Rising interest rates are often considered the kiss of death for financial companies, eating into their profitability and sending their stocks sharply lower. But some analysts say these worries have been overblown.
has vowed not to raise rates "for a considerable period," a strong gross domestic product report and a pickup in the rate of inflation have convinced some analysts that it's only a matter of time before rates are increased.
Financial stocks, of course, are considered very sensitive to changes in interest rates, and some investors worry that the group will be hurt by a rate hike in 2004.
There are legitimate reasons to be concerned. Banks traditionally borrow short-term funds from depositors and lend the money out at a higher rate. When short-term rates go up, profits can be squeezed. Higher rates also can hurt bond investments, whose prices decline when rates rise.
Still, some analysts say the perception of rate sensitivity is worse than the reality.
"If you look historically over time to changes in rates, the reality is that the net interest spread changes very little," said Michael Rosinus, general partner at the Tiedemann Investment Group.
The net interest spread is the difference between what banks charge on loans and their own cost of money. "Banks have gotten to be very good at minimizing the impact of changes in rates so long as they don't occur rapidly and unexpectedly," Rosinus said.
Bear Stearns chief investment strategist Francois Trahan said interest rate hikes typically come when the economy is showing strong growth and the stock market is doing well. A pickup in merger and acquisition activity and an increase in initial public offerings usually mean fatter profits for big brokers.
"The improvement in business conditions leads to an improved capital market, which inevitably favors asset managers and brokerage stocks," he said.
Trahan noted that
has consistently outperformed during the past four troughs in monetary policy and "we believe should find extra support as the yield curve continues to flatten." He also likes
Brad Hintz, an analyst at Sanford Bernstein, said that while big chunks of the securities industry aren't driven by interest rates, fixed-income shops like
are more vulnerable.
"They're most at risk because their mortgage-backed operation is so large," he said. "Mortgages are priced off the 10-year, so when that goes up, mortgage originations drop and that hurts profitability. A flattening yield curve also causes them to make less money off their inventory."
Still, Hintz also noted that fixed income is a lower-margin business than investment banking, and a pickup in the capital markets should help to offset weakness in that segment.
Tiedemann's Rosinus advises investors to position themselves carefully and move into large, diversified, money center banks, because while many banks won't be hurt financially by higher rates, they could be hurt by the negative perception on Wall Street.
"The perception is still that when rates change, there's some magnificent impact on bank earnings," he said. "I don't believe that's true, but at times like this people like to own larger, more capital-market-oriented companies where there's lots of free income and where higher rates signify better economic conditions."
He points to
as obvious choices.
Trahan said the consumer finance segment, which includes Citigroup, has "shown an ability to outperform" in past episodes of rising rates. Consumer finance companies benefit from strong economic growth and falling unemployment because fewer investors default on their loans.
Other analysts say online brokers like
stand to do well as retail investors continue to gain confidence in stocks after a three-year bear market.
While concerns about higher interest rates have perhaps been exaggerated, that doesn't mean investors should rush out and buy financial stocks. Many banks and brokers have become embroiled in the recent mutual fund trading scandal and face fines and other costs as a result. In addition, a number of stocks in the group are trading at lofty valuations, which could potentially limit any upside going forward.
"Bank valuations no longer look very compelling by historical standards," said A.G. Edwards analyst David Stumf.