Financials saw further outperformance in October as the rotation out of growth into value stocks led by bank shares continued, as bond yield saw a further recovery from the lows they hit in August and early September. The rotation was helped by progress in US-China trade talks and signs of a bottoming out in the slowdown in economic activity. Sterling rallied sharply as the UK Government came to a new agreement with the EU on Brexit offsetting the rally in equity markets.

Against this background the Trust’s net asset value fell 1.5% against our benchmark index, the MSCI World Financials + REIT Index, which fell by 2.4%. Our holdings in US banks were the biggest contributors to performance, in particular, those in JPMorgan, Bank of America and First Republic Bank, the latter on much better than expected results. Conversely our holdings in Arch Capital, Chubb and Citizens Financial Group were weak.

US banks rose 4.0% in the month (-1.2% after adjusting for the rise in sterling). As expected, the Federal Reserve delivered a 25bps rate cut in the month but signalled an ‘on-hold’ bias with the Chairman of the Federal Reserve, Jerome Powell, citing robust consumer spending, strengthening home sales and reduced geopolitical risks. Requiring a ‘material reassessment’ of their outlook to cut interest rates, market expectations on additional cuts in interest rates have fallen, while robust labour market data has reassured on the outlook for consumer spending (and its ability to offset weakness in the manufacturing segment).

US banks’ 3rd quarter results came ahead of expectations with better fee income and lower provisioning and costs helping to offset the headwinds from margin pressure. Large cap. banks reported an average 7bps net interest margin contraction in the quarter with asset yields falling 12bps while the cost of interest-bearing liabilities fell 4bps. Guidance implies we have now seen the peak level of sequential margin compression as more meaningful reductions in deposit costs come through in subsequent quarters.

Importantly, profitability remains strong (16% Return on Tangible Equity at large cap. banks) supported by benign asset quality while healthy capital levels (11.8% Tier 1) are leading to material capital return to shareholders (US large. cap banks total yield is >10%). In terms of our small and mid-cap bank holdings, earnings growth is being supported by continued strong levels of loan growth, for example First Republic Bank grew its loans by 19% and Silicon Valley Bank by 13% year-on-year, which is helping to offset the headwinds from margin compression.

European banks were not quite as strong in October rising by 3.1% (+0.1% in sterling). Sentiment has remained closely tied to developments in US-China trade talks as well as UK-EU Brexit negotiations. We are half-way through 3rd quarter results which have on average come in slightly ahead of expectations. With revenues facing headwinds across much of the region, the results highlighted the relative strength of Norwegian banking (which after the UK is our largest exposure in Europe) which is benefiting from a robust macro backdrop and upward loan repricing following interest rate increases.

The overall macro picture coming out of Asia remains subdued although there is some evidence of a recovery in exports. A lack of inflationary pressures has enabled a number of central banks to cut rates during the month. Added to which some countries cut reserve requirements for banks and we suspect that more cuts will be forthcoming. More encouragingly, countries are beginning to use fiscal measures (such as increased government spending and cuts in tax rates) to help boost growth. The latter boosts coupled with rate cuts should feed through into an improved macro picture towards the end of the year and we are more positive on the overall outlook than we were a few months ago.

The recent rotation out of growth stocks into value stocks, of which banks play a prominent part, is not surprising considering the latter’s underperformance. We have seen a number of pointers that suggest that markets are exhibiting less than their normal efficiency. Some of these are probably wishful thinking on our behalf, but the combination of them all would suggest that the rotation we have seen could carry on much further than investors are prepared for.

The failure of one of the UK’s most well-known fund managers and his firm rhymes with the sacking of a prominent value fund manager in 2000 at the peak of the TMT bubble. The valuations of some early-stage technology businesses appear to show little relevance to the underlying prospects of the businesses in question as highlighted by the failed IPO of WeWork and others. The extreme valuation differential of safe low volatility businesses to the market versus history and the discount that value stocks equally trade to the market vs history again has suggested that valuations are at or close to extremes.

Furthermore, we have also had inbound questions on the investability of US banks over concerns of the risk that US interest rates will inevitably become negative as they have in Europe and Japan. An investment trust with a focus on European value stocks has recently appointed a new manager with a growth mandate. Finally, we have been told of fund managers being scoffed at in a meeting by a fund buyer for investing in a paper company, a classic old-economy value stock. All contrarian signals.

Against this background we reduced our exposure to a number of our more defensive holdings, but also our holding in Blackstone, the alternative asset manager, following a very strong rally in its share price this year, in part on it becoming eligible for inclusion in indices. Conversely, we increased our exposure to emerging market banks, adding to a number of holdings, including HDFC Bank and Bank Central Asia while also starting new holdings in Mexico and Brazil. As a result, gearing has increased to around 4%.

08 November 2019

Nick Brind

Fund Manager

John Yakas

Fund Manager