Financials lagged wider equity markets in July as bond yields came under pressure from mixed economic data and the spread of the Delta variant globally, which has resulted in weaker sentiment towards cyclical sectors and therefore financials. Against this background, despite the Trust’s overweight position in bank stocks, which underperformed during the month, the fall in net asset value of 1.0%, was less than the 1.3% fall in our benchmark index.
US financials fell by 0.7% over the month, led by banks, despite second quarter results coming in well ahead of expectations, primarily driven by lower provisions for loan losses, due to the write-back of provisions built up in 2020 but, positively, not the sole influence, with fee income showing strength. As a result, earnings’ estimates for US banks have risen sharply this year but with net interest income expected to have bottomed this quarter, the first signs of a pick-up in loan growth should be supportive in the second half.
US SMID-cap bank results, where the Trust has a key overweight position, were equally encouraging with asset quality also remaining resilient while revenues were driven by strong loan growth. For example, Silicon Valley Bank grew loans 36%, Signature Bank 21% and First Republic Bank 23% respectively year on year. Growth has been funded by strong inflows of low-cost deposits which has increased all banks’ interest rate sensitivity materially.
Growth has been funded by strong inflows of low-cost deposits which has increased all banks’ interest rate sensitivity materially.
European financials rose 0.2% in July although, as in the US, the banking sector was relatively weak as concerns around COVID-19 came back into focus. Second quarter GDP rose sharply as restrictions were lifted and domestic spending recovered with the labour market continuing to improve. European banks that announced results before the month end showed similar trends to their US counterparts with provisions for loan losses coming in lower than expected, as well as higher revenues similarly leading to upgrades to earnings.
Asian financials fell 3.2% as regulatory developments in China weighed on sentiment and added to market volatility led by pressure on Chinese stocks. Having initially focused on anti-trust issues with large technology companies in China (Alibaba and Tencent), regulatory scrutiny broadened out in July to other sectors (including education, food delivery and gaming). Along with efforts to reduce the scope for regulatory arbitrage by technology companies as they grow rapidly and expand into new sectors, recent regulatory changes are in keeping with the stated objectives of tackling social inequality (of which rising education costs are a factor and have contributed to a decreasing birth rate).
The ultimate objectives are still unclear and the intervention by Chinese authorities had a destabilising effect on markets and added to growth concerns related to rising COVID-19 infection rates. The Trust is underweight China and we viewed the sharp selloff as an opportunity to add to our holding in AIA Group which offers attractive long-term growth, in particular as new provincial licences are granted in China, and near-term catalysts related to the lifting of COVID-19 restrictions, including a recovery in the Hong Kong offshore market when the border reopens.
During the month the Bank of England, the European Central Bank (ECB) and the Monetary Authority of Singapore all announced the removal of capital return restrictions. While each regulator called on banks to be prudent on payouts in the near term, the return to normality with the removal of restrictions first imposed in March 2020 is a significant positive for the respective banking sectors. Indeed, the ECB even acknowledged that they expect “a number of banks” to pay catch-up dividends from 2019-20, or initiate share buy-back programmes in the fourth quarter.
The ECB’s lifting of restrictions, which applies from September 2021, preceded the release of 2021 stress test results. Using more credible assumptions than in previous years, for example with unemployment peaking at 12.1%, came broadly in line with expectations and did not suggest banks’ capital return plans would be prohibited. While the market reaction to the lifting of restrictions was muted, we view it as an important development for the sector given the scale of potential capital return (a number of our holdings offer a total return well in excess of 10% to be paid over the next nine months).
July also witnessed the publication of the Bank of England’s long anticipated consultation paper on MREL (ie, the minimum amount of bonds that a bank must hold in theory to prevent public money from being used to bail it out if it were to fail). Very little new has been proposed, other than to give smaller banks longer to meet the requirements which will be marginally helpful, and they did not, as had been hoped, raise the threshold at which UK banks would have to comply currently set at £15bn in assets versus €100bn in Europe.
We believe the tailwinds remain very positive for the sector over the next couple of years. In our opinion, the recent results have confirmed the resilience of the sector with companies almost without exception beating expectations in addition to the clarity on capital return.
Over the past couple of months as concerns around the reflation story have risen, financials have given back some of the outperformance since the positive vaccine news in November. Nevertheless, we believe the tailwinds remain very positive for the sector over the next couple of years. In our opinion, the recent results have confirmed the resilience of the sector with companies almost without exception beating expectations in addition to the clarity on capital return.
The Federal Reserve’s July senior loan officer survey showed a further rise in demand for loans across most categories, with the exception being mortgages. The Bank of England and ECB’s surveys released last month also gave a similar message so this should bode well for a pick-up in loan growth in the second half of this year and into 2022. Consequently, with valuations remaining undemanding we remain constructive on the outlook for the sector.