The US financial sector is off to a strong 2013 after years of underperforming. The continually improving housing market is the driving factor. However, some of the setbacks in the financial sector are still present beginning with the extremely low interest rates and the lower interest-rate-spread revenue that lenders have accepted. New regulations create more costs for financial services organizations and counterparty relationships with European banks could result in losses for US banks if the European banking system collapses.
Regardless of the setbacks, market analysts see economic drivers that could continue strengthening the financial sector, even with low rates. Borrowing and repayment rates should increase as macroeconomic improvements continue and unemployment rates continue to drop. It looks like banks will have better operating leverage as the economy improves, because they’ve cut costs by reducing staff and locations. Once interest rates start increasing, the financial sector will start to see increased spreads.
For investors who are comfortable with the financial sector risks, the exchange-traded fund Financial Select Sector SPDR is a basket of US financial companies offering a broad US financial services sector exposure. This fund defines the financial services sector as commercial banks, diversified financial firms, capital markets companies, insurers, REITs, and consumer finance firms. It consists of 80 firms.
The US economy reacts to the high beta exposure offered by the financial services sector. Relatively small changes in unemployment and consumer confidence, directly affect loan repayment rates and consumer willingness to borrow.
Low interest rates have affected the banking industry’s interest-rate-spread revenue. In addition, new regulations which prohibit deposit-taking banks from engaging in proprietary trading and limit debit-card fees resulted in higher compliance costs, and high unemployment. Banks were able to manage their expenses by cutting staff and branch locations. In addition, bank stress tests reflect that they can withstand a serious economic shock.
However, banks have seen an increase in income due to the mortgage-refinancing boom and the solid fee they charge. A stronger housing market also means lower default rates and higher valuations for bank’s mortgage-backed securities. In 2012, low interest rates and better credit spreads led to significant debt-underwriting activity for investment banks. The stronger economy will help investment banks’ financial advisory and equity trading businesses as well.
In the life insurance industry, insurer’s economic capital levels have decreased to new lows, because of the persistently low interest rates leading them to take steps to improve their positions. They are now offering corporate pensions and asset management in addition to insurance.