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As you know, inflation was already high due to the impact of the global pandemic: governments around the world cut interest rates and increased spending. Layer on supply chain issues due to factory shutdowns, shortages of semiconductor chips and various other factors and inflation was already a problem even before Russia invaded Ukraine. This event caused a new and perhaps even more important problem: a sharp increase in the price of oil – an important determinant of inflation. As a result, the Federal Reserve, which was already far behind the inflation curve, finds itself in an even bigger hole. The fact is that the 0.25% increase in the fed funds rate this week is only the first of what the Fed currently expects to be six more hikes. The financial services industry is heavily dependent on higher interest rates: they typically profit from the low interest rate they pay on customer deposits compared to the higher rate they can earn by investing and lending . Therefore, investors should consider allocating part of their portfolio to the financial sector, and the Vanguard Financials ETFs (NYSEARCA:VFH) is a high-quality, cost-effective way to do this.

Investment thesis

As we just explained, interest rates are a key driver of earnings in the financial sector – and this should lead to higher stock prices for companies operating in the sector. Indeed, since the beginning of the year, the financial sector (represented by the ETF VFH) has outperformed the broad stock indices of the S&P500, the DJIA and the Nasdaq-100 – represented by the ETFs (SPY), (DIA) and (QQQ), respectively:

% change in VFH price vs peers
Data by Y-Charts

The current cycle of Fed interest rate hikes is just beginning with this week’s 0.25% hike: the first rate hike since December 2018. Also note that CNBC reported:

Along with the rate hikes, the committee also forecast increases at each of the remaining six meetings this year, indicating a consensus funding rate of 1.9% by the end of the year. This is one percentage point higher than that reported in December. The committee foresees three more increases in 2023, then none the following year.

Federal funds rate

Federal Funds Rate (New York Times (Federal Reserve))

However, investors should consider that even if rates were to reach 1.9% by the end of the year (which is by no means certain…), this would still remain well below the index. current consumer price index (“CPI”). The CPI is clearly off to the races with the latest reading hitting a whopping 7.9%:

Consumer price index

IPC (Federal Reserve)

The point is this: all other things being equal, the current rising interest rate environment should be a powerful tailwind for the financial services sector going forward. With that as a backdrop, let’s take a closer look at the Vanguard Financials ETF to see how it has positioned investors to benefit from the trend.

Top 10 holdings

The top 10 holdings of the Vanguard Financials ETF are shown below and correspond to what I consider to be a fairly well-diversified 40.6% of the overall portfolio:

VFH ETF Top 10 Holdings

VFH ETF Top 10 Holdings (Vanguard)

The top two holdings, each with an 8.1% weighting, are JPMorgan Chase (JPM) and Berkshire Hathaway (BRK.A).

JPM – with leading investment banking, commercial banking, credit card and asset management franchises, is perhaps the most dominant and arguably best managed bank in the United States

Berkshire Hathaway is up 35% over the past year and is currently trading at over $515,000/share, an all-time high. Its shares benefit not only from its financial and insurance exposure, but also from the relative strength of major holdings such as Apple (AAPL), BNSF Railroad, and it’s now a $7 billion stake in the stock of western oil (OXY), who has been on a real tear lately:

Western Oil Price Chart
Data by Y-Charts

What I mean here is that although VFH is a financial ETF, such a large weighting in Berkshire actually offers investors a bit of diversification and exposure to other sectors as well.

Wells Fargo (WFC), the fourth position with a weighting of 4.1%, may well be one of the most indebted banks when it comes to rising interest rates. For years, the bank was mired in scandal and mismanagement. However, highly respected Seeking Alpha contributor Stephen Simpson believes sentiment is improving for Wells Fargo given its asset sensitivity, loan growth and operating leverage. Wells is currently trading with a forward P/E = 12.9x and a yield of 1.94%.

Asset management companies like Charles Schwab (SCW), black rock (BLK), and Goldman Sachs (GS) are also well represented in VFH’s top 10 holdings, with an overall weighting of 6.8%. Goldman Sachs is down quite dramatically from its 52-week high and is currently trading with a forward P/E of just 8.75x:

Goldman Sachs Price Chart
Data by Y-Charts

When it comes to the broader portfolio, as you might expect, Diversified Banks have the largest allocation at 22.4%. The second largest sub-sector is the Regional Banks, with a weighting of 15.8%. Next come asset management (9.0%) and investment banking and brokerage (8.6%).

From a valuation perspective, note that the recent market correction has really taken down the VFH ETF’s valuation metrics and made the fund a value play against the broader market despite the generally bullish outlook. of the sector compared to expectations for further interest rate hikes:

VFH ETF Valuation Metrics

VFH ETF Valuation Metrics (Vanguard)

I would say that a P/E ratio of 11x compares quite favorably to the EPS growth rate of 16.5%. Pull on VFH’s current 1.9% yield, and the ETF looks very attractive in my opinion.

Risks

All the normal market risks also apply to the financial sector: the impacts of covid-19 (supply chains and factory closures), Russia’s invasion of Ukraine and the potential for economic catastrophe mutually assured if China chooses to help Russia and the United States respond with direct sanctions against China. These pose huge geopolitical, economic and market risks given the global economy which was arguably still in the early stages of recovery from the worst impacts of the pandemic. The fact is, the bullish tailwind of rising interest rates could be significantly affected by a number of dynamic geopolitical factors that no one – including myself – can predict with 100% accuracy how they will unfold. That said, with inflation so high, investors need to consider alternatives to holding cash, which still pays next to nothing (the 10-year Treasury is only giving 2.15%).

Summary and conclusion

The combination of the interest rate hike cycle and the recent market selloff has, in my view, made the financial sector a relative bargain against broader market averages like the S&P500, DJIA and QQQ. The Vanguard Financial ETF has an excellent portfolio that is well positioned to benefit from trending interest rates, has a P/E ratio of just 11x – less than half that of the S&P500 S/E=25xand has a relatively profitable expense fee of 0.10% – which is the same as the Financial Select SPDR ETF (XLF). XLF is an alternative to financial ETFs that investors should also consider. Either is likely to outperform the broader market over the next year.

I will end with the graph below which compares the returns of the VFH and XLF financial ETFs over the past 5 years:

Graphic
Data by Y-Charts

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