Market review

February was another good month for equity markets, as resilient economic data and higher than expected inflation pushed both recession worries and interest rate cut expectations further into the future. Against that background, financials slightly lagged wider equity markets rising 4.4%, as illustrated by our benchmark index, the MSCI All Country World Financials Index, with the net asset value of the Trust rising by 3.9%, held back by a couple of our European holdings.

We have been cautious on the commercial real estate (CRE) sector over the past few years, seeing banks with a significant exposure to it as high risk due to where we are in the property cycle. In Business Cycles by Lars Tvede, he describes the property cycle as the “Mother of all Cycles” and highlights One Hundred Years of Land Value in Chicago, a PhD written by Homer Hoyt in 1933, a real estate broker, which first provided detailed analysis of such a cycle. The analysis has been backed up by others, including no less than Arthur Burns in 1954, who would become better known as the Fed Chair in the 1970s, criticised for not raising interest rates quickly enough in the face of inflationary pressures.

The conclusion was that, on average, property cycles last around 18 years, albeit with some variation. With property prices peaking in 2007, this would suggest the next peak would be in 2025, all things being equal, with financial markets likely starting to discount this risk a year or two beforehand. While arguing for caution, due to the size of the property correction in 2008-09, and the impact it had on the banking sector, we thought the downturn would be milder in its impact this time around. In particular, as over the past decade, banks have significantly reduced their lending to CRE and loans have been underwritten on much lower loan-to-values.

However, no cycle is the same. This one has been characterised not only by extremely low levels of interest rates that were in place prior to the pandemic leading to very low cap rates, followed by a very sharp and sudden rise, but also by structural changes to retail and office-working habits, following the growth of Amazon and the pandemic, respectively. This has made for a particularly difficult investment environment, with office and retail properties suffering significant falls in price, albeit while the so-called ‘Beds, Sheds and Meds’¹ have performed relatively well.

Resilient economic data and higher than expected inflation pushed both recession worries and interest rate cut expectations further into the future.Recent announcements by New York Community Bancorp (NYCB) and Aozora Bank, a Japanese lender, that both would be taking larger than expected CRE provisions brought the potential risks of the sector sharply into focus. An unlikely name to be associated with US CRE, Aozora reported a $2.3bn US CRE portfolio as of the end of December 2023, with 74% classified as office and, crucially, 37% as non-performing, leading to a fall of over 35% in its shares before they saw a partial recovery, albeit with limited impact on its bonds.

This had a knock-on effect at several German CRE-focused lenders, including Deutsche Pfandbriefbank, with its AT1 bonds falling around 60% to deeply distressed levels and its share price falling a further 30% over the month. Part of the former Hypo Real Estate group, which coincidentally failed in 2008 on the back of commercial property stress, 15% of the bank’s c€30bn CRE portfolio is concentrated in New York City office and retail properties.

This has been further compounded by the bank’s sizeable exposure to development properties, which makes up 11% of its CRE loans, which are considered riskier than lending on investment properties, and also its concentration to German offices, with the sector suffering the sharpest drop on record in year-on-year prices in the fourth quarter of 2023. Despite several efforts by management to reassure investors during the month, with communications around funding requirements and deposit balances, the bank’s subordinated bonds saw no recovery.

New York Community Bancorp’s issues are largely idiosyncratic. Having pushed through the $100bn in assets level following the acquisition of assets from Signature Bank, regulators took a dim view of the lower level of reserves it has set aside for loan losses relative to peers. There has also been concern around rent-controlled multi-family lending in New York, which NYCB dominated, due to changes to legislation which made it much harder for landlords to raise rents. Forced by regulators to sell a large loan, part of the jump in its provisions was the mark to market loss on the loan.

Consequently, we have remained cautious on US banks, notwithstanding our main view that this will be an earnings drag for the sector as exposure to office CRE, which has been the main concern, represents a low single-digit percentage of loan books and is already well reserved. Our main holding remains JP Morgan, being one of the few US banks to manage its interest rate risk effectively over the pandemic. We also have large holdings in Wells Fargo and Citigroup, both of which have self-help levers to pull, with the former benefiting from the lifting of one of its consent orders during the month.

1. Apartments, Logistics and Healthcare