Rising interest rates generally indicate a strong economy, which is generally good for the stock market. However, there's one industry that could be a disproportionally big winner.
A full transcript follows the video.
This video was recorded on March 26, 2018.
Michael Douglass: Let's talk a little bit about the key takeaways for investors. Now that we've given all of this information, let's try and distill it down. Of course, the first thing that bears mentioning is, an expanding economy is generally good for just about everybody stocks-wise. But there are still going to be disproportionate winners, and also some potential losers. Let's talk a little bit about disproportionate winners first.
Matt Frankel: The biggest disproportionate winner is banks that make their money off of interest rates, that's the whole reason they're there. Generally speaking -- we did a three-part series on banks earlier in the year, and it's a little more complicated than this, but the general idea is, banks take in deposits at low interest rates and loan out money at higher interest rates. The difference between them is known as the net interest margin. This is the profit margin in the banking world.
As interest rates rise, the rates that banks pay out rise as well, generally, and the rates that they charge consumers for loans tend to rise, as well. But, the rates that they're charging on loans tend to rise a little bit faster than the rates that they're paying out on deposits. If you have a savings account, you'll notice that your interest rate probably has not gone up by 150 basis points in the current rate hike cycle. This results in what's called margin expansion, where banks' profit margins get a little bigger as interest rates get higher, which we've already started to see over the past few years in a lot of the major banks.
Douglass: And, in fact, Bank of America (NYSE:BAC) CFO noted on their most recent quarterly call that, "With respect to asset sensitivity as of 12-31, an instantaneous 100 basis point parallel increase in rates in estimated to increase net interest income," or NII, as he called it, "by $3.3 billion over the subsequent 12 months." That's a big difference. And it's worth noting that, especially now that we're still near the bottom of the interest rate cycle, there's a lot of margin expansion potentially open to banks.
Frankel: There's definitely some margin expansion that happens when interest rates are at the lower end of the spectrum. You'll see this taper off if interest rates start to get a little on the high end, like 5% at the federal funds rate like Michael just mentioned. But, for the time being, we're still close to what you would call a normal level of interest rates. So, over the next few years, you should see margins expand significantly at most U.S. banks.
Douglass: Right. Interestingly, just this morning, when we were talking through and prepping for the show, I pulled net interest margin from S&P Market Intelligence for Bank of America, Citigroup (NYSE:C), Wells Fargo (NYSE:WFC), JPMorgan (NYSE:JPM). These are the big four banks. And I looked at what net interest margin looks like in 2017 and what it looked like in 2006, before the financial crisis.
What's interesting is, in 2006, Bank of America and Wells Fargo had bigger net interest margins than they do today. That's not terribly surprising, that's kind of how that's supposed to work. But Citigroup and JPMorgan had smaller net interest margins than they do today. And given that, again, there was a significantly higher federal funds rate, and we think a significantly higher federal funds rate will lead to net interest margin expansion, well, that doesn't really totally make sense. Now, of course, there are a few countervailing issues here, Matt, as you pointed out when we chatted about this.
Frankel: Yeah. Well, first of all, pretty much any comparison between a bank now and the same bank before the financial crisis happened is not a complete apples to apples comparison. There are a lot of assets that were on bank balance sheets, especially institutions like Citigroup back then, that are no longer the case. So, you really can't judge that too much. I'd say, if you want to see the effects of margin expansion, look at banks that are more like a traditional savings and loan that did well during the financial crisis, Wells Fargo being one of them. You mentioned that Wells Fargo had a significantly higher net interest margin in '06 than they do today. This is a case where you can really see the effects over time. Just keep in mind when you're looking at pretty much any bank that had a tough time during the financial crisis that you're not looking at the same bank 10 years ago.
Douglass: Right. And this is actually one of the interesting problems when thinking about interest rate cycles -- they tend to run fairly long, and this one has run very long by historical standards. What that means is, getting an apples to apples comparison between any two time periods can be somewhat difficult, because this isn't the sort of thing where there's a massive change in interest rates in a year or two, usually. So, it's really very difficult to see from a historical perspective how these things work, because so much has changed. Think about how much the world has changed since 2006, even leaving aside the financial crisis. The first iPhone happened in 2007. So many things have changed and shifted that it's really difficult to get a good historical perspective there.
Matthew Frankel owns shares of Bank of America. Michael Douglass has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.