September delivered on its historical trend as the worst month for investing, with concerns on the outlook leading to a sharp sell-off in equity and bond markets, as higher than expected US inflation data released in the month were accompanied by continued hawkish central bank comments. Global financials fell 4.3% over the month while global equities fell 5.5%, as illustrated respectively by the MSCI ACWI Financials Index and MSCI ACWI Index respectively, both in
sterling terms. Against this background, the Trust’s NAV fell 3.8% largely due to the strong relative performance of our bank holdings, in particular in Asia.

US financials

US and Canadian financials fell 4.1% in September, marginally outperforming the sector, in part due to the resilience of the insurance stocks. An acceleration in core inflation raised expectations for a more aggressive response from the Federal Reserve in response to persistent inflation. While there are signs that consumer inflation expectations are moderating and corporate pricing power is weakening, – a National Federation of Independent Business survey noted that 32% of businesses intend to raise prices over the next three months compared to 51% in May – Fed commentary highlights
their continued focus on the labour market given the associated inflationary risks.

Feedback from US bank managements has been consistent in terms of asset quality (though we are yet to see signs of a downturn in early warning indicators) and deposit betas (lower than expected given excess liquidity in the system) which is supportive for net interest margins. Consequently, we expect a resilient third-quarter earnings season, with any rise in provisioning to be driven by macro adjustments in models and precautionary management overlays as opposed to delinquencies.

US and Canadian financials fell 4.1% in September, marginally outperforming the sector, in part due to the resilience of the insurance stocks.Given balance sheet strength, we expect US banks to prove resilient to the economic slowdown, and valuations now discount a material rise in provisioning, in excess of Covid levels for US SMID-cap banks. As a result, we think they offer strong recovery potential and, albeit with rising funding costs set to become more of a differentiating factor in terms of growth potential, we have adjusted our portfolio. Consequently, we have sold our holding in Signature Bank while
raising it in SVB Financial Group, and starting a new holding in Cullen/Frost Bankers, a Texan regional bank.

European financials

European financials fell 4.0% during the month, despite the weakness in the UK following the announcement of a mini-budget which included £45bn of debt-funded tax cuts, which led to significant pressure on the currency and rising UK government bond yields. While the government subsequently cancelled their plan to abolish the top rate of income tax in response to fierce criticism, the damage to their credibility is likely to endure at a time when the UK is particularly vulnerable to changes in capital inflows, due to its wide current account deficit.

The Trust only has around 2.5% of its portfolio invested in domestic UK businesses and during the month we reduced our holding in OSB Group, the buy-to-let specialist lender, given the potential consequences for the housing market from a sharp rise in interest rates. While we expect losses on mortgages to remain low at OSB due to average mortgage loan-to-values (LTV) of 61% and the broader UK banking industry due to even lower LTVs, any weakness in the housing market is likely to weigh on UK bank stocks.

Feedback from September’s Monte Carlo reinsurance conference was very constructive, with expectations the market would continue to harden with reinsurance rates expected to increase by more than inflation, which is reassuring for our holdings in Arch Capital, Beazley and Lancashire Holdings. A reduction in reinsurance capacity while demand continues to increase, driven by concerns around climate change as well as inflation, underpins this outlook. Consequently, we bought a position in Hannover Re, which has a strong underwriting track record and should be a beneficiary of the improving outlook.

Asian financials

Asian financials fell 5.8% with Japanese financials falling 3.6% due to general risk aversion as well as signs of softening economic activity. The extension of lockdowns in China, with around 68 cities in partial or full lockdown as part of the country’s zero-Covid policy, remain a headwind on domestic demand while weaker global demand was evident in the Caixin PMI (focused on export-oriented SMEs). China, Japan and South Korea all intervened in their currency markets in September due to disquiet about the weakness of their currencies against the US dollar.

While India, the Trust’s key overweight in the region, is also facing a challenging external environment, including commodity prices that are well above pre-pandemic levels, domestic demand remains resilient and the feedback from managements has been positive (loan growth to be supported by higher capex). The latest data from HDFC Bank supported this view, with loan growth in the latest quarter accelerating to 23.5% from 21.5% in the previous quarter, with strength in both retail and corporate lending.

While we expect continued volatility in what remains an uncertain economic environment, the market dislocation is opening up extremely attractive investment opportunities and an incentive to reduce cash. Valuations for our more defensive holdings are not expensive, while increasingly pricing-in a severe scenario in the case of our bank holdings in terms of loan loss assumptions. At the end of the month, global banks were trading at a 0.88x price-to-book ratio, a level below which they have only traded on 245 days or 7% of the time since the global financial crisis.