United Kingdom

Return of inflation boosts financial stocks: The funds that are well positioned to ride the recovery

The recovery of global stock markets since the successful rollout of vaccines in developed economies has favoured some sectors over others. 

Financial stocks and funds that hold them - having been some of the hardest hit equity holdings at the start of the pandemic - have recovered strongly since November. And many retail investors are looking to gain extra exposure to the sector in their portfolios.

Last March, as investors stared in the face a sharp global recession, cyclical and so-called value stocks - styles into which financials typically fall - took a significant hit. The narratives of the post-pandemic market heavily favoured growth stocks.

Now, financials are benefitting not only from the recovery trade into value and cyclical stocks but also from the return of inflation. 

Financials favoured: Banks and insurers stand to benefit from rising inflation and value rotation

Having suffered since 2009 from rock-bottom interest rates and tight monetary policy, banks and other financial services companies are now looking forward to rejuvenated economies and the possibility of rising rates. 

For banks, low rates reduce the margins to be made on lending and uncertain job markets bring the prospect of bad loans being written off. For financial services, customers confident in their finances are more likely to purchase savings, investment and insurance products.

In the UK, the Prudential Regulation Authority's decision to ask banks to stop dividend payouts last year also did little to help their share prices.

Sentiment for equities generally is optimistic off the back of the vaccine rollout and the potential for economies to reopen and consumer spending to soar. Since November, however, the financial sector has outperformed the wider market as vaccine optimism started to take hold.

The MSCI World Financial Index is up 23.6 per cent in total return terms year-to-date, outperforming the MSCI World Index return of 13.4 per cent over the same period. Tech stocks, some of the runaway winners in post-pandemic 2020, have this year eked out a return of 9.9 per cent in comparison. 

'The global recovery will be highly supportive for the [financials] sector,' Thomas Moore, fund manager of Aberdeen Standard Equity Income said.

'Specialist lenders should directly benefit from increased loan demand and reduced impairments, while asset management companies are likely to benefit from increased fund flows and higher market levels.'

Inflation re-emerges: The ONS this week revealed that the CPI measure of inflation had nudged above the BoE target of 2% in May. As recently as July it was close to zero. 

Inflation signals are coming thick and fast both at home and globally as businesses reopen and the economy heats up. The latest UK consumer price index shows inflation surged to 2.1 per cent in May, up from 1.5 per cent in April.

Driven by the rising cost of clothes, fuel, food and drink, it is the first time inflation has jumped above the Bank of England's 2 per cent target in two years.

The Federal Reserve this week reacted to inflationary evidence in the US by warning that two rate rises will probably be required in 2023. That is two more than it had slated previously, but the new outlook puts it in line with money market forecasts for US rates. 

Fears that inflationary shocks and their effect on bond yields will cause a taper tantrum have yet to be justified. For the moment, price pressures are putting more momentum behind the rotation of funds into previously unloved stock market sectors and geographies.

'When there is less certainty about the value of future cash because of the impact of inflation, many investors tend to refocus on the here and now and gravitate away from "growth" sectors like tech companies towards businesses on currently attractive valuations, with strong balance sheets and the potential to churn out higher dividends in the not too distant future,' says Jason Hollands, managing director at Tilney Bestinvest.

Recovery trade: How the FTSE 100 index has perormed in the last 12 months.

Financials sit comfortably in this space and if inflation forces central banks to start raising interest rates, banks should improve their margins.

'Banks today are even more sensitive to higher interest rates than they were previously,' said Nick Brind, co-manager of financials specialist Polar Capital Global.

'This is due to the actions of governments and central banks to cushion the downturn last year, which has led to a huge growth in deposits.'

The question for retail investors is, how much of the expected recovery in financial sector businesses has been priced into their share values already. Much will depend on the course for inflation and therefore interest rates.

However, many analysts expect the recovery is not over for financials, and the London blue-chip indices that they feature in heavily.

Laith Khalaf, financial analyst at DIY investment platform AJ Bell, highlighted the need for investors to have some exposure to the financial sector.

'This area of the market is likely to move in step with fortunes of the economy at large, but it's also an area in the UK which has been unloved for a long time, so many portfolios may have little or no exposure,' he added.

Hollands also suggested investors who are heavily exposed to growth stocks and funds consider augmenting their portfolio with more value titled opportunities.

The UK market has a particularly high exposure to the financial sector, which represents around 23 per cent of the market. Jupiter Income has 27 per cent in financials including big positions in the likes of Aviva, Standard Chartered and Royal Bank of England. Fidelity Special Situations' two top holdings are Legal & General and Aviva.

'For those tempted by a specialist financials fund and wanting to cast their net globally, the Polar Capital Global Financials Trust is a UK-listed investment trust managed by a team with strong expertise investing in this space,' Hollands adds.

The trust's share price is up 21 per cent in six months and 74.2 per cent in the last year.

Its top holdings are mostly in large, developed market companies including JP Morgan, Bank of America and Paypal. But 28 per cent of its portfolio is in emerging markets and almost 10 per cent in fintechs.'

The Association of Investment Companies has produced a useful table that shows the investment trusts that have the highest exposure to financial stocks.  

Top 20 investment companies with highest exposure to financial services 
Investment Company AIC sector Portfolio held in financial services (% net) Data as at  
Polar Capital Global FinancialsFinancials 99.7 per cent 30 April 2021 
Augmentum Fintech Technology and Media 94 per cent 30 September 2020 
Chrysalis Investments Growth Capital 51.0 per cent 31 March 2021 
Aberdeen Standard Equity Income UK Equity Income 38.3 per cent 31 May 2021
Barings Emerging EMEA Opportunities Global Emerging Markets 36.3 per cent 30 April 2021 
VietNam Holding Country Specialist 34.9 per cent 30 April 2021 
JPMorgan Indian India 34.7 per cent 30 April 2021 
Middlefield Canadian Income North America 34.5 per cent 30 April 2021 
Vietnam Enterprise Country Specialist 34.0 per cent 30 April 2021 
JPMorgan European Income Pool Europe 32.0 per cent 31 March 2021 
JPMorgan Global Emerging Markets Income Global Emerging Markets 32.4 per cent 31 March 2021 
Ashoka India Equity India 32.0 per cent 31 January 2021 
Lowland UK Equity Income 32.0 per cent 30 April 2021 
Diverse Income UK Equity Income 31.3 per cent 30 April 2021 
BMO Capital & Income UK Equity Income 30.4 per cent 30 April 2021 
Dunedin Enterprise Private Equity 30.0 per cent 31 December 2020 
BMO UK High Income UK Equity Income 29.4 per cent 30 April 2021 
Aberdeen New India India  27.8 per cent 30 April 2021 
BlackRock North American Income North America 27.2 per cent 30 April 2021 
Dunedin Income Growth UK Equity Income 26.8 per cent 30 April 2021 
Source: Association of Investment Companies    

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