Financials navigate AI - February Trust Update

Market review

Financials lagged wider equity markets in February as there was a rotation out of more cyclical into defensive sectors as a number of stocks were hit by AI concerns. These moves were subsequently overshadowed by events after the end of the month in the Middle East. Against that background, the Trust’s net asset value fell 1.1% while the benchmark, the MSCI ACWI Financials Index, rose 1.1%. Our European bank holdings were the biggest detractors from performance, albeit individual holdings in FlatexDEGIRO and S&P Global were the largest individual drags, the former on profit-taking with the latter on a combination of AI concerns and marginally weaker-than-expected results.

Alternative asset managers

Alternative asset managers have been in the wrong postcode for the past year. While the backlog in private equity deals and more difficult fund-raising environment has been unhelpful, of more concern was the growth in the asset class leading to poor underwriting decisions. JP Morgan’s CEO Jamie Dimon’s comment last year on the bankruptcies of FirstBrands and Tricolor, to expect more “cockroaches” added to the negativity. Increased redemption requests for a Blue Owl non-public BDC (business development company¹) following a failed merger with a publicly traded sister fund and subsequently a Blackrock BDC and KKR BDC both seeing write-downs led to further weakness, but the fear that the industry’s large exposure to software is a significant risk from AI disruption led to another sharp selloff in share prices.

Against that background, the industry so far has continued to see strong inflows at odds with the coverage given to a small number of funds, where net inflows have slowed rapidly or reversed, while it continues to sit on a lot of dry powder – funds not yet invested. For now, defaults have been idiosyncratic and it would take an economic downturn to lead to substantially higher losses. Nevertheless, we have been underweight the subsector for some time, having reduced our exposure from around 10% two years ago to just over 1% seeing better risk/reward elsewhere. Having sold our holding in EQT during the month, our only holding currently is in Blackstone, which is the largest and most diversified of the alternative asset managers, with over $1trn in assets under management.

AI dystopia

The publication during the month of a dystopian investment blog on the impact of AI set in 2028 and looking at what had changed also impacted the share prices of other companies across the sector. As well as focusing on the alternative asset managers that have insurance subsidiaries, it raised the fear of much higher unemployment which would impact the banking sector, that Visa and Mastercard would be disintermediated while American Express would also suffer from a shrinking white-collar customer base due to job losses. Not mentioned but also affected in February were businesses such as S&P Global and Moody’s where concern that their data analytics could be impacted overlooked the fact that much of the data is proprietary.

CEO, Andrea Orcel, highlighted in an interview how an AI model that took a week to develop reduced the time for a credit officer to collate the data needed for a loan application from six weeks to 14 minutes with 98% accuracy – and they expect that to improve.

February also saw some sharp rotation with US and European banks selling off sharply intra-month, the former down nearly 10%. European banks were also weaker despite fourth quarter results leading to further positive earnings revisions. We put the price moves down to derisking as opposed to anything fundamental. Nevertheless, there are concerns that AI will lead to job losses and that its disinflationary affect will lead to lower interest rates and competition for deposits which will result in lower profits. On the latter, an analysis by broker Keefe, Bruyette & Woods shows that the incremental benefit in constantly moving savings accounts is de minimis, at no more than €7 per month when optimising 100% of balances over €10k, so we felt that much of the concern has fallen wide of the mark.

AI as an opportunity

Conversely, banking and insurance have been seen as the two sectors that will benefit the most from AI, according to a report by the consultancy firm Accenture, because they are very process driven. More recently, PwC also highlighted the opportunity from “melting of [the] middle office” where they believe banks could cut significant costs. Outside significant savings in automating responses from customers with simple questions, allowing staff to focus on helping those with more complex queries, specific examples have to date been relatively limited. However, JP Morgan has previously highlighted the significant improvement in onboarding new customers, where in one year they were able to process 50% more clients with 20% fewer staff, a significant improvement in efficiency.

Nevertheless, in the past two months, two bank management teams have highlighted the opportunity and raised medium-term earnings guidance significantly. UniCredit, Italy’s second largest bank, is targeting a 25% return on tangible equity in 2030 versus the 19% it achieved in 2025 and 6.7% in 2019. Similarly, Banco Santander, Spain’s largest bank which recently bought TSB in the UK and announced the acquisition of Webster Financial, a US regional bank held in the Trust, is targeting a 20% return on tangible equity versus around 15% today. Both see costs as a significant driver to achieving those targets. For example, UniCredit is aiming to cut costs by 1% per annum each year until 2028 and its CEO, Andrea Orcel, highlighted in an interview how an AI model that took a week to develop reduced the time for a credit officer to collate the data needed for a loan application from six weeks to 14 minutes with 98% accuracy – and they expect that to improve.

Outlook

The war in the Middle East will overshadow any other news in the short term and has led to the US seeing some better relative performance, as the selloff in Europe and Asia has been greater, reflecting the importance of imported oil and LNG from the Middle East for their economies. History shows that with very few exceptions equity markets have always been higher in fairly short order after other geopolitical events. The risk of disrupted oil supplies as during the 1970s still carries significant tail risk even if economies are less reliant on it today than they were 50 years ago. The invasion of Ukraine, which led to a significant spike in energy prices in Europe, also provides evidence that the impact may not be as significant.

1 BDCs or Business Development Companies were created by Congress in 1980 to spur investment to smaller and medium sized businesses in the US which they do by providing primarily debt finance on a senior secured basis.