In Fisher Investments UK’s experience, investors often treat equity sectors as monoliths – i.e. as if all companies within a sector will behave the same. For example, giant semiconductor firms’ moves will mirror the entire, broad Technology sector’s, or Pharmaceuticals determines the Health Care sector’s prospects. But Fisher Investments UK’s research analysts have found reality is more nuanced – as we will show using the Financials sector. Understanding industries’ unique characteristics can help investors position within sectors for the conditions they expect, in our view.
Financials are the second-largest sector globally, at 13.7% of the MSCI World Index by market capitalisation.[i] But there are three chief underlying industry groups: Banks, Diversified Financials and Insurers. While similarities among them exist, there are notable differences, too.
Let us start with Banks, which comprise about 43.7% of MSCI World Financials market capitalisation – easily its biggest industry.[ii] Whilst banks vary in size and services offered, their primary way of making money is through lending. Banks borrow at short-term interest rates (e.g. what they pay depositors on a savings account) and lend at long-term rates (like business loans or mortgages). The spread, or difference, between those rates is a proxy for banks’ loan profitability. We think this is why the shape of the yield curve – the graphical representation of one bond issuer’s interest rates across different maturities – matters to bank lending. If short-term rates are noticeably lower than long-term rates, the larger spread constitutes higher loan profits – a stronger incentive to lend.
Along with the yield curve, the broader economic environment also impacts banks’ profits. During expansionary periods, we find companies reliant on bank lending – usually smaller firms sensitive to economic trends – seek capital to grow, buoying demand for bank loans. In contrast, during economic downturns, banks often expect loan losses, and they set aside capital to cushion any hit, in our experience. That weighs on their profits. Later, when the economy improves, banks may release these reserves, a temporary profit boost. We think monitoring these conditions can provide a sense of whether Bank equities are in or out of favour.
By contrast, take Insurers, which makes up about 22.4% of the MSCI World Financials.[iii] Insurance companies are in the business of transferring risk – compensating a policyholder in the event of loss or damage. The biggest sub-groups are Life & Health Insurance and Property & Casualty (P&C) Insurance. The former offers insurance for personal and family loss (due to death, disability, accident or unemployment) whilst the latter insures against damages to people or property.
Insurers’ primary revenue sources are premiums (the amount the insured pays in exchange for coverage) and fee income, which is tied to investment management. Insurance companies aren’t as economically sensitive – i.e. demand for their products generally doesn’t depend on the economic cycle – so the industry is considered more defensive than industries like credit-sensitive Banks.
From an investing perspective, Financials’ various industries will often behave similarly. One way to see this is by reviewing how often Banks and Insurers outperform global equities simultaneously using correlation coefficients. Correlation coefficients are a statistical measure of how often two variables move together. A correlation of 1.00 is identical movement and -1.00 is polar opposite.
Over the past 20 years, the correlation coefficient between Banks’ returns relative to the MSCI World Index and Insurers’ is 0.66.[iv] That means Banks and Insurers tend to perform similarly more often than not – leading and trailing broader markets concurrently. By contrast, Banks’ relative returns correlate far less with other select industries’ returns relative to the MSCI World: Software & Services (-0.34), Textiles & Apparel & Luxury Goods (0.10) and Pharmaceuticals (-0.38).[v] Insurers’ relative returns have similar correlation coefficients to those industries’ relative returns: -0.25, 0.07 and -0.25, respectively.[vi] That illustrates, in our view, how industries within the same sector will behave in similar ways relative to the broader market.
But identifying industry-specific nuances can help investors position within the sector as the market cycle evolves. Fisher Investments UK’s research analysts have found economically sensitive equities tend to fare best early in bull markets (periods of generally rising equity prices). Banks fit that, in our view. But when bull markets mature and broad economic growth slows, other trends tend to take hold. Whilst lending may slow, we find investors’ confidence generally grows the further out you are from a bear market (a fundamentally driven market downturn of -20% or more). So other financial activity may pick up, including merger and acquisition activity and initial listings of new equities. Our research shows that may benefit Capital Markets firms, another industry within Financials. We can also envision market conditions – e.g. during a broader economic downturn – in which Insurers’ generally more-stable revenues allow them to hold up better relative to other Financials industries.
In our view, a part of successful long-term investing is looking at markets differently than the consensus. Digging beyond the sector and into industry-group characteristics is one way to do that.
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Fisher Investments Europe Limited, trading as Fisher Investments UK, is authorised and regulated by the UK Financial Conduct Authority (FCA Number 191609) and is registered in England (Company Number 3850593). Fisher Investments Europe Limited has its registered office at: Level 18, One Canada Square, Canary Wharf, London, E14 5AX, United Kingdom.
Investment management services are provided by Fisher Investments UK’s parent company, Fisher Asset Management, LLC, trading as Fisher Investments, which is established in the US and regulated by the US Securities and Exchange Commission. Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.
Investing in equity markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments UK and should not be regarded as personalised investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments UK will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.
[i] Source: FactSet, as of 10/03/2022. MSCI World Financials sector weight in the MSCI World Index. Market capitalisation is a measure of firms’ size calculated by multiplying the share price by shares outstanding.
[ii] Source: FactSet, as of 07/03/2022. Statement based on MSCI World Financials sector weightings.
[iv] Source: FactSet, as of 14/03/2022. MSCI World Banks Industry, MSCI World Insurance Industry and MSCI World Index price returns, 15/03/2002–11/03/2022. Correlation calculation uses difference in weekly price return between one industry and MSCI World Index and the compared industry and MSCI World Index.
[v] Source: FactSet, as of 14/03/2022. MSCI World Banks Industry, MSCI World Software & Services Industry, MSCI World Textile Apparels & Luxury Goods Industry, MSCI World Pharmaceuticals Industry and MSCI World Index price returns, 15/03/2002–11/03/2022. Correlation calculation uses difference in weekly price return between one industry and MSCI World Index and the compared industry and MSCI World Index.
[vi] Source: FactSet, as of 14/03/2022. MSCI World Insurance Industry, MSCI World Software & Services Industry, MSCI World Textile Apparels & Luxury Goods Industry, MSCI World Pharmaceuticals Industry and MSCI World Index price returns, 15/03/2002–11/03/2022. Correlation calculation uses difference in weekly price return between one industry and MSCI World Index and the compared industry and MSCI World Index.