Financials sector

2023 may be a year financial-sector investors would sooner forget—marked by the banking crisis and subsequent market volatility.

For 2024, macroeconomic issues like growth, inflation, and Federal Reserve policy may continue to be key driving forces for this sector and the broader market. Yet there could also be reason for optimism, given that many banks are actually on strong financial footing. Plus, rising rates have dramatically altered the landscape for the financial sector in the past few years—creating potential opportunity for bottom-up stockpicking.

Recovering from volatility

The defining month of 2023 for the financial sector was March, when Silicon Valley Bank suffered a bank run, triggering its closure. Regulators then closed Signature Bank and First Republic Bank—with JP Morgan Chase acquiring most of the First Republic's business. And UBS acquired Credit Suisse, as the latter saw depositors withdrawing funds and its share price declining in the aftermath of the Silicon Valley Bank closure.

News headlines around the time of these closures may have stoked investor fears and prompted memories of the many bank closures of 2008–2009. But rather than snowball, the worst of the issues proved to be largely company-specific, and the market returned to greater stability as the year progressed.

In terms of sector-level performance, financials fell behind the S&P 500^® in March and never made up that lost ground as the year went on, although the sector showed positive year-to-date returns as of mid-December.

Looking ahead with cautious optimism

Looking ahead to 2024, there may be reason for cautious optimism. While the 2023 closures were unnerving, investors can take some reassurance that these incidents were triggered by a specific set of circumstances that may not apply across-the-board to banks and other financials.

The absolute level of returns for financials in 2024 may continue to be driven by the sorts of broad macro concerns driving the rest of the market. But the shifts and upheaval in the sector of the past few years may have also created opportunities for bottom-up research and stockpicking to add to incremental returns.A focus on deposit quality

A focus on deposit quality

The events at Silicon Valley bank highlighted the importance of deposit quality in the current environment. For most of the past 15 or so years, interest rates have been so low that banks could pay nothing (or next to nothing) on deposits, with little risk that those deposits might walk out the door. But as interest rates have risen, depositors now may have higher-yielding options for their excess cash, such as money market funds and Treasury bonds, making deposits more vulnerable to potential flight. This is why a focus on quality deposits has become so important.

A high-quality deposit base generally means one that is "stickier," in that customers are more committed to their banking relationship and less likely to follow financial incentives (such as marginally higher interest rates) to another institution. This stickiness may give an institution three potential advantages. The first is stability, because in times of stress to the financial system, banks with sticky deposits have often been more likely to come through in relatively strong shape. The second is that this stickiness can enable lenders to fund loans at a lower cost, which has historically led to better earnings growth over time. And third, stable deposit accounts may generate more fee income for a bank.

Opportunities in turmoil from higher rates

Higher interest rates have been reverberating across the sector in other ways. For example, the level and volatility of interest rates have temporarily slowed the pace of corporate mergers and acquisitions, meaning lower fees for firms involved in debt issuance and other facets of putting deals together. However, if or when rates stabilize, such as if the Fed continues the pause it began this past fall, then deal volume could pick up again. Such a rebound in deal volume could be constructive for capital markets-focused firms, like investment banks and debt-rating agencies.

In the life insurance market, higher interest rates have allowed companies to offer products with more enticing rates. Although risks could increase in this segment if the economy weakens, in my opinion the risk/reward profile of some firms in this group looks more attractive than it has in some time.

Potential value from stockpicking

To sum up, a higher interest rate environment has considerably changed the playing field for firms across the financial sector. But a pause in rate hikes could set the stage for stockpicking opportunities in 2024, particularly among retail banks with high-quality deposit bases, capital markets-focused firms, and certain life insurers.