August was a weak month for financial markets, albeit for UK investors this was partly offset by sterling weakness. Fitch’s one notch downgrade of the US government’s credit rating to AA+, weaker than expected economic data in China and the US 10-year Treasury yield rising to its highest level since 2007 with Federal Reserve officials noting they viewed upside risks to inflation leaving open the possibility of additional hikes, all hit sentiment.
US financials fell 1.3% in August, led by weakness in the banking sector following a strong recovery in the preceding two months. While second quarter results came in largely ahead of expectations, sentiment was affected by downgrades to credit ratings of certain US banks by S&P and Moody’s, along with concern on higher capital requirements related to Basel 4 following the publication of proposals by US regulators.
While capital levels under the proposals will move higher, the average increase of 16% is lower than the 20% previously guided and the full implementation deadline of July 2028 gives a longer phase-in time than expected. There is dissent among regulators suggesting this could be modified but consequently we do not expect the regulatory changes to have a material impact on overall capital return plans, albeit we could see individual banks adjusting buybacks in the near term.
Asian markets fell 3.4% over the month, affected primarily by a selloff in China, with Chinese financials falling 8.9% following a further deterioration in economic data. The post-pandemic recovery has continued to disappoint, with weakness across the property sector (June sales -28% y/y among the 100 largest developers) with real estate and associated sectors representing 30% of China’s GDP.
With youth unemployment rising (21.3% in June), geopolitical tensions and a weakening external environment impacting exports, the incremental stimulus measures deployed are not considered sufficient to tackle the structural issues in the economy. The Trust is underweight China – exposure is primarily through the life insurers AIA Group and Prudential, and HSBC Holdings which we have reduced in recent months.
We continue to see valuations across much of the sector at odds with fundamentals and not reflecting the improvement in profitability and shareholder returns.
European financials were down 2.9% over the month led by banks, in part due to profit-taking but the announcement that the Italian government would be bringing in a bank tax also hit sentiment. European banks have performed well this year as the impact of higher interest rates on their net interest income has fed through to much higher earnings. The income they earn from loans and securities has risen faster than the increased cost of their funding, as banks have not needed to pass on as much of the increase in interest rates to their depositors.
Insurers were resilient over the month. They continue to benefit from a supportive pricing environment where insurance rate rises, outside motor insurance, are in excess of claims inflation while interest rate rises are flowing through into higher investment yields. Uncertainty on the outlook, reflected in a sharp drop in European PMI data released during the month, has also led to some rotation from the banking sector into non-life insurance, reflecting the latter’s more defensive attributes.
Against this background, the Trust’s net asset value fell 2.4%, marginally less than the wider financial sector. On an absolute basis, Mastercard was a positive contributor to performance although gearing was a drag, as was HSBC Holdings which fell on China concerns.
Relative to the benchmark, the Trust benefitted from not having a position in Block (formerly known as Square), the payments company whose shares were weak Not having a position in UBS Group, which performed strongly over the month following a positive update on its acquisition of Credit Suisse, also detracted from performance
We made a number of small changes over the month, reducing gearing slightly and adding to our holding in RenaissanceRe Holdings, a Bermuda-based reinsurer. There has been a significant number of catastrophe events in 2023 so far and the cost of these is falling, for the most part, on primary insurers as attachment points have been raised. The share prices of reinsurers have been lacklustre of late and we would expect that to unwind as we pass peak hurricane season. We also reduced some of our exposure to Asia during the month, reducing holdings in Bank Central Asia, Bank Rakyat Indonesia and HDFC Bank as well as those highlighted above.
While the outlook remains uncertain, we continue to see valuations across much of the sector at odds with fundamentals and not reflecting the improvement in profitability and shareholder returns associated with the strengthening in balance sheets and shift in longer-term inflation and interest rate environments. With valuations already implying a significant deterioration in the economic environment (banks in the US and Europe are trading at or close to record discounts to the wider equity market), we see support from delivery on capital return plans and resilience in asset quality supported by tighter credit controls, lower risk-weighted asset growth and higher precautionary provisioning.