Banking stocks make sense in an inflationary environment March 18, 2022
At a press conference of the Federal Open Market Committee (FOMC) on 26 January 2022, Federal Reserve Chairman Jerome Powell said that although the Committee will continue to maintain the policy interest rate, otherwise known as the Federal Funds Rate, between zero and a quarter of a percent, he strongly hinted at the Committee’s intention to increase the interest rate soon.
Chairman Powell also said that the Committee would stay with the previously agreed timeline and reduce the pace of net asset purchases, with a view to ending them in early March.
One of the main reasons for this was that US inflation remained well above the Federal Reserve’s target of 2%.
In December 2021, the Consumer Price Index (CPI) rose 7% year on year.
This was the seventh consecutive month in which the US CPI had remained above 5%.
Other central banks across the world have also taken a similar position as the Federal Reserve.
In the same month, the Bank of England raised interest rates for the first time in 3 years.
Central banks of other countries such as South Africa, Russia, Brazil, New Zealand and South Korea also raised interest rates last year.
The European Central Bank, or ECB, and the Bank of Japan also announced that they intended to reduce stimulus that was implemented in response to the COVID-19 pandemic, and they also hinted at possible interest rate increases in the very near term.
Response from the markets
The stock markets have not responded positively to this news.
At the end of the trading day on 26 January, the Dow Jones index was down by 0.38% and the S&P 500 index was down by 0.15%.
As of 28 January, the NASDAQ composite index had fallen over 10% from its previous peak in November 2021, entering what is known as the correction territory.
The S&P 500 index is down 9.22% year to date, while the Dow Jones index is down 5.99% year to date, after the FOMC first mentioned its intention to raise interest rates in the December 2021 policy meeting.
There are two main reasons for the poor performance of the stock markets.
Firstly, an increase in the Federal Funds Rate will raise borrowing costs for both businesses and consumers. This is because the Federal Open Market Committee decides on the target range for the federal funds rate, sometimes known as the target federal funds rate. The banks then use that as a reference for the overnight rate that they charge each other for the overnight loans that they make to other banks for their liquidity needs. The median rate of all the rates negotiated between the banks is called the effective federal funds rate. Any changes in the effective federal funds rate impacts other important interest rates such as the Prime Rate, which is the rate that banks charge their most creditworthy clients, and the Secured Overnight Financing Rate (SOFR). This has a dampening effect on future borrowing and economic activity and could affect corporate profits adversely.
Consequently, this reduces demand for the stocks of these companies.
Also, there are concerns that while rate increases are meant to cool down an overheating economy, they could be implemented too quickly or be too excessive. And they may be implemented at an inappropriate time, and could reduce demand from consumers, gradually leading to higher unemployment as businesses cut down on hiring or even retrench staff if the situation becomes untenable. This could cause the economy to spiral into a downturn.
Positive impact on banking stocks
However, this does not mean that all stocks will be adversely affected by an equal magnitude.
Some sectors, such as banking, are expected to perform better in a rising interest rate environment. This is because rising interest rates have a direct impact of increasing the net interest margin, as the rates at which banks lend usually move more quickly than their short-term funding costs, such as interest rates for deposit accounts and time deposits, which will help boost banks’ profitability.
According to Federal Reserve data, banks are also holding onto large amounts of clients’ deposits, due to reduced spending during the lockdowns and COVID-19 restrictions, and individuals choosing not to spend stimulus money that they receive from the government.
And with a marginal increase in loans, banks have been parking these funds with the central bank. While the rates paid out by the central bank for these funds are very low, they are set to increase once the Federal Funds target rate is raised, and this will also increase profitability.
Hence, investors should consider looking at banking stocks such as Bank of America (NYSE: BAC), JPMorgan Chase (NYSE:JPM), Citigroup Inc (NYSE: C).
Investors should also consider paying attention to the stocks of three Singapore banks, DBS Group Holdings (SGX: D05), Oversea-Chinese Banking Corp Limited (SGX:O39) and United Overseas Bank Limited (SGX: U11).
This is because Singapore’s interest rates are mainly influenced by US interest rates. Hence, local interest rates are expected to go up some time after US interest rates increase, and the three local banks are expected to benefit from this as well.
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About the author
Phillip Investor Centre (Holland Drive)
Ming Jie is an Investment Specialist at Phillip Investor Centre (Holland Drive) and specialises in providing investment advisory services to retail clients, with a focus on helping clients to build and manage unit trust portfolios that can help to achieve their investment objectives. He joined Phillip Securities in 2017 and graduated from University of London with an external honours degree in Economics and Finance.