Equity markets rallied in June, reversing the previous month’s falls, led by the US as the Federal Reserve indicated its willingness to ease monetary policy in the face of near-term growth risks. Sentiment was also helped over the increased optimism about the relaunch of trade talks between the US and China ahead of the G20 summit in Japan. Against this background the Trust’s net asset value rose by 4.2% while our benchmark index, the MSCI World Financials + Real Estate Index, rose by 4.3%, with performance held back by our fixed income securities.

Our holdings in OneSavings Bank and Charter Court Financial Services Group were weaker over the month. They are in the process of merging and we believe the weakness relates to concerns around the UK economy although they are both likely recipients of a warning letter sent out by the PRA to 20 ’fast growing’ non-systemic banks on a number of issues. Nevertheless, we remain constructive on both and feel their share prices discount a sharp fall in profitability.

Our largest holdings, including JP Morgan and Bank of America, were the biggest drivers of positive performance during the month on the back of higher equity markets. While the lower interest rate outlook is a headwind for bank earnings this will be offset by lower loan losses. However, many investors remain on the side-lines of the sector believing any scenario is negative, with the negative impact of low interest rates on net interest margins, or the risk of higher loan losses if interest rates are not cut by as much as expected, offsetting any positive drivers.

In the US, the results of the annual stress test (DFAST) were announced at the end of the month, with all banks passing and achieving the required minimum capital levels under the Severely Adverse Scenario (10% unemployment; c8% fall in real GDP; and house price and commercial real estate prices to fall 25% and 35% respectively). The strong performance in the stress test led to a 14% increase in capital return for largest US banks versus last year as part of this year’s CCAR (Comprehensive Capital Analysis and Review) process which reviews banks’ capital planning processes and capital adequacy.

European banks lagged the rally in June following weaker macro data and a dovish statement from the ECB. Concerns over global growth, exacerbated by the US/China trade dispute, have been accompanied by a fall in European inflation expectations with 10-year bund yields falling to a record low of -0.3%. In response to the deteriorating outlook, the ECB raised the possibility of additional monetary stimulus to raise inflation expectations back towards the 2% target. The prospect of lower-for-longer interest rates will remain a headwind for European banking revenues and has curbed any significant recovery in the sector which continues to trade at depressed valuations.

The Trust’s exposure to eurozone banks is relatively low at just over 6% and includes a holding in Banco Santander which generates c50% of its underlying profit through its emerging market operations. The Trust does have an overweight position in the Nordics (through banks and insurance companies), a region which continues to benefit from resilient macro trends, while Norwegian banks, where we own shares in DNB and SpareBank 1 SMN, continue to benefit from rising interest rates (Norges Bank raised interest rates again in June and signalled additional hikes this year).

Asian financials were relatively strong in June driven by China on hopes for a de-escalation of the trade dispute with the US. Conversely, Indian financials fell 0.2% in the month, giving back some of their gains made in the rally after Modi’s re-election. Asset quality concerns also continue to weigh on certain Indian financials and during the month a delayed repayment of a non-convertible debenture by Dewan Housing led to pressure on non-banking financial companies (NBFCs) as liquidity issues resurfaced. We have reduced the Trust’s exposure to India this year and our now our only holding is to HDFC Bank, one of the private sector banks.

We met with a couple of alternative asset managers during the month, Brookfield Asset Management and Tikehau Capital. Brookfield believe that institutions will raise their exposure to alternatives to 40% by 2030 from around 25% today and, if true, is a worrying trend for traditional asset managers considering the flows also going into passive funds at their expense. This view was also backed up by Tikehau who recounted a conversation they had with a Texan Pension fund that said that they would be raising their allocation to that level, giving it much more credence.

We have shied away from traditional asset managers because of these growth headwinds. We own shares in Blackstone which is the largest alternative asset manager globally. Not surprisingly, Blackstone’s shares have performed strongly over the past 10 years, benefiting more recently from its announcement to change its corporate structure from a publicly traded partnership to a corporation, as the former prevented many institutions from owning its shares. We also own shares in City of London Investment Group, a traditional asset manager, with its focus on the closed-end fund market but see this as a special situation.

The sector has seen a strong recovery this year (the Trust’s NAV total return is 15.4%) although it has slightly lagged underlying equity markets due to the uncertainty on the outlook for growth and interest rates. Despite the rally, bank shares have continued to derate and valuations continue to price in a materially weaker operating environment. While the recovery in the US has been the longest expansion in history, according to the National Bureau of Economic Research, it has also been far weaker than any previous recovery. This would suggest that the risks that normally build up in the banking system in an expansion have yet to do so and that therefore banks’ operating performance should surprise positively through the next downturn.

05 July 2019

Nick Brind

Fund Manager

John Yakas

Fund Manager