Interest rates have begun rising again, and this is bad news for most stocks, as companies’ borrowing costs increase, and as a higher discount rate means that the present value of expected future earnings declines. Additionally, rising bond yields make fixed income investments a more attractive alternative to equities.

The big exception tends to be banking and other financial stocks, which normally enjoy greater profits as interest rates rise. In particular, these 4 financial firms appear especially well-positioned to profit from rising rates, according to Barron’s: banking giants Bank of America Corp. (BAC), JPMorgan Chase & Co. (JPM) and Wells Fargo & Co. (WFC), as well as discount broker Charles Schwab Corp. (SCHW). The table below summarizes the factors that should propel these stocks. (For more, see also: 6 Big Bank Stocks Rebound in Major Reversal.)

4 Financial Stocks Poised To Rise As Rates Rise

Bank of America, JPMorgan Chase, Wells Fargo:
   — Deposits growing faster than the banking industry average
   — Their collective share of all bank deposits up from 20% in 2007 to 33% in 2017
Charles Schwab:
   — Net interest income was 57% of 2Q 2018 profits

Source: Barron's

Significance for Investors

Rising interest rates normally allow banks to increase their net interest spreads, their profit margins on loans. In particular, the interest rates that banks pay to depositors tend to rise more slowly than the rates that they charge to borrowers on loans.

Regarding brokerage firms, net interest income can be a significant contributor to profits, as at Schwab. Much of this income source relates to their securities lending businesses, in which brokerage firms lend securities to short sellers. Long positions in the accounts of other clients are the source of these loaned shares, at zero cost to the brokerage firm.

Additionally, brokerage firms tend to pay below-market interest rates on cash balances in clients’ accounts. Depending on how the firm is structured, the cash in clients’ accounts can be used as working capital, reducing the need for more expensive funding sources such as commercial paper.

Bank of America announced 3Q EPS was up by 43% year-over-year (YOY) and 6% better than the consensus estimate, per CNBC. The respective figures for JPMorgan Chase were 25% and 4%, per Reuters. Wells Fargo, missed the consensus EPS estimate by 5%, and reported loans down by 1% YOY, per TheStreet.

Meanwhile, higher interest rates may not be bad for all non-financial stocks, as noted below by Bank of America Merrill Lynch.

"Some areas of the market that look inexpensive—financials, enterprise tech, industrials—actually would benefit from rising interest rates.'' —Savita Subramanian, U.S. equity and quantitative strategist, Bank of America Merrill Lynch

Source: Barron's

According to Subramanian, the growth prospects of these sectors are improving. Also, Barron’s observes that rising interest rates normally correlate with a growing economy, and cites several studies. SunTrust Banks looked at the last 65 years, and found 15 periods of rising interest rates. They discovered that stocks rose overall in 12 of those periods, with an average annualized gain of 12.6%. Bank of America found that recent cycles of rising interest rates were accompanied by rising P/E ratios about half the time. Credit Suisse indicates that stocks tend to rise when interest rate increases are gradual, without spiking more than 12 basis points in a day.

Looking Ahead

Respected longtime bank analyst Dick Bove issued a glowing report on the sector earlier this year, predicting that banks were entering a “golden age” that was likely to last for decades. Now he’s not so sure, having issued a bearish assessment last week. In the least, this suggests that investors should be choosy when approaching bank and financial stocks, rather than simply buying the sector. (For more, see also: Bank Stocks’ Biggest Bull Goes Bearish on Financials.)