The narrative from the U.S. federal reserve is that interest rates will most likely be increased in late 2022 after a period of asset purchase tapering earlier in the same year.
When interest rates increase, there tends to be a period of stock rotation due to a more value-based approach by investors. Rising interest rates cause uncertainty in the future cash flows of growth stocks, which means that investors turn to more value-orientated stocks, especially those that offer dividends.
The sector that performs the best during phases of higher interest rates is the financial services sector, particularly banking. The reason for this is because banking profit margins increase as they charge higher loan premiums. There's also the factor of retrospective GDP growth leading to a strong economy, which causes rates to rise.
I'm bullish on Goldman Sachs (NYSE:GS) and Citigroup 's (NYSE:C) stocks. They're also my top picks in the banking space.
Goldman Sachs
Goldman Sachs beat revenue estimates in its second quarter with record revenue from Investment Banking, and retracement in M&A, Advisory, and Corporate Lending units.
Goldman produced a net interest income of $1.63 billion versus $1.48 billion in Q1, and $944 million in Q2 2020. The Investment Banking division's income also grew by 36% year-over-year, while Asset Management revenue ($5.13 billion) more than doubled from a year ago.
If we look at the PE ratio (6.9) out of isolation by incorporating its PEG (0.4), it's valid to conclude that the company's growth rate is still outpacing the stock price.
Furthermore, Goldman recently increased its quarterly dividend by 60%. Consistent dividend growth could be something investors favor in a higher interest rate environment, and that could, in turn, boost the stock price.
Wall Street analysts think Goldman is a Moderate Buy with a mean price target of $433.18 for the next 12 months. There have been eight Buy ratings, two Hold ratings, and one Sell rating on the stock.
Citigroup
Citi is a stock that many have been optimistic about since the arrival of the company's new CEO, Jane Fraser, in February.
It's anticipated that Fraser will emphasize the Asset Management division, while cutting off other less profitable divisions, such as Consumer Banking in Mexico.
Citi's revenue growth has been a letdown over the past five years, but signs of a more efficient business were communicated through the bank's Q2 results. Total revenue declined by $2.3 billion, but the net income increased by $5.1 billion, a 486.5% year-over-year increase.
Citigroup has managed to reduce its cost of capital by 57% since the start of 2020, and based on the trajectory the figure could decrease to the 5.2% level. Citi's debt/equity ratio has decreased by 56% since November 2020; the reduction in the debt ratio coupled with the reduction in the cost of capital means that the fair value of investors' holdings has increased.
Wall Street analysts think Citi is a strong buy, with seven analysts placing Buy ratings on the stock and none placing Hold or Sell ratings. The mean Citigroup price target is $88.71, which implies 26.4% upside potential.
Concluding Thoughts
Both of these stocks are trading at a discount, with Goldman being a pure value play and Citigroup being a bet based on asset pricing metrics.
These stocks will definitely benefit from higher yields.
Disclosure: At the time of publication, Steve Gray Booyens had a long position in GS.
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