Financials fell in June, albeit largely offset by sterling weakness, giving back some of their recent outperformance as the reflation trade took quite a sharp hit resulting in growth sectors outperforming. Despite positive economic data and a more hawkish outlook from the latest Federal Reserve FOMC meeting, bond yields came under pressure due to a sharp reversal in investor positioning which put pressure on the sector. Against this background, the Trust’s net asset value fell 0.6%, marginally outperforming our benchmark index, despite an overweight position in banks.

US financials were largely unchanged over the month with US banks giving back some of the recent gains on the back of the decrease in US government bond yields. The Fed’s annual stress tests in the month resulted in an end to the capital return restrictions put in place during the pandemic with all banks’ capital levels exceeding the minimum requirements. The subsequent bank disclosure on SCBs (stress capital buffers) and capital plans highlighted the improved outlook for capital return (median dividend increase of 10%).While the stock reaction was muted as results were largely in line with expectations, with more details on buyback plans expected to be given with second-quarter results, we expect the resulting step-up in capital return to be positive for US bank stocks. Importantly, it will also mark a quick return to a normalisation of the regulatory environment and to elevated payout ratios following a severe downturn (a significant contrast to the situation last cycle).

Given the regulatory overhang on the sector and the potential scale of capital return, we expect the lifting of restrictions to provide a positive catalyst for the sector.

European financials fell 3.0% in the month with banks again leading the weakness. Encouragingly, statements by Andrea Enria, the Chair of the ECB Supervisory Board, confirmed the end of dividend restrictions in Europe is only a matter of time with a decision expected on 23 July. Given the regulatory overhang on the sector and the potential scale of capital return, we expect the lifting of restrictions to provide a positive catalyst for the sector.

The ECB also published a detailed impact assessment of their dividend ban during the month. It acknowledged their recommendations “from March 2020 onwards resulted in bank share prices falling on average by 7%” although they admitted that other analyses point to a more significant fall. They also stated that their continued imposition could pose “several challenges” both to the authorities and banks themselves, in particular that they would be unenforceable.

Asian financials fell 1.5% in the month with broad-based weakness across the region (exacerbated by currency movements). Asian macro trends remain influenced by COVID-19 developments with a slower rollout of vaccination programmes constraining the ability to contain the rise in hospitalisations and the extent to which economies can remain fully open. A tightening of COVID-19 restrictions in Taiwan has led to a reduction in consumer spending and while export growth remains strong it moderated in June from the very high levels in preceding months.

China has also seen a slower than expected recovery in consumption trends affected by a reduction in mobility in certain regions associated with COVID-19 cases while credit tightening in recent months is expected to negatively impact domestic investment. Furthermore, Chinese stocks may be being affected by a severe clampdown on the technology sector so negatively affecting broader sentiment. Conversely, India, which had seen a material slowdown in May associated with the lockdown, is now showing a pickup in activity levels in June (back in line with April but still below pre-pandemic levels).

Globally, economic data has remained supportive of the reflation narrative albeit weakening in June with, for example, weaker US employment data than expected but arguably more than offset by record job openings. Also, while Fed Chairman Jerome Powell tried to dampen the perceived hawkish tilt, following the latest FOMC meeting, the subsequent messaging from some Fed officials, notably St Louis Fed President James Bullard and Atlanta Fed President Raphael Bostic, was hawkish with both in favour of an interest rate rise in 2022.

However, valuations for the sector remain attractive, particularly against the broader market, and with the recent pullback in the sector, we remain constructive in our outlook.

Similarly, in a more dramatic fashion, Andy Haldane, the chief economist of the Bank of England, called for an immediate unwinding of QE in his parting speech, as he expects “inflation to rise, significantly and persistently” through the second half of the year in the UK. Less surprisingly, Jens Weidman, president of the Bundesbank, warned of rising inflationary pressures while likening inflation to the Galapagos giant tortoise, which was wrongly classed as extinct for 100 years.

Either way, while the Fed has only made hawkish overtures, actual interest rate increases occurred across both sides of the Atlantic in June with the Mexican, Czech and Hungarian central banks all raising interest rates in order to stem inflation. In the short term, the Delta variant no doubt has also dampened enthusiasm towards reflation which will have impacted financials, in particular banks. However, valuations for the sector remain attractive, particularly against the broader market, and with the recent pullback in the sector, we remain constructive in our outlook.