Sector and fund performance
Equity and bond markets rallied sharply in July due to the combination of weaker economic data, which raised the prospect that central banks would not need to raise interest rates as aggressively as previously thought, and resilient second-quarter earnings. Against this background, global financials rose 4.3%, as illustrated by our benchmark index, the MSCI ACWI Financials Index, lagging the rally in global equity markets. The Trust’s net asset value rose 3.4%.
Performance was held back by the strength of diversified financial services stocks in which the Trust is underweight and, to a smaller extent, holdings in insurance stocks such as Chubb, Arch Capital and Direct Line Insurance reflecting the Trust’s more defensive positioning. Conversely, holdings in MasterCard, PayPal Holdings and East West Bancorp all saw double-digit rises in their share prices.
US financials rose over 7% during the month. US bank Q2 earnings showed resilience with earnings estimates broadly stable following the results. In general, robust loan growth and rising interest rates are leading to upward revisions in net interest income while this has been offset by lower fees and higher provisioning expectations. The overall cost of funds rose only marginally in the quarter although there was a relatively high dispersion in deposit betas (the change in deposit pricing relative to interest rate changes).
US bank Q2 earnings showed resilience with earnings estimates broadly stable following the results.The shift in the interest rate environment has refocused market attention on the quality of banks’ deposit franchises, a key indicator in the team’s investment process, which is now set to be a material differentiating factor in profitability as interest rates rise. Asset quality was solid in the quarter with net charge-offs remaining well below pre-pandemic levels while management teams have not, as yet, seen a change in early warning indicators that would signal a significant deterioration. However, given the weakening economic outlook, we expect consensus provisioning estimates will need to rise further.
Asian financials were marginally lower over the month, impacted by rising Covid concerns in China raising the prospect of renewed lockdowns alongside a further deterioration in China’s real estate sector. The recent visit by US Speaker of the House Nancy Pelosi to Taiwan has further strained US-China relations with geopolitical concerns adding to risk aversion. While Chinese economic data has started to show some normalisation post-lockdown, the commitment to a zero-Covid policy and absence of material stimulus has reduced hopes of a strong rebound in economic activity in the second half of the year.
In light of the above, we reduced exposure to Hong Kong and Taiwanese companies in July by reducing holdings in AIA Group, Chailease Holdings and HK Exchanges & Clearing. This was partially offset by a new holding in Bank of the Philippine Islands, which reported encouraging Q2 operating trends, is well positioned within digital banking (revenues per digital customer are 70% higher) and trades at an attractive valuation. The Trust has no direct exposure to China. It is worth noting that, though understandable, the current worries about China/Taiwan are not representative of investors’ broader views on Asia and some of our largest Asian holdings – HDFC Bank, Bank Central Asia and DBS Group – showed strong operating results.
European financials rose around 1% in the month, exacerbated by currency weakness with the euro depreciating 2.5% versus the US dollar. In response to elevated inflation, the ECB delivered its first interest rate hike in over a decade, ending the period of negative interest rates. The news that Nord Stream I resumed gas flows after scheduled maintenance allayed immediate supply fears but the prospect of energy rationing to ensure supplies through the winter remains a significant risk for the region.
We are midway through Q2 earnings which to date have shown positive trends for the region’s banks, leading to earnings upgrades on the back of stronger net interest income and lower provisioning. Balance sheet strength leaves them well positioned to weather a slowdown (and the continuation of buyback and special dividend regulatory approvals has been encouraging), but in light of the region’s greater vulnerability to energy supplies, we continue to take a cautious approach to our positioning.
We are midway through Q2 earnings which to date have shown positive trends for the region’s banks, leading to earnings upgrades on the back of stronger net interest income and lower provisioning.Outlook
Overall, we have been encouraged by operating trends in the second quarter, with tailwinds from higher interest rates more than offsetting the inflationary impact on costs while excess capital levels continue to support attractive yields. A rise in provisioning is set to become more of a headwind in the second half of the year, but valuations, even with the rally over the month, are already discounting a material deterioration and, in some cases, for provisioning to exceed levels we saw during the pandemic.
While financial markets have interpreted recent data and commentary from the Federal Reserve as less hawkish, we believe it is too early to read into it that central banks are likely to pivot to a less restrictive stance over the coming months until there is much more evidence that inflationary pressures are subsiding. Consequently, while we remain positive on the recovery opportunity in the sector, we have retained a relatively defensive positioning with gearing at the low end of the historical range.