Many central banks in the developed Western world have an inflation target of around 2%, a figure deemed appropriate to provide the right combination of optimum employment, price stability and economic growth. The one partial outlier from this is the US Federal Reserve (Fed), which recently changed its inflation target to an average of 2% over time – though, interestingly, without clarifying over what time.
By and large, they have all remained at this level since 2012, and the recovery following the global financial crisis. At the end of March this year, consumer price inflation (CPI) was 0.7% according to the Bank of England, 1.3% from the European Central Bank and 2.6% from the Fed. However, the equivalent figures at the end of April showed a marked increase, up to 1.5% in the UK, 1.6% across Europe and 4.2% in the US, its highest level since September 2008.
These increases are based on the rapid rise in demand of pent-up consumer spending – through physical retailers as well as online – as economies open up thanks to the continued vaccine rollout, alongside the constraints put on the other side of the economic coin, the supply chain.
Underlying all of this is the position economies were in one year ago, the point on which all these numbers are based, which was when the World Health Organisation declared COVID-19 a global pandemic. The reaction was immediate and drastic – the Dow Jones saw its single largest daily drop in history; the VIX, a volatility or ‘fear’ index, hit an all-time high; January to mid-March 2020 saw the S&P 500 down 27%, the DAX down 38% and the Nikkei down 29%. The FTSE 100 fell by 25%, its largest quarterly fall in 30 years.
Given the scale of these lows, sentiment has unsurprisingly been for a rise in inflation 12 months later so, while the outlook from here is heavily dependent on progress globally in containing COVID-19, should we be worried about inflation? There are two camps answering this question. One is investors on the side of the Fed and its view that the current pressures are temporary, so of little concern. The other is those on the side of the current trends/evidence in the real economy – including house price inflation, rising cost of consumer goods, supply bottlenecks, and some labour shortages and wage pressures – which may eventually embed themselves in longer-term inflationary pressures. With portfolios heavily skewed towards bank stocks, it is not surprising we are in the latter camp, albeit not alone as the movements in bond yields would suggest.
What does this mean for financials?
In simple terms, lower inflation and lower interest rates encourage increased consumer spending and higher levels of borrowing as returns on savings are limited. As spending increases, so do growth company revenues; as increased revenues are reported, share prices rise and stock markets rise. However, if current sentiment is right and inflation goes up, physical asset prices (housing; commodities) will rise but purchasing power will decrease so some of the demand for such growth companies will fall. Equally, the current high valuations attached to growth businesses are based on valuation parameters which rely on low interest rates (ie growth companies start looking very expensive if interest (discount) rates rise).
As the most sensitive sector to the reflationary trade, financials – more specifically the banking sector – stand to be a primary beneficiary of an upward move in both inflation and interest rate expectations.
On the flip side, while not necessarily a direct correlation, there is the suggestion of a positive connection between mild inflation and the return on value stocks – high inflation is arguably not beneficial for any sector since interest rates will need to rise materially at a time when the world remains highly indebted. As the most sensitive sector to the reflationary trade, financials – more specifically the banking sector – stand to be a primary beneficiary of an upward move in both inflation and interest rate expectations. The underlying rationale for this view is that as interest rates rise, bank margins start widening after many years of severe pressure and the loan market becomes more competitive against the bond market and specialist forms of finance. Financials are the largest constituent of value indices and so provide diversification from growth sectors that have benefited from ultra-low rates (although we would reiterate that this requires a bias to the bank sector within the financials exposure).
Despite the global economic recovery, financials continue to trade at attractive valuations in absolute and relative terms. The sector has outperformed by 5% from last year’s lows, compared to an average outperformance of 23%, looking at the past nine crises going back to 1990. This suggests there is plenty of room for further outperformance as confidence in the economic recovery builds.
Looking within the sector, banks have shown high levels of resilience in what was a severe downturn, supported by the strengthening in their own balance sheets in the preceding years – thanks to the regulation brought in after the 2007-09 global financial crisis – along with government stimulus support. By comparison, this time around banks actually built up levels of capital during this downturn and many are now in a position to return significant amounts of surplus capital to shareholders. What would really underpin banking stocks is whether the relentless pressure on net interest margins and weak loan growth starts to ease as economic recovery, supported by significant fiscal stimulus, results in a reassessment of the inflation outlook and interest rate trends.
Macro trends such as rising inflationary pressures and economic recovery are supportive, bank valuations remain very cheap against the market and, in absolute terms, they offer investors high and rising dividend yields and recovering top-line growth through margins and loan growth. Most fund managers remain very underweight the sector and there has already been evidence of material outperformance when sentiment changes. A reallocation back to what remains a very large sector seems more than past due.