State Street SPDR ETFs: Increasing Rate of Interest in Financials

October 24, 2022

State Street Global Advisors select Financials as its European sector pick for the fourth quarter, as buying a rates beneficiary is still a relatively attractive option. Financials sector earnings are highly sensitive to bond yields, with Europe being the preferred exposure.

“We believe the margin benefits of the recent rate rises and their impact on earnings have been overlooked in a risk-off market,” Rebecca Chesworth, Equity ETF Strategist at State Street SPDR ETFs says.

In the case of certain European banks, their international nature means they see an impact from the interest rate policy of the Federal Reserve as well as the ECB and Bank of England. Expectations for all these central banks became much more hawkish in the last few months, with the standout being the ECB, which in Q3 ended the use of negative rates and has seen its swaps-implied target rate more than double to 2% ahead of its last meeting of the year, set for 15 December.

Higher rates, particularly when accompanied by a normal upward-sloping yield curve, have a direct impact on banks’ borrowing and lending rates, feeding through to the net interest income (NII) margin. High street banks account for almost 50% of MSCI Europe Financials. There is more banking exposure within the diversified financials grouping, but the NII of investment banks tends to have a lower gearing because of the larger contribution from fee income and trading.

Elsewhere in the sector, rising interest rates tend to be positive for insurance (31% of market capitalisation), helping to incentivise savers and increasing the yield on life insurance portfolios. However, there is less impact on property and casualty insurance and reinsurance.

Earnings sentiment for this sector is relatively strong. Revenue expectations, courtesy of NII, have been rising ahead of cost inflation, of which wages are important, improving the operating jaws. Helpfully, the sector is also less affected by energy prices than others in Europe. Earnings forecasts rose in July against a flat — at best — scenario for the rest of European equities. This momentum helps financials’ relative P/E rating and dividend yield to remain compelling.

Investing in the whole financials sector offers a potentially safer and less volatile exposure given the benefits of diversification in this fragile market. Insurance businesses bring the quality aspects in terms of return stability and less cyclicality, while diversified financials offer a structural growth element from asset managers and the expansion of exchanges. 

Rebecca Chesworth, Equity ETF Strategist at State Street SPDR ETFs says: “In our view, the sector’s low valuation should compensate for the higher risks inherent on facing tougher financial conditions and a potential economic recession. Inevitably, lending will slow down, and bad debts will rise but the comfortable starting position, ongoing benefits of COVID provisioning and tight funding positions enforced by regulators are reassuring. Other measures to watch are the credit spreads between different eurozone countries, with fears that any fragmentation would lead to higher costs of funding for banks in peripheral countries. We prefer the European sector over US financials given the dynamics of the rates market, valuation and the industrial breakdown of both,”