Aussie equities: Unloved financials could be rate-rise winners

Near-zero interest rates have depressed returns in financial services for years. But with further rate cuts unlikely, it might be time to revisit the sector, says Pendal’s Graeme Petroni.

• Outlook for rates poses challenges for investors
• Financials one of the few sectors that can benefit from higher rates
• 10 to 40 per cent earnings upside for every 100-basis point rate rise

THE financial services sector is an important driver of overall stock market returns in Australia, making up nearly a third of the entire market’s capitalisation.

While the past few months have seen a return to favour for the big banks and other financials, it comes after five years of lacklustre share market returns.

“The biggest macro driver of returns has been interest rates,” says Petroni, who covers the financial services sector for Pendal’s Australian equities team.

“But we’re at an interesting juncture where interest rates have fallen to zero.

“It probably can’t get any worse. And that brings scope for significant share price recovery across the sector.”

Impact of rates on financials

Financial services react differently than most companies to higher interest rates, which make borrowing more expensive and slow business activity.

Higher rates allow many of the financial companies to earn increased interest income on their cash holdings. Banks can also benefit directly as they rebuild margins compressed by low lending and deposit rates.

“Financials across the board will perform well in a rising interest rate environment,” says Petroni.

Leverage to rising interest rates can be anywhere from 10 to 40 per cent earnings upside for every 100 points of rate rises, he says.

Portfolio strategy

But building a portfolio that can benefit from rising rates is not simply a matter of buying the whole sector. Each company is affected differently and each has its own idiosyncrasies.

Petroni says the three ASX companies most exposed to a rising rate environment are insurer QBE, British bank-holding company Virgin Money UK and stock market registrar Computershare.

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Insurers benefit from rising rates because of the government bond investments they hold to back their commitments to policyholders. Typically, fixed income makes up more than 75 per cent of an insurer’s portfolio, he says.

For QBE, the yield on its portfolio is now below 1 per cent — the lowest on record — meaning a 100 basis point lift in interest rates could flow through to a 15 to 20 per cent lift in QBE’s earnings.

Virgin Money UK — formed when National Australia Bank spun off its British bank businesses — is another positioned to gain from rising rates.

Bank earnings suffer from near zero interest rates because the difference between what they can charge for loans and what they have to pay on deposit accounts gets squeezed.

Computershare — which administers shareholdings for listed companies — benefits from higher rates because it invests money that it holds temporarily while distributing dividends. A 100-basis point rise in rates could lift Computershare earnings by 15 per cent.

Risks to consider

There are risks. Looming inflation is a problem for insurers because they set aside reserves based on projections of future payouts. Inflation can drive these higher.

Computershare’s clients are unlikely to allow higher interest rate earnings to flow to the bottom line without demanding their share.

And strong competition for market share among banks often eats away margin gains from higher rates.

“There are a wide range of companies in the financial services sector and they each have their own individual issues,” says Petroni.

“But they all have had a large exposure to falling interest rates — and that has been the dominant reason why they have underperformed.”

And his number one pick?

“The one that we like the most is QBE,” he says.

“The reason being is it is not just an interest rate story — it’s also benefiting from strong price rises. In the last result, the interim CEO said market conditions were better than they’ve experienced in more than a decade. Pretty strong words.”