Morningstar - Q4 2022 - 66

Investors
Murky Waters
Financial sector investors must navigate
interest-rate uncertainty.
SECTOR RAP
Laura Lallos
The U.S. Federal Reserve increased the federalfunds
rate to more than 3% after its September
meeting and is widely expected to go
higher by the end of 2022. The financial sector is
particularly sensitive to interest rates, and
a higher, lasting rate environment will benefit
those companies with positive exposure to rising
interest rates.
However, there is a material chance of the
U.S. going into a recession over the next couple
of years that could be accompanied by
accommodative monetary policy-which would
lower interest rates and cloud some of these
companies' prospects.
To gain some clarity, I spoke with Morningstar
Research Services' director of financialservices
equity research Michael Wong. Our
discussion reflects conditions and valuations as
of Sept. 30. It has been edited for length
and clarity.
Laura Lallos: Why is this a particularly challenging
interest-rate environment for investors?
Michael M. Wong, CFA, CPA,
is director, financial-services equity
research, North America, at
Morningstar Research Services LLC.
Wong: Inflation and interest rates are closely
tied together, and the drivers of inflation in the U.S.
and the rest of the globe can be different.
There's a lot of discussion about whether inflation
is transitory or whether it's more core. One
66
Morningstar Q4 2022
of the main drivers of core inflation that people are
looking at is wages. This is a little bit more
particular to the United States, where wages for
the past couple of quarters have heated up
a bit more than the rest of the globe. Part of the
reason the interest-rate environment is so
challenging is because the inflation environment
is challenging, and there are many different drivers
of inflation across the globe.
What makes it especially hard for investors
trying to figure out how inflation and interest rates
tie into their investment strategy, whether
it's with bonds or stocks, is that expectations feed
on themselves, and government monetary
policy can often confuse the situation. For example,
many people expect that interest rates could
fall in the back half of 2023. But there are
two completely separate reasons why interest
rates might fall: because the economy is
doing extremely poorly or because the economy
is doing well.
The first scenario would be that the Federal
Reserve or monetary authorities across the globe
raised interest rates too much and therefore
have to cut interest rates in order to help the
economy. On the other hand, let's say the Federal
Reserve raises interest rates just enough and
creates a soft landing that brings down the rate of
inflation. They don't have to have restrictive
monetary policy of extremely high interest rates,
so they decide to lower. Those two scenarios
have different implications for stocks and investing.
If interest rates fall because we've entered
a recession, that could be bad for risk assets. If
interest rates fall because the Federal
Reserve was successful in having an economic
slowdown without a recession, that's totally
different for stocks.
Lallos: Why are financial-services stocks particularly
sensitive to interest rates?
Wong: Interest-rate-related revenue is a core
part of the earnings stream or the business
of many financial-services companies. Outside
financial services, the most material way
that companies are affected is the interest rate
that they pay on their debt.
Banks are the most obvious. They receive
interest on their loans and also on the fixedincome
securities and mortgage-backed
or other asset-backed securities that they hold on
their balance sheet when they have more
deposits than they can find profitable opportunities
to loan out for. Then they also have it as part
of their core operations, like the interest they pay
on their deposits. What interest are they
gaining on their loans? What interest are they
gaining on the investments on their balance sheet
when they have excess deposits? And what are
they paying on their deposits?
Then you have insurance companies. People
who follow Warren Buffett and Berkshire
Hathaway BRK.A know that insurance companies
make money from investing the float in the
time between when they collect those premiums
and when they pay out. So, insurance companies
are heavily influenced by the return that
they gain on their investment portfolio, which is
determined largely by interest rates.
And then we have asset managers that have
money market funds, like Federated Hermes FHI.
In a zero-interest-rate environment, they have
to waive a lot of fees. But once interest rates start
coming back, they have a material uplift
in revenue.
Lallos: What should investors hoping to profit from
rising rates consider?
Wong: Banks are a somewhat obvious beneficiary
of rising interest rates; lately they've seen
earnings increase quite a bit. That said, one thing
to watch out for over the next couple of years is
higher credit costs as they normalize. During
COVID, credit costs went extremely low, somewhat
surprisingly. Due to government stimulus,
people were saving massive amounts of money,
because they had less things to spend on. Services
https://www.morningstar.com/stocks/xnys/brk.a/quote https://www.morningstar.com/stocks/xnys/brk.a/quote https://www.morningstar.com/stocks/xnys/fhi/quote
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