Financials continued their recent run of outperformance in October, supported by a further rise in government bond yields as markets priced in the higher probability of interest rate rises. Against this background, the Trust’s net asset value rose 3.3%, while our benchmark index, the MSCI ACWI Financials Index, rose by 3.9% with the portfolio lagging due to our mix of holdings in the US, with payment holdings particular laggards.

As inflation numbers continued to surprise to the upside, October saw an acceleration in the recent trend of hawkish central bank developments. The Canadian central bank, for example, abruptly ended its bond-buying programme, while the Reserve Bank of Australia declined to defend its bond yield target, a key pillar of their QE programme. Equally, the Bank of England’s Governor Andrew Bailey signalled the BoE “will have to act”.

The term ’transitory’, used so freely by central bankers and market commentators to describe the pickup in inflation during the summer months, also came under attack during October, with Raphael Bostic, President and CEO of Federal Reserve Bank of Atlanta, labelling it “a dirty word”, before going on to say that if colleagues mention it, they “have to put a dollar in the [swear] jar”. He went on further to describe his concerns that the longer supply bottlenecks last, the more likely they will impact on inflation expectations.

The futures market is now pricing in two rate hikes by the end of next year, although the market was taken by surprise by the BoE’s decision not to raise interest rates as expected.

Against this background, US financials outperformed rising 6.2% in the month led by diversified financials with banks rising by 5.2%. As expected, the Federal Reserve announced a tapering of asset purchases in early November which will bring quantitative easing to an end in June 2022. The futures market is now pricing in two rate hikes by the end of next year, although the market was taken by surprise by the BoE’s decision not to raise interest rates as expected.

US bank third-quarter results came in ahead of expectations leading to upgrades to earnings forecasts primarily due to lower provisioning than expected but revenues have also positively surprised (largely driven by stronger fees and trading income). Net interest margins were only 1bp lower in the quarter with loan yields stable. Loan to deposit ratios continued to fall as the influx of deposits since the onset of the pandemic has led to significantly higher cash on banks’ balance sheets.

Consequently, the banking sector has become more sensitive to a rise in interest rates with a 100bps rate rise increasing earnings on average by 13% in year one and 20% in year two (as more of the loan book gets repriced). Loan growth at large-cap banks remains subdued (with guidance pointing to a pickup in activity into year-end) while our SMID-cap banks saw an acceleration in loan growth driven by C&I lending (on average, loans rose 19% year-on-year for our SMID-cap bank holdings or 24% year-on-year excluding PPP loans).

European financials were also relatively strong in October, rising 4.5%. While COVID-19 infection rates are picking up in a number of countries in the region, the progress on vaccinations has prevented the requirement for a reimposition of restrictions so far. As with US banks, European bank results to date have come in ahead of expectations while a lifting of remaining regulatory restrictions has led to the confirmation of an acceleration in capital return.

For example, Nordea’s October dividend and planned capital return for financial years 2021 and 2022 equates to approximately 20% of its market cap. Similarly, ING Groep’s commitment to returning excess capital combined with their 70-80% dividend payout ratio supports a total yield of approximately 10% annually to the end of 2023. Both Nordea and ING Groep are held in the Trust.

October also witnessed the publication of the European Commission’s draft legislation on Basel IV which indicated a material reduction in the estimated increase in capital requirements in future years. Instead of a c20% increase in risk-weighted assets and therefore capital requirements by 2030, as recently estimated by the European Banking Authority, it will result in an increase of just 6-8%, a strong positive for the European banking sector and their capital return prospects.

Asian financials underperformed during the month, falling by 0.6% affected by weaker trends in China and Hong Kong. China’s policy-induced slowdown in the property sector remains an overhang with the government’s focus on rebalancing the economy towards consumption-driven growth and reducing leverage set to weigh on the near-term outlook. The Trust remains underweight China (1% exposure) with the exposure biased towards south and south-east Asia where we are seeing a pick-up in activity following a removal in COVID-19 restrictions.

We recently added to holdings in India, Indonesia and Thailand. In our opinion, they are all highly profitable companies which are strong beneficiaries of economic reopening and  have lagged due to COVID-19 uncertainties. A new holding was also purchased in the Tier 2 bonds of Provident Financial on issue. Gearing has fallen slightly in recent months and at the time of writing is around 7.5%, although it did briefly fall just below 6% at the end of October.

The sector has seen a strong recovery, but we continue to view valuation support in both absolute and relative terms.

While the timing of interest rate rises remains uncertain but with consensus earnings yet to capture the benefit of higher rates, and with the sector more positively geared than in previous cycles, we view this as a strong catalyst ahead. The sector has seen a strong recovery, but we continue to view valuation support in both absolute and relative terms. In particular, there is little or no premium in the valuations of those banks most sensitive to rising interest rates over those less, which implies markets have already assumed that any interest rate rises will be short-lived and the sector a contrarian call.

As at 29 October 2021