Despite 2021 not being the return to normality everyone had hoped for, it was an excellent year for equity investors with global equity markets (MSCI ACWI Index) returning 26.2% compared to 18.3% for UK equity markets (FTSE All-Share Index). Against this background, global financials and UK financials returned 26.2% and 13.7% respectively, led by a sharp rally in bank shares.
Looking forward, in our view the most likely driver of financial markets in 2022 will be inflation and the response of central banks to it.
Looking forward, in our view the most likely driver of financial markets in 2022 will be inflation and the response of central banks to it. Tail-risks abound – for example, a further spike in energy prices whether driven by geopolitical events or otherwise – but it is the prospect of rising inflation that resulted in January proving to be one of those “dangerous” months, to paraphrase Mark Twain. In December alone, there were 20 interest rate increases globally, taking the total in the fourth quarter to 54, close to the largest number ever for a quarter according to research by Bank of America. This continued into January, with a further 17 interest rate rises as well as one from the Bank of England on 3 February.
Consequently, the move in bond markets in the past few weeks as investors belatedly reacted to the shift in expectations for monetary policy resulted in a vicious rotation out of so-called growth stocks into value stocks such as banks and insurance companies at the beginning of the year. With longer-term inflation expectations still anchored, the biggest risk to investors’ positioning is that inflation, and therefore central banks’ response to it, ratchets up further or more quickly than expected.
Banking and insurance
The performance of bank shares over the past year reflects the fact that investors belatedly woke up to them being beneficiaries of the so-called reopening trade and that the jump in inflation, asleep for the past 10 years, would result in interest rates going up which would benefit their earnings. Banks’ profits have been squeezed in recent years by low interest rates as the difference between what they pay out to depositors and earn on their loans shrunk. This trend will go into reverse as interest rates rise.
Banks also took huge provisions for loan losses, in 2020, in anticipation of a significant jump in defaults. However, in reality, due to the largesse of governments and central banks to support economies in lockdown, as well as the more conservative lending policies of banks themselves, bad debts rose to barely a fifth of the levels seen in 2008-10. Perversely, consumers were not defaulting on their credit card balances but paying them off. As result, banks have been writing-back some of the provisions they set aside thereby boosting their profits.
Furthermore, we have seen banks announce large increases in buybacks and dividends as they look to return the surplus capital built up during the pandemic to shareholders. We expect this to continue. Banks have also benefited from the boom in financial markets. Loan growth, which has been relatively anaemic over the past two years, has also started to pick up as consumers are more confident to go out and spend and corporates look to invest in their businesses.
2020 was a black swan event for the insurance industry due to the cost of paying out for the cancellation of major sporting events but also business interruption policies sold to many businesses. In Australia, the wording of some insurers’ business interruption policies relied on an Act passed in 1908 that had been repealed in 2016 but they had failed to amend their wording so rightly had to pay out to policyholders. In 2021, insurers lagged the recovery in equity markets reflecting their defensive characteristics but the outlook for 2022 has markedly improved as the increase in insurance premiums is expected to more than offset any inflation in claims.
2021 was not such a good year for listed fintech companies, with payments’ companies coming under pressure over concern from the delay in the resumption of travel spend, due to restrictions, which is an important earner for the likes of Mastercard and Visa. Also, the impact of new competitors, such as Buy Now, Pay Later – which one wit has described as Buy Now, Charge Off Later due to the willingness of the companies involved to lend money with few checks – could have on long-term profitability has weighed on share prices.
Incumbents are not sitting on their hands either, relying on the inertia of customers not to shift, but are investing to compete. JP Morgan alone will spend $15bn on technology in 2022 – half of which will be investing to compete with new entrants – but they can, as they make close to a 17% return on tangible equity, a level a UK bank could only dream of. However, with valuations on some fintech businesses having derated sharply to more modest premiums to wider equity markets, the outlook is much brighter as the long-term structural growth drivers of the shift from cash to cards and growth in e-commerce continues.
All things being equal, we would expect the financial sector to generate good returns for investors in 2022, especially if central banks continue to raise interest rates. Financials is the most sensitive sector to rising bond yields and interest rates. For many banks, a 1% increase in interest rates translates to a mid-teens and above increase in earnings in the first year of an interest rate increase, rising further in the following years as more loans reprice at higher interest rates boosting profits further.
Valuations [in the banking sector] remain undemanding, supported by earnings upgrades, despite the strong recovery in 2021, and relative to wider equity markets are still below historical averages.
Within financials, the banking sector, which remains the core of the Polar Capital Global Financials Trust and the key overweight with over 60% invested across primarily US and European banks but also Asian banks, looks particularly well placed given its earnings sensitivity to interest rates and strong correlation to bond yields. Valuations remain undemanding, supported by earnings upgrades, despite the strong recovery in 2021, and relative to wider equity markets are still below historical averages unlike many other sectors which are still at or close to historical highs.
Against this background, we would expect UK financials to also do well, especially as the Bank of England has started raising interest rates after a false start. Global financials, despite having outperformed UK financials by 98% over the past 10 years, look set to continue to offer a better risk/reward over the longer term as they provide exposure to faster growing economies and companies. The sector has been out of favour for almost all of the past 15 years, but 2021 showed that may be changing.