Equity markets rose in March, despite an initial sharp fall in the first week as ramifications of the sanctions put in place by the US, UK, European and other governments to Russia’s invasion of Ukraine impacted sentiment. Against this background, the Trust’s net asset value fell by 0.2%, while our benchmark index, the MSCI ACWI Financials Index, rose 2.8% as an overweight position in US regional banks, disappointing performance from a couple of our insurance holdings and having no holdings in Australia knocked performance.
US financials fell in March, albeit after adjusting for sterling weakness, they rose slightly over the month, driven by weakness in US banks which fell 5.4%. This was offset by strength in insurance and diversified financials’ stocks which rose by 9.4% and 3.1%, respectively. Sentiment towards the banking sector was affected by a flattening in the yield curve, which inverted towards the end of the month due to concerns around the outlook for growth and hawkish commentary from Federal Reserve Chairman Jerome Powell, indicating interest rate hikes at each of the six remaining meetings this year.
While we recognise that the growth outlook has moderated and the war in Ukraine has added to inflationary pressures, a recession is not our base case for the US. Importantly, the labour market remains strong (+431,000 jobs in March), savings rates are high (US households built up $2.1trn during COVID-19, $17k per household), wage growth is rising (in line with inflation for the lowest income quartile) and financing conditions, while tightening, remain highly stimulative with real rates negative at -2.3% (real policy rates were 2% on average looking back at the past seven US recessions).
European financials were also affected by weakness in the banking sector, with sentiment driven by developments in Ukraine. Visibility on the scale and duration of the indirect impacts on the region from the war remains low. However, it is clear that Europe is now facing a combination of slower growth, higher inflation and higher interest rates. This has led to earnings estimates being cut in aggregate for the sector for 2022, although there is a large degree of variation depending on the level of direct exposure to Russia, with higher provisioning and cost estimates being partly offset by higher interest rate expectations.
The ECB noted that European banks’ exposure to Russia appears contained and dismissed the possibility of a blanket ban on bank dividends. Given excess capital levels, the outlook for European bank capital return is strong with the yield premium to the broader market at a historical high. The Trust has no direct exposure to Russia, with our European bank exposure concentrated in core Europe and the UK. During the month OSB Group, a UK mortgage lender, reported encouraging results, notably a 20% ROE supported by NIM expansion and strong cost efficiency as well as an inaugural buy-back reflecting its very strong capital ratios.
Asian financials performed broadly in line during the month, with weakness in China offset by strength in Australia, which rose 15.1%, partly on the back of strength in the Australian dollar, Indonesia and Malaysia, seen as beneficiaries of rising commodity prices. In light of the improving macro outlook in Indonesia supported by containment of the latest COVID-19 wave and a tailwind from rising commodity prices, we added to our holdings in Bank Central Asia and Bank Rakyat Indonesia Persero.
China’s zero-Covid policy continues to weigh on economic activity, with PMI data in March coming below expectations, highlighting a contraction in both manufacturing and services. This also led to more shutdowns in China (restrictions implemented in Shanghai and Shenzhen during the month) and though Hong Kong has eased certain measures (reducing quarantine for international arrivals to one week), the strict rules continue to impact the economy. While there have been some signs of policy easing in China, we have concerns about the continued drag from COVID-19 restrictions. The Trust has no holdings in China.
As highlighted above, the 2-year/10-year US government bond yield curve inverted during the month. It has been a reasonable predictor of recessions over the past 30 years, with a lead time of around 18 months. However, prior to that, it has given a number of false signals. Historical data also shows that equity markets on average continue to rise for some time after it inverts. Furthermore, the 3-month/10-year US government bond yield curve is seen as a much better predictor of recessions. It has steepened markedly this year, in contrast suggesting that the next recession, when there is one, will be further out than markets fear.
While we have taken a slightly more defensive position, given the reduction in visibility and a moderation in the growth outlook, we remain constructive on the outlook for the sector.
Consequently, we remain positive on the outlook for US banks, which are highly geared to rising short-term interest rates and improving loan demand. We expect this to more than offset the headwinds from cost inflation and a normalisation in provisioning. However, in recognition of a more uncertain environment, we reduced the size of the overweight position during the month, and post-month end sold a holding in Regions Financial, an Alabama-headquartered regional bank, and added to more defensive sectors, such as non-life insurance and exchanges.
While we have taken a slightly more defensive position, given the reduction in visibility and a moderation in the growth outlook, we remain constructive on the outlook for the sector. With bank stocks trading below pre-Covid lows in terms of relative valuations, supported by strong capital return and set to see material tailwinds to earnings from higher interest rates, we view an attractive risk/reward but acknowledge that increased visibility on the potential fallout from the Ukrainian war is likely required before market sentiment improves.
As at 7 April 2022.