Equity markets made further gains in December on the back of the continued optimism around trade talks between the US and China reaching a conclusion and the UK election result. Sterling was strong over the month on the back of the latter. Against this background the Trust’s net asset value rose by 1.7% as compared with our benchmark index, the MSCI World Financials + Real Estate Index, which rose by 0.3%. Financials marginally outperformed equity markets in December, led by UK, European and emerging market banks with insurance stocks lagging the rally.
The strongest contributors to performance over the month were JP Morgan, the Trust’s largest position, DNB, Norway’s largest bank, and OneSavings Bank, the UK buy-to-let focused lender, the latter on the back of the UK elections. Conversely the share prices of Toronto-Dominion Bank, a Canadian bank, on the back of slightly weaker results, and Wells Fargo and US Bancorp, both US banks, were marginally lower over the month.
European banks outperformed following the UK election result which has reduced political risk alongside a bottoming out in leading economic indicators which were reflected in a further rise in bond yields from their lows in September. UK equities responded positively to the general election result with the Conservative Party winning its biggest majority since 1987 (albeit this enthusiasm was almost immediately dampened as the risks associated with exiting the EU increased on the news of legislation being brought forward to prohibit an extension to the transition period).
Confirmation of a phase-one trade agreement between the US and China supported US financials with banks outperforming in the month, helped similarly by higher 10-year US treasuries. While there is execution risk and the agreement leaves many key areas unresolved it has removed the risk of additional tariffs coming into effect and marks a de-escalation in tensions between the two countries. The approval of USMCA (US-Mexico-Canada Agreement) in December further reduced trade-policy uncertainty and removed the risk that President Trump would withdraw the US from NAFTA if the revamped trade deal was not passed by the House of Representatives.
Emerging market financials outperformed developed markets in December on reduced trade concerns supporting the global growth outlook, a stabilisation in global PMI new orders and a weakening in the dollar. Latin American financials also benefited from trade developments, with Mexican stocks reacting positively to the USMCA deal while Brazilian financials (the Trust holds Itau Unibanco) were also supported by signs that the reform process is regaining momentum with proposals for tax reform to be sent to Congress.
In December, the Bank of England (BoE) also announced its annual UK stress test. As in the previous year no individual bank failed after taking into account “management actions”. While this is good news, management actions include the cancellation of dividends and AT1 coupons, neither of which would be helpful for AT1 bond and share prices should that happen. Also, under a more stringent definition of capital both Lloyds Bank and Barclays would have seen their AT1 securities written down. Again, this is unhelpful for sentiment albeit this definition is not given any credence by BoE and so rather odd of them to publicise the results.
More surprising was the decision to double the counter-cyclical buffer over the year to 2%. This will be partly offset by a reduction in what is known as the Pillar 2A capital ratio but all together the effect is not an entirely insignificant increase in capital requirements for UK domestic banks, with Standard Chartered and HSBC less affected. Aside of the short-term impact, largely masked by the post-election euphoria, this will add significantly more flexibility to BoE’s toolkit to reduce capital requirements in a downturn and therefore reduce the risk of banks needing to cut their dividends etc to preserve capital and/or slow down lending.
In a similar vein, Unicredit, Italy’s second largest bank, highlighted in December that revised rules on capital and liquidity, namely CRR2 and CRDV (Capital Requirements Regulation and Capital Requirements Directive) which become effective in June 2021, will have a small benefit for European banks. This is because European banks will be allowed, as banks in the UK already are, to meet some of their capital requirements for Pillar 2 using AT1 and Tier 2 bonds, as opposed to 100% equity. All things being equal this should marginally raise the amount of capital European banks can return to shareholders through buybacks and dividends.
We remain constructive on the outlook for the sector and the opportunities within it. While we see some risk in the short term of economic data not recovering as quickly as financial markets have started pricing in, leading indicators do suggest that growth should pick up in the second half of the year. Against that background the sector should perform well, especially as valuations for banks remain compelling, and we will use any setback in equity markets to increase gearing further.