Does higher inflation or a quicker recovery in economic growth as the pandemic recedes lead to the earlier withdrawal of quantitative easing and higher interest rates than markets are currently forecasting? Or does the easing of bond yields in recent weeks signal the anticipation that the end of the sugar rush of fiscal stimulus will lead to a return to the ‘lower for longer’ environment for bond yields that we saw in the years preceding the pandemic?
To quote Donald Rumsfeld, former US Secretary of Defense, it is one of those “known unknowns”.
In the latter scenario it is easy to see that the asset classes and sectors that have performed best over the past 10 years will probably continue to do so despite their high valuations. Most investors are likely well positioned to benefit from that, however at this juncture how do they best balance the other side of portfolio? Many have hedged with a variety of assets such as index-linked bonds despite the negative real returns they offer. Gold is often cited; equally commodities, real estate or equities, each with their own idiosyncratic risks and rewards.
A few have started to consider financials, in particular banks, as an insurance policy as one of the biggest beneficiaries of the reopening trade or higher inflation and therefore interest rates. For example, UK banks (as illustrated by FTSE 350 Banks Index) have risen by 39.9% over the past year, with individual banks such as NatWest Group and Barclays returning 94.0% and 74.6% versus the 26.6% return from the FTSE All-Share Index.
Eschewing a domestic view of the sector for a broader exposure to banks gives investors exposure to the faster growing economies of the world where banking remains much more profitable and is a growth industry unlike in the UK.
The banks’ latest results have been very strong almost without exception as they have released some of the provisions that they set aside last year in anticipation of a much deeper downturn in the economy, thereby boosting profits. They will also benefit from any pick-up in fee and loan growth as the UK economy continues to recover. Perhaps even more important, they are also very sensitive to rising interest rates which may boost their profitability so we believe they are a good hedge even if interest rates get nowhere near their pre-pandemic levels.
However, there may be a better option than UK banks to play the trade. One unintended consequence of regulations put in place in the UK following the global financial crisis to ringfence retail and small business deposits from the corporate and investment banking operations of the large UK banks has led to huge amounts of surplus liquidity building up in these new entities. As a consequence, there is fierce competition in the UK mortgage market as banks look to put these excess deposits to work to the detriment of their net interest margins and therefore profitability.
It is not surprising that since the onset of the pandemic, UK banks have underperformed global banks, as illustrated by MSCI ACWI Bank Index, by around 25%. Over the past five years the difference is even more stark with UK banks only returning 3.3% to shareholders compared to 52.4% from global banks. Therefore, eschewing a domestic view of the sector for a broader exposure to banks gives investors exposure to the faster growing economies of the world where banking remains much more profitable and is a growth industry unlike in the UK.
We believe having some exposure to a portfolio of global banks and other financial companies that benefit from higher interest rates gives the extra upside if interest rates rise as recovery continues to gain momentum. If that does not happen, there are still benefits of being exposed to a sector that should provide good returns to investors regardless as its valuation remains at a historically wide discount to underlying equity markets, in our opinion. The next 10 years for financial markets will be unlike the past 10, or the 10 before that – albeit no doubt just as volatile – but owning a broader basket of financials could well be a good way to hedge portfolios until the investment outlook becomes clearer.
Nick joined Polar Capital in September 2010 following the acquisition of HIM Capital, and is manager of the Polar Capital Income Opportunities Fund and co-manager of the Polar Capital Global Financials Trust Plc.
Prior to joining HIM Capital, Nick worked at New Star Asset Management. While there he managed the New Star Financial Opportunities Fund, a high-income financials fund investing in the equity and fixed-income securities of European financials companies, which outperformed its benchmark index in all six years that Nick managed it. Previously, Nick worked at Exeter Asset Management and Capel-Cure Myers. At Exeter Asset Management, Nick managed the Exeter Capital Growth Fund from 1997 to 2003 which over this period was in the top decile of the IMA UK All Companies Sector.