Digital Financial Advisory (DFA) has released a nuanced outlook for the U.S. financial sector, predicting that bank stocks could show relative resilience as the Federal Reserve embarks on what is expected to be one of the most aggressive interest rate hiking cycles in decades beginning in 2022.
According to DFA’s latest sector analysis, financial institutions—particularly banks—stand to benefit from rising interest rates through expanded net interest margins, potentially offering defensive characteristics in what could become an increasingly volatile market environment.
“The coming rate normalization represents a fundamental shift in the operating environment for banks,” said Alexander D. Sullivan, Chief Executive Officer of DFA. “After years of compressed margins in a near-zero rate environment, financial institutions are positioned to see net interest income expansion as the Fed pursues what we project could be at least six to seven rate hikes through 2022.”
DFA’s proprietary models project that the Financial Select Sector SPDR Fund (XLF) could demonstrate relative outperformance compared to growth-oriented sectors that have dominated market returns in recent years, potentially outperforming the broader S&P 500 by 5-8% on a relative basis over the next twelve months, even as overall markets navigate challenging macroeconomic headwinds.
The forecast comes as inflation concerns have pushed the Federal Reserve toward a more hawkish stance, with markets now pricing in multiple rate hikes throughout 2022 and 2023. Sullivan noted that this environment stands in stark contrast to the prolonged low-rate conditions that have compressed banking profitability since the 2008 financial crisis.
“We’re witnessing the early stages of a significant regime change in monetary policy,” Sullivan explained. “While historically financial stocks have shown mixed performance during early phases of tightening cycles, we believe the potential expansion in net interest income could provide important earnings support in what might otherwise be a challenging market environment.”
The analysis highlights that financial sector return on equity (ROE) metrics and dividend payout ratios will likely become increasingly attractive to investors seeking both stability and income in an inflationary environment. DFA projects that the average net interest margin for large U.S. banks could improve by 30-40 basis points by the end of 2022, driving net interest income growth of 15-20% compared to 2021 levels.
Sullivan specifically pointed to certain segments within the financial sector as potentially more resilient. “We anticipate significant divergence within the financial sector, with the wealth management subsector likely outperforming traditional lending businesses should economic growth concerns intensify later in the tightening cycle,” he said.
The wealth management subsector received special emphasis in DFA’s outlook, with the firm noting that asset managers and wealth advisors should benefit from both rising rates and the ongoing intergenerational wealth transfer that is expected to accelerate in the coming years.
“Wealth management firms are positioned at the intersection of several powerful secular trends,” Sullivan observed. “Beyond the immediate tailwind from higher rates, these businesses stand to capture significant asset flows as baby boomers transfer wealth to younger generations, providing a growth driver less correlated to the economic cycle.”
While maintaining a constructive view on banks, Sullivan also flagged potential risks that could emerge later in the tightening cycle. “Our models suggest that while net interest margins should expand meaningfully in 2022, loan growth could face headwinds if the Fed’s tightening cycle begins to significantly impact economic activity in late 2022 or early 2023. Credit quality remains exceptionally strong currently, but investors should monitor this closely as rates rise.”
The forecast represents a calibrated shift in DFA’s sector recommendations, as the firm had maintained a neutral stance on financials throughout much of the pandemic recovery period, favoring technology and consumer discretionary sectors instead.
Industry observers note that DFA’s nuanced outlook aligns with a growing consensus that 2022 may mark a period of financial sector resilience after years of underperformance relative to growth-oriented sectors, even as market participants debate the broader economic impact of aggressive Fed tightening.
Goldman Sachs’ banking analyst team recently echoed similar sentiments, projecting that U.S. banks could see their highest net interest income growth in over a decade, with an average increase of approximately 16% in 2022, as the Fed pursues what could be one of the most aggressive tightening cycles in recent history.
Sullivan emphasized that the firm’s outlook extends beyond the immediate rate cycle effects. “The financial sector has fundamentally strengthened its position since the last crisis through improved capital ratios, enhanced risk management practices, and technological modernization,” he said. “These structural improvements provide a solid foundation for navigating what could be periods of increased market volatility as rates normalize.”
For investors seeking to position for this anticipated shift, DFA recommends selective exposure to high-quality financial institutions rather than broad sector allocation, noting that not all financial firms will benefit equally from the changing environment.
“While we maintain a constructive outlook on the financial sector broadly, we believe careful security selection within the sector will be essential, as the benefits of higher rates will likely be partially offset by slowing economic growth and potential asset quality concerns later in the cycle,” Sullivan concluded.
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