The unexpected sector hit of last year was financials. Its strength came from a combination of higher interest rates, economic revival, strong financial markets and a number of key structural trends. It still looks cheap relative to many other sectors: can it repeat the trick in the year ahead?
The MSCI World Financials Index outpaced the MSCI World index by about 8% in 2024, delivering a return of 26.7%. It was a particularly strong year for a number of the US banking giants, including JP Morgan, Wells Fargo and Goldman Sachs, but payment companies such as Visa and Mastercard also saw strong gains.
The financials sector is diverse, incorporating banks, exchanges, investment managers, payment companies and insurers. Each has its own set of drivers. The banking sector, for example, has benefited from relatively high interest rates, reasonable economic growth and moderating inflation. The sector also saw a bounce after Donald Trump’s victory in the US election in anticipation of deregulation in the sector.
Investment managers have benefitted from generally buoyant financial markets, while insurers have risen on the back of an improving outlook for underwriting and premiums. Payment companies are reaping the benefits of growing global transaction volumes and an increasing move to electronic payments.
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Overall, the sector still looks relatively cheap in spite of its strength in 2024. It is on a forward price to earnings multiple of 13.5x, compared to 19.1x for the wider MSCI World index. Its dividend yield is 2.5% versus 1.7%. In particular, the banking sector has traded at relatively low valuations since the 2008 crisis and has scope to catch up.
Global fund managers are still backing the sector. For example, it remains the highest weighting in the Brown Advisory Global Leaders fund at 30.1%. The fund holds a wide range of financial companies, including Deutsche Borse, Mastercard and the London Stock Exchange, but manager Mick Dillon is particularly positive on the “exceptional quality and long-term secular growth opportunities” in emerging market financial companies.
These companies are exposed to both economic growth and the spread of financial inclusion. Mick gives the example of deposit and mortgage growth in India, microlending in Indonesia, or the deepening of financial markets in Brazil, adding: “These investments can be more cyclical in nature with revenue affected by the local macroeconomic environment.”
His holdings include Malaysia’s Bank Rakyat, and India’s HDFC Bank. He said: “We have added to all our emerging markets financials investments over the past 18 months.”
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Christine Baalham, manager on the Fidelity Global Special Situations fund, also sees opportunities in emerging market financials. She said: “We have also been augmenting exposure to credit and lending through additions to a handful of banks and payment providers that benefit from new, efficient online ecosystems.
“These operate in emerging markets that either lack established bricks and mortar competitors, or contain excessively profitable incumbents with poor, expensive-to-operate infrastructure. This provides a long runway for growth and an umbrella of profitability, respectively, as the most attractive and profitable segments are picked off by our holdings.”
The fund has 20.1% in financials, its second largest sector exposure, with familiar holdings such as JP Morgan Chase and Mastercard.
For more conventional exposure to the banking sector, investors may need to look closer to home. Financials are still a relatively large part of the FTSE 100 index, with financial services 12.1% of the overall market capitalisation, and banks 11.4%. The banking sector has been lowly rated as a result of both the general unpopularity of the UK market, and a lingering distaste after the financial crisis.
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Yet the sector has seen astonishing change. Jack Barrat, a manager on the Man GLG Income fund, said that five years ago, the banking sector looked cheap, but offered poor value. They were subject to significant regulation, which required them to rebuild their capital base. They were facing litigation for issues such as PPI. All their cash was diverted into addressing these problems. The sector also faced periodic restrictions on its ability to pay dividends.
These issues have slowly fallen away in the intervening years, at the same time as a higher interest rate environment has given them back the ability to earn a higher net interest income on their loan books. Man Income has a 37.5% weighting in financials, including 11.3% in HSBC and Barclays combined.
For the time being, the interest rate environment is still in the banking sector’s favour. Interest rates have come down more slowly than expected and remain high relative to history. If interest rates were to come down sharply, it could derail the recent rally.
There are areas where fund managers are urging caution. The European financials sector looks vulnerable to the region’s political turmoil, for example. Rob Burnett, manager of the WS Lightman European fund, said: “French bond market pressure will likely continue. This view argues against holding French financials for the time being, be it banks or insurers. It would also suggest some caution against holding aggressive positions in Eurozone financials. We continue to avoid any banks or insurance companies in the ‘red zone’”.
Financials have some tangible structural trends to support them, including the growth of financial inclusion in emerging markets, and the expansion of payment transactions across the world. They also remain an important part of global indices, at 16% of the MSCI World. This should ensure they continue to command attention in the year ahead and offer selective opportunities for fund managers.
Darius McDermott is managing director of FundCalibre
This story was written by our sister title, Portfolio Adviser
