Equity markets having rallied early in the month suffered very sharp falls at the end of February on the back of concerns that coronavirus was spreading uncontrollably and would therefore have a significant impact on global growth. The falls were partially offset by sterling strength. Against this, background financials also fell sharply, led by bank shares, with our benchmark index, the MSCI World Financials + Real Estate Index, falling 6.5%. In comparison, the Trust’s net asset value fell by 6.7%.

US financials fell 8.3% led by bank stocks as US government bond yields reached record lows and the market priced in additional monetary policy easing. While China’s containment policy has led to a consistent reduction in new infections in the month, allowing authorities to let people return to work, the global outbreak (leading to a wide range in estimated potential impacts to global growth) resulted in a heavy selloff towards the end of the month and a rush to the safety of US treasury securities. It remains too early to assess the economic impact and the extent to which it will represent a postponed or permanent loss of growth.

Equity markets were mixed in Asia. Chinese financials saw a modest recovery in the month as the government’s containment policy resulted in a continued fall in the infections rate. Sentiment was also supported by a strong policy response with the PBOC announcing measures to support the corporate sector, particularly SMEs, reduced interest rates and encouraged the issuance of virus-linked bonds (where companies must commit to spending at least 10% of proceeds on measures to combat coronavirus). Similar measures have been announced in Singapore ($4.6bn financial measures primarily focused on the travel, tourism and retail sectors) and Hong Kong ($15.4bn relief package) while Korea is expected to announce relief measures of c$10bn.

European financials fell 6.5%, in line with the broader sector, with the region’s banks falling slightly less. Market sentiment was affected by evidence that the virus was spreading in Italy and, at the time of writing has resulted in significant parts of Italy put into lockdown, which raised the risk of a much wider outbreak. In contrast to other regions, the ECB has downplayed the prospect of near-term monetary policy stimulus but noted a willingness to take “appropriate and targeted measures” to counter the slowdown. The Bank of England Governor, Mark Carney, said the Bank of England would also take all necessary steps to support the UK economy but that coronavirus would lead to, “disruption not destruction” unlike the global financial crisis.

For our bank holdings, the short-term risks to earnings are undoubtedly to the downside but what is priced in by equity markets? Analysts will start to forecast lower net interest margins on the back of the cuts in interest rates already announced and in anticipation that other central banks will also cut. If one assumes that the Federal Reserve cuts interest rates by a further 50bps to take the cut to 100bps then this would, on average, hit US banks earnings by around 7% over the next year. A mild recession could result in a 50% increase in provisioning versus a doubling for a more significant downturn which would result in a further 7% hit to consensus earnings. All told this would impact earnings by around 15%. US banks have fallen over 25% year to date at the time of writing suggesting investors assume a much more severe downturn.

However, forecasts in such a fluid situation are likely to be wide of the mark with the many moving parts including the impact on costs and degree to which banks offset increased provisions for loan losses by raising yields on new loans. Alternatively, one can fall back on valuations as a sense check – not infallible either but instructive. MSCI data which goes back to 1995, covers a panoply of downturns including the Asian financial crisis which coincided with the collapse of Long-Term Capital Management and Russia defaulting in 1998, the 2001-02 recession and Iraq war, SARS, the global financial crisis, the eurozone crisis, periods of rapidly rising and falling oil prices and the more recent period of low or negative interest rates.

Banks are balance sheet businesses and therefore a price-to-book basis which takes into account the cyclicality of the sector’s earnings is the most prudent way of looking at the sector. At the end of February, the sector was trading on a price-to-book ratio of 0.93x, while in comparison the median price-to-book ratio for the sector going back over this period is 1.69x. Banks have only ever traded below the current level approximately 5% of the time highlighting how close to the bottom of their historical trading range they currently are. While we cannot call the bottom of this fall in equity markets you are now buying bank shares at levels only seen in extreme market selloffs. As a result, we believe that any evidence that coronavirus is being contained, undoubtedly weeks away at the earliest, will result in a very sharp recovery.

09 March 2020

Nick Brind

Fund Manager

    John Yakas

    Fund Manager