Equity markets fell in February, led by Europe, as the shocking events in Ukraine and a stronger than anticipated international response understandably overshadowed other news. European banking and insurance stocks fell sharply as they are seen as some of the companies most exposed to the invasion and any indirect consequences of it. Against this background, the Trust’s net asset value fell 3.3%, in part from an overweight positioning in Europe offsetting good stock selection, while our benchmark index, the MSCI ACWI Financials Index, fell 2.6%.

US and European view

US financials fell 1.3% during the month, led by diversified financials with only insurance stocks posting positive returns. While US banks have negligible exposure to Russia, sentiment towards the sector was affected by concerns related to the indirect impacts from slower growth and weaker capital markets activity. The shift in outlook for growth and inflation was reflected in a flattening yield curve which also weighed on sentiment towards the banking sector. Fed Chairman Jerome Powell acknowledged the uncertain environment from the Russia/Ukraine war but guided for a 25bps rate rise in March given an “extremely tight” labour market and inflation well in excess of their 2% target.

As highlighted above, European financials were very weak, falling 7.9% in February. While European banks have reduced exposure to Russia since the Crimean crisis in 2014 and now have limited direct exposure, selling appeared fairly indiscriminate across the sector. For those European banks with the most exposure, notably Raiffeisen, Unicredit and Société Générale, none of which are held in the Trust, the direct impact from a full write-off is manageable from a capital perspective, although capital return expectations will be downgraded and a lower for longer interest rate outlook will impact earnings estimates.

Asian view

Asian financials were effectively unchanged over the month and therefore outperformed, supported by limited exposure to events in Russia and Ukraine both in terms of exports and tourism. Though Omicron continues to impact the region, with cases particularly high in under-vaccinated Hong Kong, the economies have been supported by good export figures, as Western markets have recovered. The next quarter should see this further supported by increased domestic consumption as Covid restrictions begin to be relaxed and tourism improves, in particular for south-east Asia.

While those banks and insurers which have direct exposure to Russia and Ukraine suffered the sharpest falls in February, it is the second order impacts on inflation, growth and credit risk that are, however, potentially much more significant for financial markets and, therefore, the sector. Indeed, with inflation expectations and commodity prices, in particular oil, gas and wheat, hitting multi-year highs, the invasion of one of the world’s largest agricultural commodity producers by the world’s largest natural gas, second largest oil and third largest coal exporter is fundamentally inflationary.

Activity

Consequently, we reduced our exposure to European banks at the end of the month and made further sales in early March, in light of events, taking our weighting to below that of the benchmark. Against these sales, we took advantage of the opportunity to start a holding in Finecobank, a leading digital bank and wealth management provider in Italy that has no exposure to Eastern Europe, and start a position in Baloise Holding, a Swiss insurer. Both should prove more defensive.

The sector remains extremely well capitalised, has strong liquidity and good profitability. The reasons for owning the sector have not changed despite events in Ukraine.

Outlook

Notwithstanding the backdrop, we continue to see a more constructive outlook for US banks due to its negligible direct exposure to Russia and a backdrop of elevated inflation and rising interest rates. However, we did reintroduce a holding in Marsh McLennan during the month, adding to our non-life insurance exposure, while also adding to our holding in Paypal Holdings, following its recent derating on disappointing fourth quarter results.

Inflationary pressures remain high in Asia, albeit they are beginning to ease in China, and there have been interest rate rises, although most are expected to come in the second half of the year, and overall expectations are not as hawkish as for the US. To date, currencies have remained reasonably resilient, but we suspect more pressures to come should oil prices remain at these levels. Our short-term preference is for Indonesia, therefore we have been raising our exposures to Bank Central Asia and Bank Rakyat Indonesia Persero on the back of a much more benign outlook for its economy.

History would suggest that falls in equity markets during wars or conflicts are buying opportunities despite the human cost involved. However, while Russia and Ukraine only account for 3% of global GDP, the ramifications of Russia’s invasion of Ukraine will be huge in the short term, as highlighted above due to the potential disruption to commodities and second order impacts on growth and inflation, as well as longer term.

Nevertheless, the sector remains extremely well capitalised, has strong liquidity, and has good profitability. The reasons for owning the sector have not changed despite events in Ukraine. Consequently, we have made limited changes to our US exposure but would likely raise our exposure to Asia, in particular India, if we see further falls in share prices. Only time will tell exactly what the impact of the war will be and in the meantime our thoughts are with those suffering in Ukraine.

As at 8 March 2022.