The stock market sell-off is broad based, with few equities escaping the carnage. On Wednesday, May 18, U.S. stocks posted their biggest daily drop in approximately two years, sending the S&P 500 4% lower. The S&P 500 is nearing correction territory, down 18% year-to-date. The NASDAQ, meanwhile, is deep in correction at 26% below its early January high.
Stocks have been falling on concerns about rising interest rates, soaring inflation, and the possibility of a recession. U.S. inflation is near a 40-year high of 8.3%.
To combat scorching inflation, the Federal Reserve raised its key lending rate in March for the first time since 2018, by 0.25%. The Federal Reserve followed that with a 0.50% move in May, the sharpest increase in over 20-years, to a range of 0.75% and 1%.
More interest rate hikes are on the way. The Economist Intelligence Unit has said it expects the Federal Reserve to raise rates seven times in 2022, totaling an increase of 2.25%, and reaching 2.9% by early 2023.
Rising interest rates are necessary to tame inflation, but it also makes the cost of everything from food, energy, and housing more expensive. This leaves consumers with less disposable income, which impacts a businesses’ revenue and profits.
Rising interest rates also make it more expensive for businesses to borrow money. Investors also tend to shun speculative growth stocks in a rising interest rate environment because the company’s potential earnings are still years away, which means they will need to continue to borrow large amounts of money. As interest rates rise, businesses are hit by both higher borrowing costs and weaker consumer demand.
Why Invest in Financials?
Investors looking to diminish the impact of a stock market sell-off will search for equities that tend to perform well in a rising interest rate environment. Some stocks have the potential to get a prolonged boost from rising interest rates because of their business models — and many are in the financial sector.
During their latest earning calls in late 2021, some of the heads of Canada’s biggest banks told investors that rising rates would benefit their firms in 2022. The Royal Bank of Canada Chief Executive Officer, Dave McKay was one of them, saying in December that the lower rates throughout the pandemic had been a drag on the banks’ revenues. “We are well-positioned to benefit from rising interest rates, given our leading Canadian deposit franchise and the asset-sensitive nature of U.S. wealth management style sheets,” McKay told investors during the December conference call. “To highlight the potential benefit over time, the impact of lower interest rates reduced our revenue by approximately $1 billion in each of the last two years.”1
Investors like Warren Buffett take huge stakes in U.S. financials. Through Berkshire Hathaway, Warren Buffett has amassed billion-dollar positions in Bank of America Corp, U.S Bancorp, and Bank of New York Mellon Corp.
When interest rates rise banks can increase the spread they charge customers. Canadian banks net interest margins were compressed during the covid-pandemic when the Bank of Canada dropped the overnight lending rate close to zero. Now that positive interest rates have resumed, banks can restore their margins to pre-pandemic levels and thereby increase their profitability.
Over the last 30-years, the earnings of the S&P 500 financial sector has grown more than six percent on an annual basis. Even after paying above-average dividends, this works out to twice the rate of GDP.
Investing in Financials with ETFs
Looking for higher yield in a rising-rate environment? Consider these ETFs targeting 7% yield, utilizing active covered call strategies in financials: Evolve US Banks Enhanced Yield Fund (TSX: CALL), Evolve Canadian Banks and Lifecos Enhanced Yield Index Fund (TSX: BANK), and the Evolve European Banks Enhanced Yield ETF (TSX: EBNK). To learn more about these three funds, click here.
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1 Source: Financial Post