The year ended on a sharp sell-off in equity markets led by the US, with the S&P 500 Index down by nearly 15% at the worst point on Christmas Eve prior to staging a partial recovery in the last few days of the year. Not surprisingly, financials slightly underperformed in the sell-off with our benchmark index, the MSCI World Financials + REITs Index, falling 8.4% versus the fall in the MSCI World Index which fell 7.6%. Against this background the Trust’s net asset value fell 7.8%.
The fall in the US equity markets was sparked by more hawkish commentary made by Jay Powell, Chairman of the Federal Reserve, regarding the outlook for interest rates and that the downsizing of the Federal Reserve’s balance sheet was on “automatic pilot”. Rumours that the US President wanted to sack the Fed Chairman, while not entirely unexpected, as suggested by his tweets on interest rates, were also unhelpful.
Similarly, the resignation of the extremely well-respected Secretary of Defence, John Mattis, seen as the only “adult” left in the White House did not help. Nevertheless, what compounded the sell-off was a bizarre tweet by US Treasury Secretary, Steven Mnuchin, that he had spoken to the six largest banks confirming they had plenty of liquidity and that none had experienced any clearance or margin issues, thereby raising questions as to whether he was aware of something.
As a result, US banks fell just over 15% over the month, compared to European banks and Japanese banks falling 10.2% and 6.5% respectively as illustrated by the KBW Banks Index, the STOXX Euro Banks Index and the TOPIX Banks Index. Not surprisingly, against this background, the Trust’s worst performing holdings were all US banks, namely JPMorgan, Bank of America and Citigroup, all large positions, with the latter falling close to 20%.
Conversely, our best performing holdings were some of our smaller holdings. Amigo Holdings, a UK unsecured consumer lender, which had struggled initially post IPO, rallied back above its issue price and with the sell-off in equity markets has now materially outperformed since IPO. We also participated in the IPO of AJ Bell, which saw a big jump in its share price. Finally, a holding in Indiabulls Housing Finance also saw some recovery in its share price.
In view of the jitters surrounding Indian financials (our largest emerging market exposure in the Trust) we recently visited Mumbai to have meetings with a number of banks and finance companies and broadly came away encouraged. The finance sector liquidity crisis has eased considerably and the worst of the asset quality cycle is behind us but that is not to say we will not see some residual impact in the coming quarterly results seasons (eg margin pressures for finance companies, possible defaults of smaller real estate developers and some further provisioning for corporate lenders).
We continue to be impressed with the performance of HDFC Bank, our largest Indian holding. They seem to be well ahead of the competition in dealing with the potential impact of technology on their franchise in the years ahead and see numerous opportunities in areas such as payments, business banking and rural banking. Overall, we came away with the impression of a market becoming more rational, added to which, though growth will slow, it will still remain one of the best in the region and the macro environment will be helped by a falling oil price, lower inflation and continued recovery from recent mishaps/policy adjustments.
Financials, in particular banks and asset managers have derated significantly over the past year. At the end of December, US, European and Japanese banks had fallen to 8.4x, 6.5x and 7.6x 2020 P/E ratios respectively, significantly wider discounts to the market than where they normally trade (especially in the US). Undoubtedly these low ratings show that the market is factoring in either a significant fall in earnings and/or little or no earnings growth into the future reflecting investors’ nervousness about the sector and where we are in the economic cycle.
2018 has been a frustrating one for investors in the sector and while the sector has nearly always, for good reason, traded at a discount to underlying markets we still believe its recent performance looks anomalous unless there is a significant deterioration in the macro environment. A flattening yield curve in the US, weaker leading indicators and central banks continuing to withdraw liquidity are a headwind but financials start from a much lower valuation already discounting more bad news to come resulting in some exceptional value on offer.
Autonomous Research (a UK institutional research firm) have looked at all US recessions going back to 1937. US banks have tended to underperform in the run-up to a recession and then outperform when recession starts – in eight of the twelve recessions over that period. This intuitively makes sense in that investors discount the risk of a sharp downturn and then when it is not as severe as expected banks then go on to outperform (three of the four exceptions being 1980, 1990 and 2007).
Royal Bank of Canada analysts have also pointed out, that every year since 1990 that US banks have posted negative returns that have not been credit related, the following year they have risen and, except for 2006, also outperformed the S&P 500 Index. Similarly, US banks over the same period have bottomed in relative terms around six months prior to the last interest rate rise and counterintuitively against a background of falling net interest margins.