Three quarters down and just one more to go before 2014 comes to a close. So far this year, financials have been profitable, but performance has been in the middle of the pack when compared to the other major sectors.
Unfortunately the drag on financials is likely to continue, but that may present interesting strategic opportunities.
Leverage Levels Are Going to Change
Many investors assume that the financial sector is mostly comprised of banks and brokerages. However, most of the companies held by the big financial exchange-traded funds aren’t banks or brokers. These other firms include real estate investment trusts, hedge funds, business development companies, closed-end funds, credit card companies, limited partnerships and holding companies like Berkshire Hathaway (BRK-A).
While banks have suffered from a reduced interest rate spread, many of these other firms have been able to leverage low rates for growth. Unfortunately, the Federal Reserve is clearly moving towards a rate hike in 2015. At the very least, quantitative easing will be ending this year. That means the spigot of virtually free money will be shut off. We expect debt financing to decline significantly over the next few quarters, which will drag on most of the financial sector unless economic growth accelerates unexpectedly.
A quick example may help make this issue more clear. Public Storage (PSA) is a REIT that specializes in temporary storage units. Interest rates have been so low that the firm has been able to grow its properties by 20% since the crisis. This expansion has been financed by callable preferred shares issued to investors desperate for yield at extremely favorable terms for PSA. The REIT’s funds from operations has grown by 40% since the crisis as well. Will Public Storage be able to sustain this growth and cash flow if rates increase and the competition for yields shifts out of its favor? Probably not.
Net Interest Margin Update
Assuming growth does not accelerate into 2015, rising interest rates will be an issue for most of the companies in the financial sector. Unfortunately, the net interest margin doesn’t look like it will shift much either, even with an increase in interest rates, which puts banks and brokerages at a continued disadvantage as well.
While there were some signs that interest margin for all banks would rise earlier this year, it has instead fallen to an all-time low.
What Should Investors Do Next?
Although this update has a slightly negative tone, we aren’t outright bearish on the financial sector. We expect that the economy will avoid any significant downturns in 2015, which should keep the financial sector profitable.
However, it seems very unlikely that growth rates will accelerate, which isn’t necessarily a bad thing for investors in financial ETFs like the SPDR Financial Sector ETF (XLF). Covered calls written against long positions in the sector, or long-short strategies that combine financial stocks with faster growing sectors could pay the dividends that will otherwise be missing as the global economy trends flat.
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