Equity and bond markets fell sharply in June, to new lows, as the late-May rally reversed on the back of a much higher US inflation report. Hawkish central bank rhetoric and weakening economic data also combined to weigh on sentiment. Against this background, global financials, as illustrated by our benchmark, the MSCI ACWI Financials Index, fell 6.6%, underperforming wider equity markets (MSCI ACWI Index), which fell 5.1%, with only insurance stocks showing some degree of defensiveness. The Trust’s net asset value fell by 6.2%.
US financials fell 7.8%, with bank stocks falling 9.9% over the month. The Federal Reserve raised interest rates by 75bps, in line with market expectations that had been revised up following much stronger CPI data. While markets took comfort from forward guidance on the next rate hike and that Fed Chair Jerome Powell sees long-run inflation expectations coming down “sharply”, until there is some sign of moderation in inflation pressures, the market remains sceptical as to the ability of the Federal Reserve to engineer a soft landing.
Strong performance points to attractive levels of capital return, with most detailing a quarterly dividend rate increase
The release of annual US bank stress test results in June were reassuring, highlighting the resilience of the sector. Against a severely adverse scenario, including a peak unemployment rate of 10%, a 55% fall in equity prices, and GDP falls of 3.5% from Q4 2021 through to Q1 2023, aggregate capital ratios would only decline 2.7 percentage points to 9.7%, which is more than double the minimum requirement of 4.5%. Positively, this strong performance points to attractive levels of capital return, with most detailing a quarterly dividend rate increase, albeit buyback plans have been scaled back resulting in an expected total pay-out of c50% in 2022.
We expect US banks 2Q22 results to be solid, driven by net interest income growth from wider net interest margins and stronger loan growth, while trading revenues should benefit from heightened volatility. However, given the weaker outlook for the US economy, management commentary during results calls on asset quality indicators will be key. While we expect a pick-up in provisioning from very low levels, with robust household and corporate balance sheets, we do not expect the current slowdown to result in the deterioration in asset quality that is being priced into valuations.
Asian financials were relatively resilient in the month, falling only 2.5%, supported by a recovery in China and Hong Kong where sentiment has been supported by an easing in Covid restrictions. Economic trends in the region are not widely different from the West in that interest rates are beginning to rise and inflationary pressures are growing, although the scale is broadly more benign (some of this might be because governments are more active in insulating the population from the worst of the energy cost rises, although these will begin to fade going forward).
Interest rates were increased in the Philippines, Australia, Taiwan and Korea in June and even laggards such as Thailand and Indonesia are expected to increase soon. Exports have generally held up, albeit Korea saw weakness in its exports to China, but trade balances are being impacted by higher energy imports with trade deficits rising or surpluses falling. To date, this has not resulted in aggressive downward pressure on currencies, but it remains a worry over the next few months.
A number of economies are seeing a recovery in domestic consumption, including Hong Kong, Vietnam, Indonesia and Thailand, which bodes well should exports slow as Western markets weaken. Overall, the region is weathering pressures well, although our Indonesian holdings saw some pressure on falling commodity prices towards the end of the month. We have also been raising our exposures to Hong Kong, Malaysia, Thailand and Japan and expect to increase it further as the region’s domestic economies continue to open up and areas such as tourism see greater recovery.
European financials were also very weak in June, falling 7.3% with sharp falls in bank stocks as a shift in interest rate expectations was not sufficient to support share prices, but insurance stocks again performed more defensively. Given the prolonged headwind to bank profitability from negative rates, the shift to a more normalised interest rate environment is a significant development, with the ECB noting their intention to start hiking rates next month.
However, concerns about fragmentation within Europe, a major fear during the Eurozone crisis a decade ago, resurfaced in June. Peripheral sovereign spreads widened sharply amid concerns that rising interest rates in Europe could put pressure on certain sovereigns, like Italy. This was despite a speech by Isabel Schnabel, an executive board member of the ECB, stating its commitment to anti-fragmentation has no limits, albeit spreads did narrow again following an announcement later in the month that work was being done on a new anti-fragmentation tool.
We remain constructive on the outlook for the sector, although we expect financial markets to remain volatile until the outlook for inflation, interest rates and growth is more certain.
Looking forward, we believe valuations for the sector are very cheap on many metrics. For example, just taking data for the past 10 years, global banks have only ever traded on a lower price to book 11.5% of the time and, for earnings, 2.5% of the time over that period. Consequently, we remain constructive on the outlook for the sector, although we expect financial markets to remain volatile until the outlook for inflation, interest rates and growth is more certain. With the Trust’s share price having fallen to a discount to net asset value of around 10%, we believe investors can buy the sector on an extremely attractive multiple.