Financial markets rallied sharply in November as US inflation data surprised to the downside, with a below consensus increase of 0.4% month-on-month, and central banks across both sides of the Atlantic signalled their intentions to slow the pace of interest rate tightening. Against this background, the Trust’s net asset value rose 4.2%, against the benchmark index, the MSCI ACWI Financials Index, which rose by 5.1% , with the difference due to our underweight in China and some of our smaller US banks lagging the rally during the month.

We do not expect to see the level of asset quality deterioration that is currently implied by valuations
Market review

Fed Chair Jerome Powell noted during a speech at the Brookings Institution that ”the time for moderating the pace of rate increases may come as soon as the December meeting”. We believe there is evidence of moderating inflation within core goods, as pandemic dislocations fade, and housing – rent prices for newly leased apartments points to further falls – with shelter inflation representing 57% of core services CPI. However, the labour market (adding 263,000 jobs in November) is a potential risk to the Fed’s ability to downshift if data continues to surprise to the upside.

With savings well in excess of pre-pandemic levels, apart from the lowest income group, and the labour market remaining solid, we do not expect to see the level of asset quality deterioration that is currently implied by valuations, with feedback from bank managements continuing to note stable trends. In a number of cases, the market is assuming a worse provisioning experience than seen during Covid, when banks were providing on the basis of unemployment exceeding 10%, while the sector has benefited from tailwinds to pre-provision earnings due to rising interest rates and therefore increased net interest margins.

Our Asia research trip

Following a recent visit to the region, we made some small adjustments to our investments in Asia during the month primarily on the back of a weaker macro environment. We believe the outlook remains reasonable but the strong support from export growth has clearly gone into reverse (in particular in North Asia and those reliant on technology exports) and domestic factors are, as yet, not picking up sufficiently strongly, although those reliant on tourism, such as Thailand, are being helped. We believe inflation has likely peaked in a number of countries and interest rates, helped by a slower pace of rises in the US, are likely to be close to their highs. However, like much of the rest of the world, worries are focused on where the growth drivers will come from.

However, we should not be overly gloomy and a recent visit to Thailand and Indonesia reinforced that – and results from the banking sectors have also been resilient. The picture from Thailand was one of a subdued macro outlook, with the exception of the tourism sector, and bank earnings helped by rising margins (although even that will tail off as deposit costs catch up) being offset by cost pressures and some worries about asset quality going into 2023 as the clean-up post-Covid continues to affect the loan book – it should be noted there was less government support during the pandemic than in many other countries. We have reduced our exposure to Thailand having sold KasikornBank and Srisawad in recent months.

Against an incredibly difficult background for financial markets in 2022, financials outperformed, reflecting in part the benefit of rising interest rates
A much more positive picture came out of our visit to Jakarta, not surprising considering the boost provided by strong commodity prices. The macro picture remains healthy – even inflationary pressures eased this month – and bank profitability is exceptionally high. Asset quality is improving and restructured loans have fallen sharply while overall balance sheets look in good health. Indonesia is second to India in terms of our Asian exposure and we remain overweight with valuations being the principle stumbling block to raising exposure further (our holdings are Bank Central Asia, the leading payments/network bank in the country, and Bank Rakyat Indonesia Persero, the leading micro lender).

Outlook

Against an incredibly difficult background for financial markets in 2022, financials outperformed, reflecting in part the benefit of rising interest rates – which for banks offset some of the concerns around the deteriorating economic outlook. The relative performance was also supported by the very strong performance of the insurance sector as it benefited from its defensive characteristics and rising insurance and reinsurance rates, notwithstanding investment losses from falling bond prices. Looking forward to 2023, investors are understandably cautious, especially after the recent rally in equity markets. Areas of the sector that offer the most compelling long-term structural growth have derated materially over the past year, while the more cyclical elements of the sector have already priced in a significant deterioration in earnings. Consequently, our view remains very constructive on the outlook, but conscious that financial markets are likely to remain volatile until there is greater certainty of the duration and depth of the slowdown in growth and its impact on inflation and therefore the path of interest rates.