May was a volatile month for financial markets, with global equities whipsawed by profit warnings from Target and Walmart, weaker economic data in the US raising concerns about the US economy, and hawkish central bank commentary offset by moderately better news flow out of China. Against this background, the Trust’s net asset value rose by 1.2%, while our benchmark, the MSCI ACWI Financials Index, rose by 1.7%.

US review

US financials rose 3.0% in the month led by the banking sector on the back of comments, in particular, by JP Morgan CEO and Chairman Jamie Dimon, who stated at the bank’s investor day that “Credit looks really good. We’ve never seen it this good”. Fed commentary remained hawkish, with consensus expecting a 50bps rate hikes in both June and July. Leading indicators remain mixed, with the ISM manufacturing survey ahead of expectations (supported by higher new orders in May) while consumer confidence continues to weaken with future prospects affected by persistent inflation.

While it is clear that growth momentum is fading, commentary from bank managements is at odds with the increasingly downbeat market assessments of the economic outlook. Household and corporate customers hold more cash than they did pre-pandemic while loan growth remains healthy, driven by commercial and industrial loans as businesses build inventories and invest. In terms of performance, despite strong operating trends, SMID-cap banks, where we are significantly overweight, have underperformed in recent months given the risk-off environment which has affected the Trust’s relative performance.

Europe and Asia review

European financials rose 3.9% following a strong recovery in the second half of the month led by the banking sector, albeit they continued to see heightened volatility. While the economic outlook remains uncertain, results reassured as to the potential impact from Ukraine with bank managements generally reiterating capital return plans and financial targets. The driver of the outperformance was a shift in expectations for interest rates which led to consensus-raising 2023 earnings forecasts as higher net interest income estimates have more than offset the expected increase in costs and provisioning.

Asian financials fell 0.8% as weakness in Japan and Australia was only partially offset elsewhere. Tentative signs that the drag from Covid restrictions may be easing in China and Hong Kong was reflected in better-than-expected manufacturing PMIs for China. In Hong Kong, retail sales rebounded in April (+31% versus March) coming in ahead of expectations and benefiting from the government’s consumption voucher programme. We have recently raised our exposure to Asian life insurers (AIA Group and Prudential) which should be beneficiaries of a normalisation in economic activity into the second half of the year.

While the outlook remains uncertain and warrants caution, we have been reassured by results which continue to show robust trends leading to earnings upgrades.

Fund activity

During the month, we reduced exposure to two of our SMID-cap banks with technology exposure (Signature Bank and Silicon Valley Bank) which are most at risk if the deterioration in sentiment towards the technology sector continues. However, with valuations now implying a significant pick-up in provisioning (in some cases in line with the Covid recession), we view attractive recovery potential in a segment where earnings are highly geared to rising interest rates while continuing to benefit from strong loan growth.

We also added to our European bank holdings during the month, starting a new holding in Hong Leong Bank, a Malaysian bank we see as well positioned. Taking advantage of the back-up in bond yields, we have also started to very selectively add to our high yield and investment grade bond exposure, with new holdings purchased in a Lancashire Tier 2 bond and the RT1 securities of Rothesay and Pension Insurance Corporation.

Outlook

Looking forward, the key focus remains the feasibility of a soft landing. Historically, these have been difficult to achieve, with 11 of the past 14 interest rate cycles in the US followed by recessions. Research by Alan Blinder, the Fed’s former vice chair, however, suggests this might not necessarily be the case. According to his work, 7 of the 11 assessed resulted in “pretty soft” landings, with the one occurring between the end of 1993 and April 1995, when the Fed raised interest rates by three percentage points to 6%, seeing growth slow but the economy continues to grow.

In summary, while the outlook remains uncertain and warrants caution, we have been reassured by results which continue to show robust trends leading to earnings upgrades. We expect provision estimates to rise further given a deteriorating growth outlook, but for some banks this has been more than captured by recent share price falls while earnings estimates are being supported by revenue upgrades. Strong balance sheets, combined with low levels of risk added to balances sheets in recent years, underpin our confidence in the outlook.

As at 13 June 2022.