A combination of tailwinds has given the financials sector a boost. Amid strong performance in January, investors have poured $352 million into EMEA-listed financials ETFs – more than any other sector during the month. The sector is a clear beneficiary of rising interest rates, but also offers low valuations and healthy dividends, which may provide support if economic growth worsens from here.
This year has started well for ETFs providing exposure to European financials, both from a flows and performance perspective. The sector gained 10.6% in January, easily outpacing the 6.8% rise in the broader MSCI Europe. The European financials sector has been rising on expectation of higher interest rates across the eurozone and other European countries, which is good news for banks operating on the continent. Indeed, both the ECB and BoE were in action last week, raising their base rates to 4% and 2.5%, respectively. At the same time, we have seen fears of deep recession abating, which reduces the riskiness of the sector.
Investors have taken note. Banks and broader financials ETFs with European exposure saw $352 million of net inflows in January, higher than any other sector and a big turnaround from the direction of investor interest during most of 2022. In terms of institutional investor positioning, which we can monitor through the State Street custody business, we see that investors are only modestly overweight, less than in other regions.
EMEA-Listed European Sector & Industry ETF Flash Flows Show Turnaround for Several Sectors
Looking at a scenario of rising rates alongside a still fragile economy, our Q1 Sector & Equity Compass focused on financials as one of the picks. The sector is a clear beneficiary of rising interest rates, but also offers low valuations and high dividends, which may provide support if economic growth worsens from here.
Compared with other central banks, we expect the ECB and BoE to raise rates further and to stay higher for longer. This would have a big impact on the net interest income margins of banks and positive earnings momentum should continue. This is good news for P&L accounts. Meanwhile, healthy balance sheets should support expansion and distributions. Banks' capital positions are relatively strong and can manage some credit risk, and the big insurers are showing solid Solvency II ratios.
We are early in the reporting season for European financials. So far the results are mixed, although the number of positive surprises has exceeded misses. The points of interest to investors include the impact of higher central bank rates on margins, with the hope of positive jaws between revenue growth and cost rises, including wages. For retail banks it is about levels of lending and bad debts, while for investment banks the key points are whether trading volumes can offset fewer transactions and IPOs. Insurers are hopefully reporting on a harder rate environment.
Even though the sector has outperformed for a few months, its forward P/E rating of 9 is at a 40% discount to the broader market, still well below average levels over the last 10 years and showing the impact of positive earnings sentiment. Forward price/book of 9 is at average historical and relative levels. An average dividend yield of more than 5% adds to the sector’s valuation argument.
While banking ETFs offer a higher sensitivity to rising rates, investing in the whole financials sector offers relatively safer, less volatile exposure given the benefits of diversification. Insurance businesses offer quality aspects, in terms of return stability and less cyclicality, and the prospects for reinsurance rates hardening this year. Diversified financials boast a structural growth element from asset managers, expansion of exchanges and index businesses.
For fans of the SPDR Sector ETF Momentum Map, financials looks well positioned among European sectors in the Leading Quadrant; it is second only to consumer discretionary in terms of Relative Strength Ratio and Momentum. To learn more about how to use the Sector ETF Momentum Map, please review this helpful guide.