The Stock Market And The Financial Sector: Are Rising Interest Rates Always To Be Avoided?

As inflation rises and Federal Reserve interest rates go up correspondingly, many investors are reducing their stock holdings to maintain a healthy bottom line. This move is to be expected, as traditionally, ballooning interest rates are cause for concern and can diminish shareholder value. Yet, it’s important to remember that higher rates are not necessarily always a negative shift in the wrong direction. In fact, for investors with shares in smaller banking corporations, the jump can come as a welcome change.

Consider, for example, the Hennessy Small-Cap Financial Fund HSFNX. Its 38 holdings, worth a collective $200 million in assets, are comprised primarily of smaller-scale banks that operate at the community or regional level. For the most part, these entities aren’t up against big industry giants such as Bank of America BAC or JPMorgan Chase & Co. JPM. Rather, these holdings are asset sensitive, and as a result, the investments and loans they distribute are repriced at a quicker pace than their deposits. As such, when interest rates rise, there’s more of a difference between the banks’ borrowed assets and their lended ones. The result? A net margin that’s considerably larger than it was at the onset.

One way these smaller banks have a leg up when it comes to interest inflation? They’re not as affected by major industry shifts, primarily because they’re so dependent on the day-to-day transactions that drive them. In industry jargon, these transactions are known as “sticky deposits” and center around personal accounts on an individual level -- checking accounts, savings accounts and personal loans most specifically. With less emphasis on wholesale fundings than their larger-scale counterparts, there’s less potential for a liquidity crisis, such as the one faced by General Electric Corporation GE in 2008.

For savvy investors looking to cash in on this change, the emphasis should be on banks that follow a solid and proven lending strategy, have established credit quality, and have measures in place to ensure their expenses are properly managed. Then, a willingness to ride the industry wave will be key, as it may take a few years for shares of these companies to outperform the market as a whole.

One example of an over-performing stock is that of Brookline Bankcorp BRKL. The Boston-based holding company was the Hennessy Small-Cap Financial Fund’s fourth-largest holding at the close of 2018. Another standout is Banc of California, Inc. BANC, which recovered from repercussions including low asset quality and loan issues following a too-quick expansion. Now, the bank is projected to trade for 13 times its 2018 earnings estimate next year.

Moving forward, only time will reveal the extent to which industry changes will affect the banking sector as a whole. Yet, even amid inflation and rising interest rates, investors interested in the financial sector have plenty of solid options for moving forward. This might simply mean taking a second look at smaller entities that are less affected by the sector’s ebb and flow and more so by the communities that frequent them.