Following on from the “everything rally” in November, December was the second consecutive month of strong performance for financial markets. Further dovish commentary from Federal Reserve (Fed) officials, in particular Fed Chair Jerome Powell, along with favourable economic data supporting the prospect of a soft landing, saw equities extend gains generated in November. The MSCI All Country World Index (MSCI ACWI) rose by 4.1% and yields on government bonds dropped further, with the US 10-year Treasury falling to 3.9% having peaked at 5% in October.
Against this background, financials outperformed, rising by 5.1% as illustrated by the Trust’s benchmark index, the MSCI ACWI Financials Index, led by US banks and consumer finance stocks seen as the biggest beneficiaries of the change in outlook. The Trust’s net asset value rose by 5%, with performance benefiting from an overweight in US bank holdings but held back by a larger overweight position in insurance stocks, notably reinsurers, that fell over the month as investors rotated into more cyclically exposed stocks within the sector.
The Fund’s best performers in terms of relative contribution included OSB Group and call options on the SPDR S&P Regional Banking ETFwhich we bought in November. Having sold our holding in OSB Group earlier in the year, we bought back our holding in November as we felt the share price had overreacted to a disappointing trading statement. Its shares have since recovered sharply following a reassuring trading update that reconfirmed earnings guidance and noted stable asset quality. It has also benefited from the recent downward shift in interest rate expectations which had dampened sentiment towards the stock due to concern that buy-to-let landlords would come under increasing pressure due to rising interest costs when remortgaging.
The worst contributors in the month in terms of relative performance were Arch Capital and RenaissanceRe Holdings. Following strong relative performance in the preceding months, both were affected by the market rotation in December and the shift out of more defensive stocks. In contrast to last year, which saw a material increase in reinsurance rates, more muted expectations on January renewal pricing have dampened enthusiasm, while the recent fall in bond yields will likely put pressure on investment income. Nevertheless, we continue to have a constructive view as valuations have dropped to very attractive levels which we feel more than discounts a modest risk to earnings.
While the rally in the sector over the past couple of months has lifted valuations from the extremely low levels they were trading at over the summer, they still remain inexpensiveNorth American financials rose 5.7% over the month, benefiting from the downward shift in interest rate expectations. Two weeks after Powell noted it would be premature to speculate on when monetary policy might ease, a more dovish tone at the subsequent FOMC meeting surprised financial markets with the Fed’s dot plot revised lower and now indicating three interest rate cuts expected in 2024. The shift in tone follows a continued moderation in core inflation in November, the lowest reading since January 2021. As highlighted above, US banks were very strong, with those sitting on the largest unrealised losses in their securities book benefiting the most.
Emerging market financials also benefited from the change in interest rate outlook, expectations for easing liquidity conditions and a weaker US dollar. The divergence in performance within emerging markets seen during the year continued with strong gains in Latin America and South and South-east Asian markets (India and Indonesia outperformed) alongside underperformance in China where growth concerns and unresolved issues within the real estate market remain an overhang. The Fund is marginally overweight Latin America via a holding in Grupo Financiero Banorte and we added to our exposure through a new position in Gentera, the largest microfinance company in the region.
European financials underperformed in the month, affected by the insurance sector, although have still outperformed for the year as a whole supported by strong gains in both the banking and diversified financials subsectors. Following earnings upgrades for European banks on the back of higher interest rates, we expect the shift in monetary policy outlook to drive a change in leadership and have adjusted the Trust’s positioning towards some of the less interest rate-sensitive banks in Europe, for example adding to holdings in BNP Paribas and ING Groep.
Within diversified financials, alternative asset managers saw strong gains in December and we used the opportunity to increase our exposure. European alternative asset managers for the most part have lagged their US peers in 2023, which performed much better than expected despite concerns around weaker fundraising activity and concerns on marks taken on legacy assets. Recent feedback from our meetings with managements points to an improved outlook for fundraising and deal activity supported by the shift in interest rate expectations.
While the rally in the sector over the past couple of months has lifted valuations from the extremely low levels they were trading at over the summer, they still remain inexpensive, trading at a 11.2x price-to-earnings (P/E) ratio for 2024 estimates. However, relative to wider equity markets(i.e., the MSCI ACWI trades on 16.8x P/E forward ratio), financials still trade in their lowest quintile of cheapness, at around a 33% discount, since the global financial crisis despite the inclusion of payments companies in May 2023.
However, banks are still in the cheapest decile on a P/E basis relative to wider equity markets, albeit on 8.7x 2024 estimates they are not as cheap as they were in absolute terms, having recovered from a low of 7.1x in March 2023 after the failure of Silicon Valley Bank, First Republic and Signature Bank and the forced sale of Credit Suisse to UBS. However, on a price-to-book (P/B) basis, they are much closer to their average at around 1.0x book value, lower than justified by the improvement in profitability but reflecting the fact that equity markets are assuming it is unsustainable. Unsurprisingly, diversified financials trade on higher multiples, in line with wider equity markets.
Despite the awful events in the Middle East, the continuing war in Ukraine and ongoing tensions between the US and China, financial markets surprised positively in 2023, led by the ‘Magnificent Seven’. Understandably, financials lagged in part due to idiosyncratic issues back in March. Sentiment towards banks has been weak since early 2022 when rising inflation and interest rates led to worries about the outlook for growth and the impact on the sector from higher losses. Two years on, we would expect that uncertainty to be resolved with the balance of probabilities suggesting a softer slowdown which would be very positive for the sector, albeit not without volatility in the meantime.