Macro Research

The financials sector is the heart of our economy and you should not ignore it

The financials sector plays a very important role in any economy. While short-term downside risks remain, we believe investors should pay attention to the long-term tailwinds supporting the sector. Here is why we believe the global financials sector deserves a 3.5 Stars “Attractive” ratings.

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  • Published on 26 Aug 2020

The financials sector is the heart of our economy and you should not ignore it  | Open a FREE FSMOne account and manage all your investments conveniently in ONE place
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The financials sector plays a very important role in any economy. It is made up of the banking industry, insurance industry, and other diversified financials. 

A growing middle-class population will support the financials sector in terms of higher demand for better financials products and a higher consumption rate. 

The increased adoption of digitalisation will also have a positive impact across financial institutions in terms of revenue growth and lower costs.  

Interest rates across the globe are at an all-time low. While we acknowledge that low-interest rates will likely persist, we believe an eventual recovery in the global economy will lead to rate hikes, which will spur a recovery in the valuations of the global financials sector.

Based on our fair PB, this translates to an upside potential of approximately 27.4% by 2022. The global financials sector is also currently offering a decent yield of 4.2%, where investors will be paid while waiting for share prices to re-rate. 

Overall, we assign a 3.5 Stars “Attractive” rating to the financials sector.

The financials sector has always been one of the most heavily regulated sectors of an economy, and for good reason. Financial institutions play a very important role in an economy by mobilising funds, and providing liquidity in the form of loans, deposits, and investments.  

Look around and you will realise that everyone living in a developed economy has established a relationship with at least one financial institution. Almost all businesses would also require financial services at some point in time, be it for loans, insurance, or just simple financial transactions.

As such, it is very clear that the financials sector is highly interconnected with everyone and everything. It’s safe to say that no economy can advance without a strong financial system, underscoring the systemic importance of financial institutions in our world today.  

The sub-industries of the financials sector 


As one of the 11 sectors under the GICS classification system, the financials sector is made up of the banking industry, insurance industry, and other diversified financials. 

We are probably most familiar with the banking industry, which refers to the financial intermediaries that connect savers and borrowers. Unlike other businesses that sell products or services, banks make money by selling money. Firstly, banks take in deposits from customers and pay interest to deposit account holders in return. They will then channel these funds to borrowers as loans, on which they charge interest. By doing so, banks ensure that most money in the system are put to good use. 

There are also insurance companies, which offer risk management products to their customers and collect premiums from them in return. The premiums collected from their customers will primarily be placed in low-risk investments, helping the insurance companies to earn the spread between their investment return and what they have to pay out as benefits to the insured. The insurance companies can be viewed as large investors in the financial markets, ensuring the financial stability of individuals and groups/corporates by insuring their risks. 

Finally, diversified financials refers to a range of companies that offer a wide variety of financial products and services, such as the investment banks, asset management firms, brokerages, consumer finance and others.  

Long-term trends that will benefit the financials sector 


Overall, the financials sector had a good run over the last decade despite a few bumps along the way (Chart 1). However, just two months into 2020, we saw a massive sell-off in financial institutions across the globe as a result of COVID-19. Shares of the global financials sector plummeted by almost -40% at a point as most countries imposed lockdown measures, sparking fears among investors that financial institutions may not be able to handle the expected increase in bad debts, increasing claims, and loss of profits. 

Chart 1: Global financials sector share price movement over the last decade
 
While short-term downside risks remain, we believe investors should pay attention to the long-term tailwinds that will benefit the global financials sector. 

Growing middle-class population: By 2030, it is forecasted that the global middle-class population will increase from roughly 3.7 billion in 2020 to approximately 5.4 billion. This is an important milestone given how a growing middle-class population generally bodes well for the entire financials sector. 

An increasing number of wealthy individuals will spur demand for wealth management products, a trend which the asset and wealth management industry can capitalise on. A growing middle-class population is also favourable for the banks given how rising consumerism (retail sales and big-ticket items) will support loan expansion and card fees. Besides, as their living standards improve, demand for better medical care and wealth protection needs increases as well.  This will spur demand for long-term insurance products that will protect and help plan for their future wealth needs, benefitting the insurance industry. 

