Equity markets were mixed but largely flat in September albeit financials frustratingly continued to underperform. US financials were weak on the back of weaker loan growth expectations and less hawkish commentary from the Chairman of the Federal Reserve on outlook for interest rates, while European and Japanese financials performed strongly. The Trust’s net asset value fell by 1.5% as compared with our benchmark index, the MSCI World Financials + Real Estate Index, which fell by 1.1%.

European financials did see some recovery during the month before giving most of it up on concern around events in Italy after the coalition government agreed to target a higher budget deficit than the market had expected. The proposed budget deficit of 2.4% of GDP, up from 0.8% in 2018, has raised concerns regarding Italy’s debt sustainability and reduced confidence that Finance Minister Tria will act as a moderating force on the populist government.

The spread between 10-year Italian and German bund yields widened to 300bps, its highest since 2013. Whilst the banking sector has significant exposure to Italian government bonds, the impact to capital from the spread widening is relatively small so far (~8bps hit to capital ratios on average) but the sector faces an overhang from what are likely to be fraught negotiations with the EU on budget targets. The Trust’s only holding in Italy is Intesa Sanpaolo which represents 1.2% of the portfolio.

The best performing holdings in the Trust in September included, Swedbank, a Swedish bank, Sumitomo Mitsui Financial, a Japanese bank, and KBC Groep, a Dutch bank. Swedbank, however, has fallen post month end as it has operations in Estonia which has come under intense scrutiny following the revelations of money laundering in Danske’s Estonian branch. We do not have a holding in Danske, whose shares have fallen around 30% year-to-date.

Poorly performing holdings, not surprisingly, included Bank of America and Wells Fargo for the reasons described above as well as Indiabulls Housing Finance, an Indian housing finance company, which suffered a sharp fall in its share price on the back of concerns around liquidity in the non-bank financials (NBFCs) sector. The catalyst was IL&FS Group, a private infrastructure development and finance company, missing a number of debt payments raising the spectre of a wider problem of solvency and liquidity, with particular concern focused on housing finance companies because of their asset/liability mismatch.

We suspect that fears were exacerbated by rising interest rates (which puts pressure on NBFCs’ margins) and growing expectation that the fast growth and high valuations were under threat. Subsequent to this the Reserve Bank of India has clearly stated that it will provide liquidity to those that need it and many of the NBFCs have issued statements highlighting that there is much leeway in their funding composition and issuance. Our exposure to India is through a 1.1% holding in HDFC banks, that has been almost unaffected by the sell-off and a 0.5% holding in Indiabulls Housing Finance, which we took the opportunity to add to post month-end.

Our recent work on cost trends, focusing on the years 2008 to 2017, has highlighted some interesting results and divergences between regions. In general, European banks have made much larger cuts to branch networks and headcount than their peers in the US, potentially a reflection of the greater revenue headwinds faced in Europe, and, as a result, have seen an improvement in efficiency compared to more mixed trends in the US.

Nordic banks look particularly well positioned operating with low cost/income ratios and generating revenue growth whilst making material cuts to branch networks. For example, Swedbank and DNB, Norway’s largest bank, have reduced branches by 62% and 84% since 2008 respectively and headcount by 31% and 35%. Technology spend as a proportion of total costs is relatively high in the Nordics (>20%) and has allowed the banks to maintain their market shares despite the branch reduction. The Trust is overweight the Nordic region which benefits from a resilient macro backdrop and gearing to higher interest rates.

As we have highlighted in previous commentaries over the last few months, the sector has performed poorly with share prices lagging the change in earnings expectations and bond yields. For example, P/E multiples for US and European banks for 2019 estimates have fallen to 11.2x and 8.5x respectively. This is a 32% and 37% discount to the S&P 500 and STOXX Europe 600 indices, well below the average that they have traded at over this period and further back. For the US the discount has ranged from 13% to 37% over the last 5 years while for Europe it has ranged from 10% to 50%, in both cases the lows being in July 2016.

The MSCI World Value Index has now underperformed the MSCI Growth Index since 2007, with only a brief pause in 2016, for the longest period since 1974 which is as far back as the data we have goes. This correlates well with the underperformance of financials over this period. Sentiment does not yet feel as negative as it did in July 2016 but the sector is without doubt out of favour and as the market prices in a slowdown into 2019 so it should reduce downside risk in the sector if a slowdown comes about. Conversely, it also provides significant upside in the sector if investor’s pessimism is proved wrong.

08 October 2018

Nick Brind

Fund Manager

John Yakas

Fund Manager