the market for much of 2022. However, the group outpaced the broader market over the latter part of the year, accompanied by a fresh surge in bond yields. Rising interest rates tend to boost bank profitability by widening the differential between what banks earn (on loans they make) and what they must pay (on deposits they hold).
Past performance is no guarantee of future results. Financial sector performance is represented by the S&P Financial Select Sector index. Data as of Data as of 12/9/22. Source: S&P Dow Jones Indices, a division of S&P Global.
Although credit performance has continued to show strength, rising recession risk has called into question whether that strength will continue through 2023. While banks' third-quarter results continued to show the benefits of higher rates, they also included evidence of some banks preparing for the possibility of a weakening economy—by setting aside capital to cover potential losses on future credit defaults.
Still an out-of-favor sector
Ever since the bank bailouts of the Great Recession more than a decade ago, the federal government has closely monitored the capitalization of the largest U.S. banks through a series of "stress tests" designed to simulate a variety of worst-case scenarios. The banks have passed these tests, indicating reduced risk in the group.
But despite banks' improved financial standing, some investors still seem to be avoiding the sector. As of late 2022, financials were one of the cheapest sectors in the S&P 500®, and also very cheap relative to the sector's own historical valuation patterns.
Of course, there's no way to know exactly how the current economic cycle will play out, or whether 2023 could bring an outright recession or a soft landing. But if banks are being cautious in setting aside capital for loan losses, it could mean that they are better positioned than the market expects. That could bode well for banks' ability to navigate a variety of economic scenarios that may arise, while staying positioned to benefit from any potential subsequent recovery or extension of the current economic cycle.
Areas of potential opportunity
Banks with strong deposit bases and conservative credit profiles, which—along with fee income—can help them weather macroeconomic turbulence. Although banks can borrow from other banks to fund loans, it's cheaper for them to do so with their own deposits. As long as they continue to maintain credit standards on loans, such banks could prosper, even if higher rates dampen overall loan growth or trigger a spike in defaults or delinquent loans. Meanwhile, fee income tends to be recurring and can provide stability for earnings if there is an economic downturn.
We have also favored investments in insurance, which tends to be less economically sensitive than some other segments, because people and business by and large maintain their insurance policies even if there's an economic downturn.
These themes typify our current thinking—emphasizing company-specific drivers that could enable some firms to prosper, despite the uncertain economic outlook for 2023.