Banks: A respite from rising rates

If rates continue to rise, financials could be the place to be, Russ Koesterich says.

While interest rates have stabilized in recent weeks, investors were unnerved when yields spiked 75 bps in barely 10 weeks. And while long-term rates have already tripled from last summer’s lows, real or inflation-adjusted rates remain deeply negative; this suggests more room for rates to rise.

The potential for another surge in interest rates probably leads the list of investor anxieties. Those looking for higher rates can point to the fact that real yields remain exceptionally low, even by the diminished standards of the last decade. At roughly -0.80% 10-year real yields are about where they were six months ago. This is hard to reconcile with the events of the past six months: roughly $3 trillion of fiscal stimulus, the potential for another $2 trillion of infrastructure spending, a successful vaccine rollout, a rapidly healing labor market and U.S. households sitting on a couple trillion dollars of excess savings.

Given this scenario, it’s fair to assume that rates will continue to rise. This raises the question: Which parts of the equity market will prove the most resilient? My take would be financials.

Rising rates will reset valuations

Technically speaking, a higher discount rate cannot help a company’s valuation. That said, different sectors respond very differently to rising rates. Financials tend to benefit as rising rates typically accompany faster growth. Beyond the cyclical tailwind, banks also benefit from a steeper yield curve, which flatters their net-interest-margin (NIM). 

Today, despite the likelihood for higher rates, financials remain one of the cheapest sectors globally (see Chart 1). This is also true in the United States. The U.S. financial sector is trading at roughly 1.5x price-to-book (P/B). Not only is this cheap relative to the sector’s history, valuations look particularly low when compared to the broader market. U.S. financials are trading at just 35% of the P/B of the S&P 500.

Chart 1
Global equity valuation by sector

Global equity valuation by sector

Source: Refinitiv Datastream, MSCI, and BlackRock Investment Institute, as of April 21, 2021.
Notes: The bars show the current 12-month forward P/E ratios of MSCI sector indices. The dots show the 10-year average for each sector. The P/E ratios are calculated using I/B/E/S earnings estimates for the next 12 months.

Focusing just on the banks reveals the same type of discount. Based on P/B banks are trading at roughly 30% of the market’s valuation. Historically, the ratio has been closer to 40%.

To the extent rates rise from here, bank valuations are likely to normalize relative to the broader market. Focusing on the past decade, bank valuations have become highly dependent on the level of 10-year Treasury yields. During this period the level of rates has explained approximately 70% of the relative valuation of U.S. banks. Based on this relationship, a 2% 10-year yield would suggest banks trading back towards their average relative valuation.

For investors the takeaway is that while the market may temporarily come under pressure if rates spike higher, financials will probably hold up better than most sectors. Safe havens during periods of rising rates are extremely valuable. Ironically, it can be harder finding a hedge against too much growth versus too little. Financials can provide part of the solution to a booming economy and normalizing rates.

Russ Koesterich, CFA, JD
Russ Koesterich, CFA, JD
Russ Koesterich, CFA, is a portfolio manager for BlackRock’s Global Allocation Fund and lead portfolio manager on the GA Selects model portfolio strategies.
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