Digitalisation: Digital technology has revolutionised the way we live and it has become an indispensable part of our everyday lives. The COVID-19 pandemic has further accelerated the adoption of digital technology across all aspects of our life and it is no longer an option for businesses, including the financials sector, to stick to their traditional ways.

The majority of the large financial institutions in our society today have been around for decades and most of them are still using their legacy IT systems, which can be time-consuming and expensive. Therefore, as major players start to adopt new technologies, this could benefit them in terms of revenue growth and cost savings.  

For instance, technology allows financial institutions to enhance their ability to collect and analyse information. This can help to create more targeted marketing or cross-selling opportunities, which can boost customer conversion rates and ultimately, improve revenue growth. By migrating to digital platforms, financial institutions can also leverage new technology like automation, artificial intelligence, cloud solutions etc., all of which will help to improve efficiency and reduce overall operating costs. 

Eventual recovery in interest rates: In the first half of 2020, central banks across the world slashed their respective interest rates to near-zero in a bid to fight the COVID-19 crisis. While we acknowledge that interest rates are likely to remain low in the near term, we believe potential rate hikes when the global economy starts to normalise should spur a recovery in the valuations of the global financials sector. Rate hikes will be a positive catalyst for the banks and other diversified financials, whose profitability depends on net interest income. Rate hikes will also be a positive catalyst for the insurance companies since higher interest rates will translate to higher yield earned on their investment portfolio, which has a direct impact on the insurers’ profitability.

Taking part in the growth of global financials through these recommended products  


The financials sector has always been one of the most important and influential sectors in many economies. As more financial institutions around the globe adopt new technologies and expand their suite of services for the consumers, this could drive continued growth within the global financials space. 

The financials sector is the heart of our economy and for that reason, investors should not exclude them from their portfolio. Taking into account the recent sell-off, the global financials sector is currently trading at attractive valuations (Chart 2). We adopted a fair PB ratio of 1.1X, which translates to an upside potential of approximately 27.4% by 2022. The global financials sector is also currently offering a decent yield of 4.2%, where investors will be paid while waiting for share prices to re-rate. 

Overall, we will be assigning a 3.5 Stars “Attractive” rating for the financials sector. 

Chart 2: Valuations of the global financials sector is still low
 
To take part in the growth of the global financials sector, investors can consider doing so through our recommended ETF – iShares Global Financials ETF (NYSE:IXG)

The iShares Global Financials ETF (NYSE:IXG) is made up of almost 200 securities, including some popular names such as Berkshire Hathaway Inc, JPMorgan, Ping An Insurance, and S&P Global (Table 1). This ETF also uses a representative sampling strategy (partially replication) and the securities are selected based on their market capitalisation. As of August 2020, it has about 50% exposure to US-domiciled companies, 15% to financial institutions from Europe, and roughly 5% each from China, United Kingdom and Australia. 

Table 1: Industry breakdown of IXG ETF 

Industry

Weight (%)

Banks

48.7%

Insurance

23.0%

Diversified financials:

   Asset Management & Custody Banks

6.4%

   Investment Banking & Brokerage

4.5%

   Financial Exchanges & Data

7.9%

   Investment Holding Companies

7.6%

   Other diversified financials

1.3%

Source: iShares by BlackRock, iFAST compilations

Data as of August 2020


While headwinds in the market persist, we believe positive catalysts, such as a sooner-than-expected economic recovery, and interest rate hikes could potentially spur a recovery in valuations. If you favour a passively-managed solution, our preferred ETF pick for this sector is the iShares Global Financials ETF (NYSE:IXG). You may also consider the Fidelity Global Financial Services A-EUR if you prefer to gain exposure to the global financials sector through an active approach. 

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a NIL position in the abovementioned securities. The analyst who produced this report holds a position in iShares Global Financials ETF (NYSE:IXG).

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