April was a brutal month for equity markets, as illustrated by the MSCI ACWI World Index which fell 8.0%, albeit due to US dollar strength. For sterling investors this resulted in a fall of “only” 3.5%, as increasingly hawkish central bank rhetoric and China’s zero Covid policy weighed on sentiment. Against this background, the Trust’s net asset value fell by 3.5%, while our benchmark index, the MSCI ACWI Financials Index, fell 3.9%.
US financials were very weak, falling by 6.3% led by bank shares. The weakness in US banks came despite an encouraging first quarter results season which has led to earnings upgrades (FY23 EPS estimates +3.4% since mid-February versus S&P 500 FY23 estimates of +0.5%). Upgrades have been driven by an improved outlook for net interest income, reflecting stronger loan growth and interest rate increases more than offsetting fee income headwinds. Despite concerns on inflation and a moderating growth outlook, costs came broadly in line with expectations, with full-year guidance typically reiterated, while asset quality remained benign.
The main negative was a larger than expected impact to capital and book values as unrealised AFS losses increased on securities portfolios. We would note that capital positions remain robust and the impact (only the largest eight US banks’ regulatory capital is affected) will be offset over time as rising interest rates feed through into higher revenues. Following a de-rating (due to both share price weakness and earnings upgrades), we added to a number of our SMID-cap US banks which reported strong trends. For example, Signature Bank and SVB Financial Group, saw a year-on-year increase in net interest income of 41% and 64% respectively .
Markets in Asia continue to be overshadowed by the strict lockdowns being implemented in China and worries over the impact this will have on China’s and the region’s economies. There have been positive noises from the Chinese government on potential support measures and bank reserve requirements were cut during the month. However, we expect further negative news flow over the coming month as lockdowns are reflected in economic data. Having said that the region’s exports continue to show strong growth and trade surpluses are healthy.
Not surprisingly inflation is rising and there are growing worries that some countries are behind the curve in terms of raising interest rates, so we suspect more rate rises are ahead. The reluctance to raise interest rates is primarily because of weak consumer confidence throughout the region exacerbated by rising fuel prices (a number of countries have managed fuel prices so far but are likely to be forced to raise them in the next few months). There is little evidence of these pressures feeding through into the loan book quality of the banking sector and overall the results season of our holdings was positive.
Arguably, the best results are coming from our Indonesian bank holdings with accelerating loan growth a key positive. Deposit-rich franchises are also beginning to see positive impact on their net interest margins and there is more to come as interest rates are increased (generally most retail banks in Asia have large pools of low-cost deposits, reaching 80% in the case of Bank Central Asia and 48% in the case of HDFC Bank). The latter also announced the merger with HDFC Corp, which we view positively albeit the share price has come under pressure over the potential overhang as both stocks are widely owned by foreign investors.
European financials were relatively resilient, falling only 3.4%, despite continued concerns on the outlook for the war in Ukraine. In a shift from its stance in December, the ECB signalled its willingness to raise interest rates in 2022 in response to rising inflation (core inflation accelerated to 3.5% versus 3% in March) with the market now pricing in around 80bps interest rate increases by the end of the year. Eurozone GDP data was in line with expectations and highlighted the complex macroenvironment with the quarter affected by the Omicron wave, higher energy prices and weaker economic sentiment related to Ukraine.
We are halfway through first quarter results for European banks which have come in ahead of expectations (by 18% on average for the banks that have reported) on the back of lower provisioning, as seen in previous quarters, but also stronger revenues, in particular growth in net interest income which was only partially offset by higher costs. We have been encouraged by results so far but given a high level of uncertainty related to the war in Ukraine, we have not added to our exposure in the region.
Looking forward, the relative performance of US banks has been highly correlated to US 10-year government bonds since the global financial crisis, ie banks have outperformed when bond yields have risen and vice versa. However, this relationship has broken down in the past couple of months to a much bigger degree than the only other time it has happened in the past 12+ years, at the end of 2018. On that occasion, the relative performance of bank shares was a better indicator that the Federal Reserve would have to rein back on raising interest rates and bond yields consequently fell.
US banks are also seeing improving operating trends as well as having very robust balance sheets.
Going back to before the global financial crisis when the correlation between bank shares and government bond yields was significantly lower, the degree of dispersion was only as significant as it has been recently in 1994, 1999 and 2007. While in the latter instance history speaks for itself, in the two other occasions banks then went on to significantly outperform the following year, in 1995 as the increase in interest rates led to a soft landing while in 2000 it led to the bursting of the TMT bubble and the outperformance of value stocks.
As highlighted in March’s fact sheet commentary, due to the increasing uncertainty about the outlook we have raised exposure to more defensive sectors. Nevertheless, we remain overweight banks, in particular through the Trust’s holdings in the US which have de-rated to very attractive levels and are also seeing improving operating trends as well as having very robust balance sheets. Consequently, we feel the Trust is well positioned to benefit as and when there is any improvement in the outlook.
As at 10 May 2022.