Equity markets reversed the previous month’s fall with the US almost touching a new high. Financials outperformed over the month on the back of the partial recovery in bond yields and a sharp rotation out of growth stocks into value stocks, with banks being the biggest beneficiary. The brief style rotation reversed the risk-off trading in August, highlighting the crowded positioning in growth stocks which have consistently outperformed value stocks over the past decade.
Against this background, the Trust’s net asset value rose 3.2% while our benchmark index, the MSCI World Financials + REIT Index, rose by 3.4%. As highlighted above, our US and European bank stocks were particularly strong over the month, with our holdings in Bank of America, KBC Groep and JP Morgan the biggest positive contributors to performance. Conversely, the biggest drag on performance was our holdings in Mastercard and Visa while our fixed income holdings, not surprisingly, also lagged the rally in equity markets.
The rally in US financials in September was closely correlated to the pick-up in bond yields (10-year bond yield up 17bps) with the yield curve steepening slightly from an inverted position to a small positive (2-10 spread up 5bps). The rotation was supported by an easing in geopolitical concerns, with the US and China agreeing to resume trade talks while statements by both sides suggested they were looking to de-escalate the ongoing economic conflict (although it remains unclear what concrete steps have been taken towards securing a trade agreement).
Economic data remained mixed with uncertainty related to trade developments weighing on manufacturing while the Citigroup Economic Surprise Index rose to its highest point since April 2018, supported by home sales and jobless claims. The outlook will, therefore, depend on the extent to which global headwinds weigh on the more resilient trends in the labour market and services sector. However, with banking sector valuations already discounting a materially weaker environment (provisioning would have to rise 2.2-4x consensus 2019 estimates to reach fair value on our US large-cap bank stocks) we increased our banking exposure.
US repo (short-term funding) markets suffered a spike in cost towards the end of the month. As far as we can tell, this is largely driven by the unintended consequence of liquidity requirements put in place post the financial crisis, something we highlighted last year. As banks now are required to hold a higher amount of high quality, short-dated securities – in other words government bonds, cash and deposits – at central banks then the ability of the Federal Reserve to shrink its balance sheet from here is vastly reduced, with consequences that as yet are not well understood.
European banks were similarly strong over the month, helped by increased expectations that a no-deal Brexit could be avoided and an ECB policy meeting that partially mitigated the impact from deeper negative rates through the introduction of deposit tiering. The prospect of lower-for-longer rates is a headwind to European banks but the ECB clearly signaled the limits of monetary policy (the heads of the German, Austrian, Dutch and French central banks all voiced opposition to the ECB’s decision for additional loosening) while calling for fiscal stimulus to provide greater support (with the Dutch government announcing tax cuts and additional investment in the month).
Bank of America Merrill Lynch held their annual financials conference in September for European financial companies. It is one of the largest if not the largest conference for the sector. Attendance appeared to be down on previous years although to what extent that is a consequence of MiFID II with institutions now having to pay to attend is hard to know. Sentiment remains negative and all the CEOs we saw expressed their frustration with the ECB’s policy of negative interest rates. One analyst suggested that the ECB be sent a book on the US savings and loans crisis to understand the risks of its negative interest rate policy.
In September, Deutsche Bank analysts published a research note titled The History and Future of Debt highlighting the biggest risk to bondholders is the likelihood of higher debt to facilitate fiscal spending resulting in higher inflation, higher nominal GDP, higher yields and larger central bank balance sheets as they buy further government bonds to keep yields down. Mario Draghi, the outgoing President of the ECB, has pushed for increased fiscal spending for some time as have others including the Financial Times. Logically, all things being equal this should lead to higher interest rates which would be very beneficial for the sector.
We reduced holdings in Mapletree Commercial Trust and Frasers Centrepoint Trust, both Singapore REITs, a holding in OCBC, a Singaporean bank; and Tisco Financial Group, a Thai consumer-focused bank. Conversely, as highlighted above, we took the opportunity to add to a number of our US bank holdings following the weakness in their share prices. These included JP Morgan, Bank of America, PNC Financial Services and Citizens Financial Group. We also added to holdings in AIA Group, HDFC Bank and Bank of the Philippine Islands.