ETF.com: In that same vein, when it comes to financials, the narrative is that rising rates are good for the financials sector because it improves its lending spreads. Is that something you consider?
Chisholm: I have heard the statement that interest rates are significant for financials and that's the play. When you look historically, on average, rising rates actually decrease your odds [of outperformance], marginally. It hasn’t been a significant positive factor historically for financials.
There are three critical drivers to financials' relative performance. The first is what everybody says: net interest margins. That's the spread between short- and long-term interest rates. Essentially short rates rising usually means a steepening yield curve; therefore, net interest margins expand. If you get that right, that'll give you about 60% chance of getting the financial sector right. So it’s a positive, but it's not a lock.
The second thing that's more important than that is loan growth. And the Trump administration and financial deregulation could impact that. Banks are more willing to lend. If willingness to lend goes up—we can study it historically—you have 71% odds of loan growth acceleration regardless of the base rate, which is an inflection from here, and we're at about average loan growth. If you get loan growth right, you have about 70% odds of getting the financial sector right. That's positive.
The final thing that trumps everything else in financials, especially when it's going bad, is credit. That's what we've seen over the last two years. Net interest margins have compressed, the short end has stayed down, and that was a negative. Loan growth accelerated, but not to great rates; so that was a loose positive. But credit has deteriorated, until now, for about 18 months. That overwhelmed the financials and compressed their multiples more than relative earnings offset it. On a go-forward basis, that's the factor that changes the most.
So if you say, “What if your base case plays out and profits recover? What are the odds that credit deteriorates?” Your odds are 10%.
Most likely, credit actually improves off of pretty decent levels. If credit improves, loan growth accelerates, and net interest margins expand, and you have the trifecta [for financials]. And it's shifting from an area where none of those have been particularly positive over the last 18 months to all three of them being positive, potentially, going forward.
ETF.com: Deregulation can be a more powerful fuel for credit growth, mitigating what higher interest rates might be. Again, the intuitive thought is, higher interest rates will mean less loan growth because lending will get more expensive.
Chisholm: I would say that not only does it mitigate it, but they're correlated. If I tell you profits are going to recover, almost by definition I'd tell you that odds are that interest rates rise. The interesting thing about interest rates rising is that when they do, so does GDP growth. And so does investment spending.
All these things are correlated, which, for me, leads me to the conclusion that interest rates are more often than not a function of growth, not a deterrent to growth. Now, of course we can point out the obvious examples where they were a massive deterrent to growth in the '80s. But more often than not, you see lending accelerate along with interest rates.
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