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Why bank shares and insurers are are set to shake off rising rates and inflation risks

03:00, 30 June 2022

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despite the turbulence of inflation and rising interest rates, analysts see the sector on the road to recovery – Photo: Shutterstock

Bank shares and insurers’ valuations have suffered the same fate as the rest of the global equity markets in recent weeks. But despite the lingering turbulence of inflation and rising interest rates, analysts who spoke to Capital.com believe the sector is due for recovery through the second half of the year.  

Following a peak seen during the first quarter of 2022, global stocks have declined considerably: the S&P 500 (US500) is down 16% in the past quarter, while the S&P 500’s financial sector has not been far behind at 15%.

Insurance companies such as Aviva (AV), Legal and General (LGEN) and Direct Line insurance (DLGI) have seen their values drop by almost 5%.Banks such as Barclays (BARC), Goldman Sachs (GS) and Bank of America (BAC)  have seen their stop prices drop much lower, by 10% or more.

Goldman Sachs (GS) share price

Rising interest rates usually have a positive impact on the sector: banks can now charge higher interest on loans and insurance companies can charge larger premiums.

However, when this scenario is paired with persistent inflation, revenues from investment income can shrink. This is because both banks and insurance companies take the funds they receive from customers and invest it to benefit from returns. And a slowing global economy is likely to place these investments under threat in the short term.

Despite this, analysts believe that the sector can recover once inflation peaks, making stocks in the sector potentially attractive for bargain-hunters.

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Aviva (AV) share price

Rising interest rates and inflation: the impact on banks

In general, rising interest rates are a positive for banks. They can charge higher rates for the loans they issue.

Rob Murphy, Managing Director at Edison Group told Capital.com says the the speed of the rate increase is something investors should watch.

“As long as interest rates rise gradually, then one can expect net interest margins to expand without impacting the ability of borrowers to repay (defaults) or trading profits (mark to market of securities positions).”

If the rates do increase quickly “then ultimately defaults will increase for both corporate and consumer borrowers as their incomes fall (GDP, unemployment) and interest costs rise.”

Lloyds Banking Group (LLOY) share price

As interest rates are currently being raised quickly, banks will become more concerned with the credit quality of their borrowers, which reduces their ability to take risks and can effect profitability.

Investors may be pricing this concern in with banks stocks such as Barclays (BARC), Lloyds (LLOY) JP Morgan (JPM), Citigroup (C), Goldman Sachs (GS) and Bank of America (BAC) all losing around 10% of their value during the past month.

Murphy does not believe inflation on its own is something to worry about. “Inflation is less of a problem in itself for banks than one might expect. Higher operating costs would be a negative, but on the other hand demand increases for working capital loans for instance – and collateral values will tend to reduce the severity of ultimate losses if borrowers do default”

Barclays (BARC) share price

Rising interest rates and inflation: the impact on insurers

Similar to banks, the insurance sector can benefitfrom times of rising interest rates.

Marius Strydom, CEO of South African investment research form Austin Lawrence Gidon, explains how inflation too can benefiot insurers: “Inflation can be very positive for insurance companies if it allows them to increase their premiums to appropriately price for the underlying risks they cover,” he says.

“The rising general inflation environment is likely to support insurance companies in repricing their products, not just to close the pricing gap that has emerged in recent years, but to better price for an increasing risk environment going forward,” Strydom explained. “This improved pricing discipline for the insurance sector is likely to be supported by enhanced pricing discipline by reinsurers in the wake of Covid-19 and the Ukraine invasion.”

Stocks in the insurance sector have fallen in the past month, though not as much as banking stocks. Aviva (AV) , Prudential (PRUI), Legal and General (LGEN), Direct Line insurance (DLGI) and Phoenix Group (PHNX) have alldrifted down by less than 5% during the past four weeks.

Legal and General (LGEN) share price

Pressure on investment income

Banks and insurance companies don’t only profit from on loan interest and premiums: one huge area of income also comes from efficiently investing the funds they receive, to earn an investment income. This is where inflation and interest rates may impact the sector the most.

As to banks, Murphy explains, “All banks are exposed to the value of financial assets through government bond, corporate bond and other holdings as well as trading books. Financial assets tend to fall in value as interest rates rise.”

Strydom says the insurance sector is likely to face a similar problem “The negative short-term impacts are mostly related to fixed-interest investment portfolios who have suffered realised and unrealised losses in line with the rises in fixed interest yields.”

Strydom adds: “However, once these negative portfolio adjustments have run their course, the higher yields on these portfolios will result in healthy investment returns on existing investments while new investments and reinvestments will yield more than they have historically, driving overall higher investment income”

 

Outlook for bank shares and insurers

As short-term pressures play out, the financial sector is likely to refurbish its profitability, potentially making some of the strongest banks and insurers a bargain in the long run.

For banks, once inflation slows, the sector is likely to increase its prices. Murphy says that “slowing inflation would benefit valuations generally as the market reduces future interest rate expectations and has more confidence in future economic growth.”

The insurance sector is likely to see enhanced margins soon, says Strydom. “We believe that the insurance sector is entering a hard premium cycle, which will boost underwriting margins and will be supported by improved investment income from higher interest rates,” he said. “This hard underwriting cycle is likely to usher in a period enhanced margins, higher earnings growth and improved dividends.”

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