As shown below, 2020 was not an easy year for bank investors, either relative to overall markets or other subsectors within the financial sector, but the final quarter suggested the beginnings of a revaluation of the most critical component of the financial sector. So, what is needed to sustain a rally and what should investors be wary of?

Below, we review the fundamentals of the US banking sector from the recently concluded fourth quarter results.

US banks v long bond yields

US banks v S&P Index

Tech and healthcare v financials and energy as a % of global equities

S&P500 Ex Tech v KBW Bank Index in 2020

Source: BofA Global Markets; MSCI.1Source: Bloomberg, December 2020.

What is supporting the sector?

Rising rates: The 10-year Treasury is now at its highest level since the COVID-19 selloff and when this rises it clearly boosts sentiment. If sustained (with Democrat control of Congress providing a tailwind to this view), rising rates will eventually feed into rising margins, greater loan demand and higher returns without added risk. The flood of new deposits during the crisis has made banks far greater beneficiaries of rising rates.

Further proof that balance sheets are not as bad as 2008: Despite banks weathering the 2020 storm well, the truth is many investors do not believe the loan book quality figures and Q1 results will be critical to reinforcing our message that they have provided conservatively for future losses.

Dividends: Regulators are moving in the right direction in terms of dividends and buybacks but a full restart of dividends in Europe and buybacks in the US will further boost sentiment. Underpinning this are the current strong capital positions.

M&A: Excess capital along with pressure on managements in a low-rate environment to deliver efficiency improvements is expected to lead to an acceleration in M&A activity. The increase in M&A activity seen in 2H20 was supported by regulatory changes (particularly on capital requirements and use of bad will).

Fintech is not a Kodak event: New entrants are here to stay but digitisation is a positive for both them and incumbents, and COVID-19 restrictions have accelerated these trends to the benefit of all. Footfalls in branches have collapsed (-40% in UK bank branches). Use of automation and the cloud could also lead to significant cost reductions. But we need to see evidence of benefits through cost structures.

Banks reflect the macro environment: Some countries have weathered the crisis better than others and that will be reflected in their banks. This helps explain why our funds shifted materially into Asian markets in the latter half of 2020 and we expect recovery there to be stronger.

What could cause worries?

COVID-19 in 2021: Sadly, it is not finished and current trends in terms of lockdowns suggest further economic pain in the first and even second quarters of 2021. Governments are providing support, but non-performing loans could restart and past experience suggests many businesses fail as economies begin to recover, particularly if the numerous government support measures begin to fade after Q1.

Regulatory/political risks: The pandemic has seen unprecedented government involvement in many aspects of the economy and as the dividend restrictions highlighted, the banks were not immune and are always an easy political target under the guise of consumer championing. Equally, some of the relaxations of regulations to aid lending and liquidity could well be tightened again or governments could remain long-term players in providing lending. The risk of higher taxation as governments look to reduce debt to a sustainable level is always there although we suspect all sectors may be impacted.

Rising rates are good to a certain point: We all want to see wider margins but in a highly indebted world, an extended bond market and with real estate heavy loan books, we do not want to see sharp rises and sentiment could quickly turn more negative if that were to happen. Be careful what you wish for, but weak economies suggest this scenario is still in the distance.

The Polar Capital Global Financials Trust has more than 60% of its investments in the banking sector, a proportion which we raised consistently throughout the second half of 2020 and into 2021. The earlier charts highlight that we have barely scratched the surface in terms of a rotation to the sector and a narrowing of the discount attached to banks in recent years. There remain ample opportunities ahead.