2024-01-14 11:29:18 ET
Summary
- While insurance benefits from persisting inflation, IYG has more banking exposures that would not benefit, at least to the extent that rates will positively correlate with inflation.
- With the picture being ambiguous, the PE doesn't offer a great margin of safety, and the expense ratio is not low despite finance being a well-known and liquid market vertical.
- We think that the pressures being put on banks currently, even if not extreme, will persist as we believe inflation may not come down rapidly. So we pass on IYG.
The iShares U.S. Financial Services ETF ( IYG ) covers US financial picks on a value weighted basis. That means both insurance and banking. We have a view that inflation will continue to surprise to the upside. We made this view clear for a couple of months now in particular while markets began pricing in substantial cuts. In light of that, we see a mixed picture for IYG. While insurance may benefit, there could be more incremental pain for banking businesses which also share rather equally in IYG. We would much rather skew to an insurance focused portfolio.
IYG Breakdown
IYG is composed of a large exposure to Berkshire ( BRK.A )( BRK.B ), then JP Morgan ( JPM ), followed by some credit card picks as well as more full service banks and rating agencies, with some asset management too. On balance, there seems to be much more focus on banking than insurance within IYG, with the only major insurance pick for the first couple of pages of holdings being Berkshire.
The PE is above 16x, and the expense ratio is at 0.4% which is not great for a pretty liquid segment of the market, with a pretty easily classified theme, however, according to the FactSet data , it's still lower than the 0.6% average.
Comments
Banking suffers quite a bit on the fact that most in their lending and deposits business have been running with portfolios that expose them to unfavorable duration gaps. Simply, they are forced to lend long and borrow short-term, and in a persistently low interest rate environment before COVID-19, that has resulted in a negative duration gap that exposes banks negatively to higher rates.
This wasn't immediately visible, as deposit beta, which is how sensitive deposit rates are to changes in prevailing rates, doesn't kick in immediately, with rate increases needing to be observed as rather sustainable. But now that is kicking in and with competition from alternative financial institutions, deposit beta is likely higher than it would have been a decade ago. Banks are by no means disastrously positioned, but observing declines in net interest income should be expected at this point. Persistently higher rates would make all this incrementally worse.
In insurance, it is quite simple: higher rates are great for insurance companies as they earn more on their reserve portfolios, which are heavily skewed into fixed income. Longer-term, they also offset higher capital costs by getting that performance on their large reserve portfolios.
The issue is IYG has more banking than insurance, and with our concerns around the inflation battle we don't think IYG is such a great pick.
Bottom Line
We are still seeing wage growth, and incidentally we are seeing still strong employment figures . Critically, in the US, inflation expectations remain above the 3% mark, and expectations fulfill the inflation prophecy. We expect with conviction that inflation will not fall, and see Powell's comments as more of a concern for the latter part of the Fed's two-part mandate rather than the inflation component.
Nonetheless, we think that they will not ignore persisting inflation either as it would permanently cripple Fed credibility, and that inflation would still correlate positive to the rate situation, even if growth is becoming a concern for the Fed mandate. We don't think that rates would fall meaningfully with inflation still persisting at current levels.
We are seeing inflation persist at substantial rates in the US, and also in Europe , although European inflation is rather independent from US inflation these days, as commodity deflation which affects global markets has already occurred to a meaningful degree.
A 16x PE doesn't offer a great margin of safety, with earnings yields at only around 6%. Note that the deposit and lending businesses may be more resilient than other components, especially for full-service banks, in particular investment banking and other transaction driven businesses, which may suffer on macro pressure as well as possibly renewed uncertainty around capital costs and inflation. While insurance exposures will do well, we feel that blending with the banking component, IYG doesn't strike us as excellent value, and the 0.4% expense ratio is not insubstantial with reference to the 6.25% earnings yield.
For further details see:
IYG: Some Duration Gap Bite-Back, But Insurance Still Looks Good