With Thursday’s Federal Open Market Committee (FOMC) meeting fast approaching and a weak consensus suggesting that the Fed may finally raise interest rates from their record lows, many investors will probably be wondering where they will turn to if markets take a southward turn over the coming months.
It is with this in mind that I turn my own thoughts on one or two areas which are of particular interest to me.
Inter-dealer brokers are a fantastic play on the changing winds of monetary policy…
Inter-dealer brokers like ICAP (LSE: IAP) and Tullett Prebon (LSE: TLPR) have long lamented the pains of ultra low interest rates, low market volatility and reduced trading activity at the banks. However, ever more hawkish noises emerging from the Federal Reserve and the Bank of England are a sign that the outlook is beginning to brighten for these companies.
Given that their revenues and earnings (commissions) are largely dependent upon transaction volumes within financial markets, as opposed to the overall direction of the underlying asset prices, rising interest rates are great news for inter-dealer brokers.
Some shrewd investors saw this opportunity a long time ago and bought both companies heavily, prompting notable gains in the shares over the last 12-18 months. However, with transaction volumes still some 30% below their pre financial crisis peaks, the current recovery could still have legs to go further in the coming quarters.
In addition to their advantageous position when it comes to rates, both companies are much more attractive from a risk perspective, relative to the banks and asset managers. Most notably because they lack the heavy balance sheets, mortgage credit risks and the exposure to the overall direction of markets that many of these comparative companies have.
Furthermore, on a price-to-earnings basis, valuations are also reasonable — with Icap trading on 16.1x and Tullett at 15.5x 2014 earnings. This compares favourably with the riskier banks, insurance companies and asset managers, whose current multiples range from 15x to 19x 2014 EPS.
As a result, Tullett and ICAP are two companies that I will be keeping a very close eye on over the coming quarters.
Did I mention insurance companies already, non-life insurance companies?
I wrote at length about this recently; however, it is an idea that is well worth a quick recap as this industry is also one of the fortunate few that will benefit from higher rates over the medium term.
Given that Hiscox (LSE: HSX) and Beazley (LSE: BEZ) were among the non-life companies to derive a considerable portion of their earnings from their bond portfolios before the financial crisis, they should also be among those to benefit from a gradual push higher in rates.
Furthermore, on a price-to-earnings basis, both companies are also attractively valued with each trading at a discount to the wider non-life sector as well as the riskier banking sector.
Given that the non-life sector currently averages 17.8x and the banking sector 19.2x 2014 earnings, the 14.4x multiple at Hiscox and the 13.7x figure at Beazley are particularly attractive when considering the medium term outlook for earnings.
Barclays could also be worth a go, for those with the requisite stomach…
If, for whatever reason, the above industries are not of interest, then you might like to consider a company like Barclays (LSE: BARC), whose fixed income, currencies and commodities (FICC) business has been the bane of its existence of late.
With interest rate and FX volatility likely to return to markets over the coming quarters, the once-prized FICC business could soon begin to make a more meaningful contribution to earnings.
However, those that do venture here would do well to consider the potential for further skeletons to emerge from the closet, in addition to the group’s complex capital structure that sees most of its earnings eaten by bondholders.