Financials, particularly banks, tend to benefit from an environment of higher inflation and higher interest rates. Lending and net interest margins increase, boosting profits, and asset quality generally performs well. Our research also shows that in an inflationary environment, credit spreads for banks can tighten versus industrials (excluding energy-related companies).
Fundamentals across financials are also in good shape, notably at US banks, where balance sheets have strengthened and many reported robust 2021 profits from high merger and acquisition (M&A) activity and trading volumes.
Given the strong fundamental backdrop, we think some US banks are attractive at current spreads. Part of the reason is technical. Last year, an unprecedented volume of supply drove spreads wider, particularly in A-rated credits, and at a time when A-rated risk underperformed. This year we expect much less supply, which could lead to tighter spreads.
We prefer US over European banks based on diverging inflation and interest rate outlooks as well as current valuations. We expect the US Federal Reserve (Fed) to raise rates four times this year with risks skewed to the upside, while we think the European Central Bank (ECB) will keep policy rates on hold until 2024. Spreads between large US and European banks are also tighter than usual, suggesting relatively attractive valuations in the US.
