When you compare the developed world to developing regions, what criteria would you usually compare? Infant mortality, GDP growth, literacy levels, poverty, etc. probably top the list. The strength of the capital markets, however, is often overlooked by many people – and that’s something worth looking into the details, according to us.
In the developed world, strong equity and debt markets allow entrepreneurs to reach potential investors and seek funding with far greater ease, facilitating the pursuit of progress. Strong markets bring the transparent, liquid movement of money, provide regulations protecting buyers and sellers, and have governance that encourages innovation and intellectual property. They let companies focus on what they do best – providing products and services that the world is looking for – and provide fair, efficiently priced values so investors can make informed decisions. What’s the benefit of having world-changing ideas if you can’t pursue them due to a lack of funding? Encouraging investment and facilitating robust, transparent capital markets is a critical objective for the developing and frontier markets to progress, in our opinion.
On that note, let’s look into the details of the US financial sector – the backbone of the world’s strongest economy. As a tactical play, the S&P 500 financial sector (XLF) is a pretty tempting buy right now. Here are three reasons why we think so:
– A strengthening economy: The US job market is showing significant, sustained growth, and finally, wages are also showing signs of increasing – as we think will inflation, and therefore, the interest rates in the 2nd half of 2015. According to the Financial Times, Apple’s corporate bond sale earlier this month signals companies are racing to lock in low rates, projecting a rise sooner than later. The financial sector will be one of the beneficiaries of the interest rate rise as they earn more on their deposits (through steepening yield curves/differences between short and long term rates), lend more with a strengthening economy, and see investor confidence with time. In January, the sector had the 2nd largest monthly (positive) change in jobs, according to WSJ data – sandwiched between construction and restaurants/bars. Think about it. Those two categories hire more hourly employees and are susceptible to weekly layoffs; financial companies would hire longer term. This projects management confidence, and investors should take note.
– The recent performance: Last year, the financial sector underperformed the S&P 500 by nearly 4%, and this year has started pretty rough, with XLF down a massive 7% compared with a flat broader market. JP Morgan, Citigroup, and other major banks trade at forward P/Es between 10-13, far below the S&P 500’s and their own recent averages, according to Yahoo Finance data. The banks have shaped up with stronger balance sheets through deleveraging (per McKinsey, the financial sector debt has fallen by 24 percentage points of GDP) and capital-bolstering due to regulatory requirements, but investors haven’t rewarded them…yet. We don’t believe such a discount is warranted, and it’s worth moving in at these levels.
– The components: Berkshire Hathaway is the biggest holding in XLF. Its stock hasn’t really blown away the S&P 500 since the recession, and CEO Warren Buffett will possibly name a successor this year. That may provide a change in strategy, and a possible kick starter to the stock. Meanwhile, JP Morgan, Citi and other banking behemoths remain under regulatory-hangover, ‘systematically-important’ tags and too-big-to-fail worries. We think the litigation issues have passed, but the stocks don’t reflect that. Earlier this year, Goldman Sachs called for the breakup of JP Morgan due to recent capital requirements, stating it could be worth as much as 25% more if broken up. If it occurs, this could start a trend, and undoubtedly benefit shareholders. Meanwhile another set of the financial sector, regional banks, will benefit from the strong dollar and strengthening economy due to being domestically focused and not facing global currency headwinds. Real estate investment trusts, meanwhile, were among the best sub-sector performers last year – and S&P is going to give this field its own designation as an 11th sector in the index in a couple of years. This projects an increasing importance, and we suggest allotting some money now.
What it means for you: Think of adding a bit of XLF to your portfolio. The WSJ highlighted a fascinating insight in late 2014 from a research paper from NYU’s Edward Wolff – ‘for the wealthiest 1% of Americans, only about 9% of their total net worth is tied up in their home. That’s compared to 63% for the broad middle class’. The rich invest, with a significantly higher percentage of their assets tied to stocks, compared to the less rich. Consider the capital markets as a smart way of storing some of your cash in the long term, and know that by doing so, you’ve probably directly or indirectly benefited smart ideas – such as the next Facebook or Apple – that need capital to change the world.
