Here’s a strange thought. Perhaps one of the better places to hide for equity investors in a future sell-off are shares in banks.
Clearly this sounds like a daft claim after the global financial crisis, but bear with me. The last market panic was because there was a very real concern that the banks and their practises were the cause of the downturn.
Most recessions and accompanying stock market sell-offs are for more mundane reasons, such as a slowing of trade, or political concerns. If the next recession does happen for a more ‘typical’ reason – not a banking and liquidity crisis – then there’s every reason to think that banks might provide defensive qualities.
That’s certainly the view of fund managers at Polar Capital. They run the well-established Polar Capital Financial Opportunities fund alongside the Polar Capital Global Financials (PCFT) investment trust.
A few months ago, they put a note reminding us of the 10th anniversary of the global financial crisis and observing that the global banking sector was in much, much better shape. Called, a little unimaginatively, The Financial Sector, 10 years after the crisis, the report highlighted 10 key reasons for investors to look at the sector today. In no particular order they were as follows:
- The balance sheets of financial services firms are in excellent shape.
- The regulatory regime has reduced risk and improved quality.
- Investors are overstating the risks in the sector due to their experiences in 2007-09.
- Interest rate trends are providing earnings support.
- Structural and cyclical positioning is stronger than assumed
- It is anticipated that loan growth will accelerate.
- Expect technology and mergers and acquisitions will provide a catalyst for efficiencies.
- Constantly evolving opportunities in fintech and emerging markets.
- Valuations are exceptionally low.
- Strong capital and dividends support valuations.
I’ll come back to some of these observations shortly but for me the most interesting chart was the one below which showed how US banks (the lion’s share of most banking portfolios) performed during recessions. The bottom line is that most US banks tend to outperform during recessions, except if the cause of the recession is a banking crisis.
Source: Polar Capital, Bloomberg, Moody's, company data, Autonomous Research estimates.
Which brings us back to those 10 points – we might have a future banking crisis if the banks’ balance sheets are in a dismal shape. The evidence suggests the opposite. Largely because of the heroic efforts of the banking regulators worldwide – a wonderful example of international coordination – we’ve seen huge capital raising, and a refocusing back onto core financial activities.
Personally, I would have preferred more separation of investment banking from ‘utility’ high street banking, but the reforms have been thorough and methodical and as interest rates in the US have risen, profitability has increased.
Slowly but surely a new paradigm for banking equities has emerged – boring utility style stocks. In this new narrative, the ability of banks to leverage their balance sheets to fund risky financial engineering has been circumscribed. Returns on capital have increased but the risk profile of the very big, systemically important, banks has become much more defensive.
We can see that in two very different observations. The first is that the big banks still get lambasted for not lending to small- and medium-sized enterprises (SMEs). I am especially critical of this failure to lend but let’s be honest SME lending is, indisputably, risky, and we can’t have it both ways – we want banks to be more conservative but also at the same time be more risk friendly by lending to SMEs.
The other observation is the credit default swap market, which I have touched on before in this column. This slightly opaque market looks at the pricing of financial products designed to pay out if a big bank defaults. The last time I looked these swaps were near short-term lows. This is a real time market (that means very short term in perspective) and is powered by lots of contrasting dynamics but current pricing suggests that most big institutional investors are intensely relaxed about the risk of default.
The net effect of these forces is that bank stocks have become more defensive, arguably even value oriented.
Source: Polar Capital, Bloomberg.
That’s the message of two charts from the Polar presentation – they look at European and US bank valuations through one metric, price to earnings ratios. These are close to seven-year lows. This is echoed by the sheer number of bank and financial stocks that sit inside quant-driven value portfolios.
Source: Polar Capital, Bloomberg.
There is though one mammoth elephant in the room that could have a huge impact on these valuations – fintech and technological disruption. The Economist magazine ran an excellent supplement on these huge and important trends only last week.
Banking has always been a technology heavy sector. I remember one insider once telling me that HSBC was a giant tech business (with huge staff numbers in India) that happened to own a few branches dotted around the world. Thus, the payments revolution, banking in an app, and new digital wealth propositions was bound to have a huge impact on the industry.
