With the FTSE 250 already down around 25% since the start of the year, on top of record-high inflation, things may look bleak for stock markets. However, certain sectors benefit financially from increased interest rates. So, let’s look at two shares for me to potentially buy that I think will outperform the market going forward.
Why do some sectors benefit from higher interest rates?
Interest rates are very influential in determining the prices of stocks and shares. Generally, theory indicates that returns on debt increase as the costs incurred by borrowers rise. This can cause stock prices to drop as that cost may increase business’ future cash outflows, reducing their present values.
However, financials will directly profit from rising returns on debt as net interest margins will increase while the associated costs will stay relatively level. This is particularly applicable to banks that conduct most of their business through traditional banking activities such as mortgage lending, where an incremental change to interest rates can have a significant effect on the average cost of monthly mortgage payments.
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Alternatively, the uncertainty induced by falling share prices from higher interest rates may increase demand for fund managers effective in mitigating market losses, as well as benefit companies with an interest in gold prices — a popular safe haven for capital.
Why I would buy Virgin Money UK
Back in May this year, when the Bank of England raised the base rate to 1.0%, Virgin Money (LSE: VMUK) was able to increase its net interest margin to approximately 1.85% for the year, up from 1.75%. I expect this margin to increase further, which is very exciting for a bank with 80.43% of gross customer loans on their balance sheet being mortgages according to their 2022 interim report. In comparison, mortgages make up 56.21% of NatWest’s lending in the same report.
However, up until now, interest rates on saving have remained low despite base rate increases. If banks like Virgin Money start to compete on higher savings rates, this will start to put pressure on net interest margins and profitability again. However, Virgin Money does not have a notably high exposure to interest-bearing liabilities.
Why I would buy Legal & General
Legal & General (LSE:LGEN) is, undoubtedly, a big name in investment management, pensions, and protection in the UK. Since 2014, Legal & General has not experienced much growth in its share price. L&G currently has around £1.3trn in assets under management and is the UK’s market leader in pension annuities.
A large portion of L&G’s pension product funds will be invested into bonds to generate retirement income for clients. Previously, the low interest rate environment will have been hindering L&G in terms of pre-tax profits since lower bond yields require more funds invested to generate the same amount of income. Clearly rising, interest rates are already relieving pressure on L&G, with its 2022 interim report showing a 212% increase in its solvency ratio.
Quality and a strengthening balance sheet certainly make L&G a potentially solid choice for my portfolio in an uncertain, contractionary market.
