Financial markets fell in September, albeit sterling weakness dampened the fall, as the sharp rise in bond yields hit sentiment. With the 10-year US Treasury, for example, reaching a 16-year high of 4.7%, and the 10-year German bund rising to a 12-year high of 2.9%, financials outperformed over the month led by banks and insurers. Against this background, the Trust’s net asset value rose 1.9%, while our benchmark index, the MSCI All Country World Financials Index, rose 1.8%.
US financials underperformed during the month, rising by 0.5% as weakness in diversified financials and banks offset better performance by insurers. Resilient economic data in the US combined with relatively hawkish Fed commentary led to US Treasury yields rising sharply as expectations shifted towards a higher for longer interest rate level. Feedback from bank managements at recent conferences has suggested little change in earnings guidance. However, there were varied comments on the impact of new capital proposals linked to Basel III, which remains an overhang on the sector.
European financials outperformed during the month, rising by 2.5%, led by the banking sector despite the announcement of additional bank taxes and potential changes to the ECB’s minimum reserve requirements which impacted sentiment. A side-effect of quantitative easing is that the money created by central banks buying government bonds ends up in the banking system, where it is deposited back at central banks, and on which they get paid the so-called deposit facility rate, currently 4%, above a minimum level of reserves, as part of supporting the transmission of monetary policy.
To put in context how significant this is, European banks hold over €3.6trn in deposits at the ECB, of which only €165bn do not earn an interest rate and the interest income they generate is risk-free. Despite reassuring comments by ECB President Christine Lagarde at their September meeting, commentary through the month from members of the ECB’s Governing Council, along with the head of certain central banks and press report leaks, suggested a desire by some for the ECB to raise the unremunerated level of minimum reserves for Eurozone banks from 1% to 4% of eligible liabilities. At the upper end it would have a high single-digit hit to earnings.
Asian financials rose 4.5% over the month, also outperforming on the back of the continued strength in Japanese financials, which rose 10% in September, but also strength in Chinese financials due to additional stimulus measures announced by the Chinese government. The combination of a potential shift in monetary policy following a return to inflation in Japan combined with a greater focus on corporate governance and shareholder returns has increased interest in Japanese equities. Hong Kong financials fell 3.4%, affected by concerns related to commercial real estate and overseas selling by global funds, which have reduced their position in Chinese equities to the lowest level since 2020.
Trust’s best performers in terms of relative contribution during the month were Sumitomo Mitsui Financial Group (SMFG) and Chubb. SMFG rose 12% in September with sentiment towards Japanese banks supported by the prospect of a shift in monetary policy as Bank of Japan Governor Kazuo Ueda signalled the possibility of an end to the negative interest rate environment. This could lead to earnings for Japanese banks being upgraded sharply. However, following material outperformance this year, we took some profits in our Japanese bank holdings with valuations largely reflecting such an event.
This environment should be supportive for value stocks and bank stocks.
The worst contributors in the month in terms of relative performance were CAB Payments Holdings (CAB) and Caixabank. Despite CAB reporting solid maiden results, which highlighted strong growth with underlying revenues rising by 62% year-on-year and reconfirmed medium-term guidance of 35-40% revenue growth and 55-60% EBITDA margins, the broader pressure on the payments sector weighed on the stock. Concerns regarding commoditisation within the payments sector following Adyen’s (a European payment company) results have led to a material derating in the subsector. Nevertheless, we believe CAB, as a provider of B2B FX and cross-border payments focused on emerging markets, should be insulated from this trend.
After a decade of low interest rates, the speed with which they have ‘normalised’ combined with the prospect of only a gradual decline looking forward has raised concerns about the economic outlook. However, beyond the near-term uncertainty, this environment should be supportive for value stocks and bank stocks in particular as, if bond yields stay higher for longer, it gives them a longer time to extend the duration of their securities portfolio and/or lock in interest rate hedges at the higher levels.
Consequently, we see a clear disconnect between the improved underlying profitability outlook and current valuations which are at record lows relative to the broader market. Notwithstanding this, we expect economic uncertainty to dominate market sentiment in the short-term so have remained relatively cautiously positioned. Gearing is at the lower end of the historical range and our banks’ exposure similarly so, albeit we are overweight within the context of our benchmark. Therefore, while we are constructive on the bank sector for the reasons described above, we are waiting for a fatter pitch, like the one we saw in the second half of 2020, to take our banks’ exposure up materially.
In the meantime, we have added to our reinsurance exposure by, for example, reducing our holding in Berkshire Hathaway to add to holdings in RenaissanceRe Holdings as well as Munich Re which we switched into in the month from our holding in Hannover Rueck. We also added to our holding in Beazley during the month following a fall in its share price due to confusion of how the introduction of a new accounting standard, IFRS17, had impacted its results. September is the month that reinsurance executives meet in Monte Carlo to start thrashing out the following year’s reinsurance programs with their clients and feedback has been positive that the tailwinds the sector has been benefiting from will continue into 2024.