But as an enormous evangelist for this disruption – and an enthusiastic customer of Starling, Revolut, Freetrade and the wonderful Curve card – I have sad news to deliver. These upstarts are all great value for money and doing well but for the foreseeable future they pose no threat to the big banks. More to the point the big banks – especially BBVA – are getting adept at watching these new players, copying the ideas or simply buying the businesses.
Which opens up another prospect – as the fintech wave intensifies, collaboration and acquisition might help drive down costs for the big banks, giving them better profit margins. It’s not quite what we evangelists for fintech wanted, but I think it’s inevitable.
So, this brings me back to one simple conclusion – fintech could be good for positive change for some of the established incumbents.
Where does this leave the humble private investor? One slightly worrying aspect for me is the provincial nature of most UK investors. When they talk about banking and financial services, discussion very quickly centres on how cheap shares in Lloyds (LLOY) looks for instance – and I do think it represents great value by the way.
But if we look at the big benchmarks covering this space, one quickly realises that the UK banks really aren’t that important. Over 60% of the market value of financial services businesses – which includes more tech-driven outfits such as Visa (V.N) and Mastercard (MA.N) – sits in the US. If you want to invest in a diversified and sustainable fashion in financial services generally, and banks specifically, then you need to think global.
Funds are the best route into financials
I think that forces us to go down the fund route, either via passive index tracker fund which invests in something like the MSCI World Financials index or through an actively managed fund.
As with many sector specific funds, there is some evidence to suggest that putting your money with active managers who really know a sector is a sensible strategy.
In the table below I have broken out recent returns for the limited number of specialised global financial services funds available to UK investors. There aren’t many that I would highlight but three out of the four have comfortably beaten the MSCI benchmark index. You’ll note that one hasn’t – Polar Capital Financial Opportunities.
Arguably that’s because the Polar funds are much more invested in banks per se rather than broader, tech-influenced financial services stocks. The Polar Capital fund’s top holdings are either banks like JP Morgan Chase (JPM.N) and Bank of America (BAC.N) or boring, defensive insurance businesses like AIA (1299.HK).
By contrast Guy De Blonay’s Jupiter Financial Opportunities fund has a much more tech feeling to it – top holdings in that fund consist of Paypal (PYPL.O), a business I rate highly by the way, Visa, Mastercard and Global Payments (GPN.N).
The reason why these different fund profiles matter is that the more tech enabled payments processing financial services businesses have been on a tear over the last few years while the big banks have fallen behind and become more value oriented.
Polar Capital would not doubt argue that in a recession, the more lowly valued banks might outperform he racier tech-enabled financial services processors but to date, those fintech enabled businesses look like they’ve been the better bets.
My hunch is that if you are more defensive in outlook, the Polar Capital fund might be a better bet whereas if you think that fintech could really enable huge growth in the sector the Jupiter or Aberdeen funds might be a better bet. But whatever your take my sense is that this sector absolutely deserves some dedicated exposure for the retail investor, possibly as part of a satellite portfolio.
|Fund||1-year return (%)||3-year return (%)||5-year return (%)||Yield (%)||Top 5 holdings|
|Aberdeen Financial Equity||6.8||58.1||72||1.1||Visa 6.8%, AIA 4.5%. Intercontinental Exchange 4.3%, Housing Development Finance 4.2%, Prudential 4.2%|
|Janus Henderson Global Financials||4.7||55.6||62.5||1.2||Mastercard 7%, Visa 6.7%, JPMorgan Chase 5.3%, BoA 4.5%, Synchrony Fin 4.7%|
|Jupiter Financial Opportunities||6||56.7||72.6||0.3||Paypal 5%, Visa 4.9%, Mastercard 4.8%, Global Payments 4.1%, Citi 3.9%|
|Polar Capital Financial Opportunities||-3.6||42.5||56||n/a||JPMorgan Chase 5%, Arch Capital 4.3%, AIA 3.5%, BoA 3.4%, Mastercard 3.2%|
|Polar Capital Global Financials (PCFT)||-2||53.7||49.6||3.2||JPMorgan Chase 5.1%, BoA 3.7%, Mastercard 3.1%, Chubb 3.1%, Arch Capital 2.4%|
|Index: MSCI World Financials||-2||51.6||65.5||3.4||JPMorgan Chase 5.8%, BoA 4.3%, Berkshire Hathaway 4.2%, Wells Fargo 3.3%, HSBC Holdings 2.6%|
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