The banking sector has been a significant drag on the UK market. Since 2006, the All Share index has risen by 19% but the five banking constituents of the FTSE 100 have, on average, fallen by 70%. As Nick Brind, co-manager of the Polar Capital Global Financials Trust (LSE: PCFT), notes, this was not just the result of the financial crisis. Since mid-2013, the five have slipped by 30% while the All-Share has returned 46% and the MSCI Global Financials index 77%.
A difficult domestic market
It’s not hard to see why. With interest rates at zero, it is virtually impossible for UK banks to make sufficient margin to cover costs, bad debts and a reasonable return on capital. Fee income is under relentless pressure from specialist providers of insurance, investment advice and foreign exchange, competition in the commercial market is intense and investment-banking income has withered. Regulators stopped banks paying dividends in 2020 and their overall rate of corporation tax is 8% higher than standard. “UK banks are not a good guide to the opportunities in the sector,” says Brind.
Banks in the US and emerging markets have fared better so PCFT has prospered, returning 102% since mid-2013 and 54% since the trust survived a continuation vote at the cost of buying in 40% of its shares last April. This has led to an acceleration in relative performance, which has been 14% ahead of the global financial index since then. The shares now trade at a small premium to net asset value (NAV), enabling PCFT to reissue most of the shares it bought back. Assets have increased to £250m and though the yield has dropped below 3%, dividend growth is likely to resume this year.
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Over 90% of PCFT’s portfolio is outside the UK; 63% is invested in banks, 14% in insurance, and 10% in “financial technology” (such as PayPal and Mastercard). Nearly half of assets are in North America and 20% in Asia ex Japan. The sector has started to outperform but Brind believes there is much more to go for.
“Banks underperformed in the pandemic by more than in the global financial crisis,” he says, “but the rise in loan losses has been muted while payments of deferred interest have resumed. US banks are incredibly well reserved so provisions are likely to be released in 2021-2022 , enabling a resumption of share buybacks.” A strong recovery in earnings is expected, helped by the steepening of the yield curve. “This is very good news for the sector as the performance of banks is highly correlated to bond yields.”
Rising interest rates bode well
A 1% rise in US interest rates, says Brind, causes bank earnings to rise 12% in year one and 20% in year two. The discount of share prices to book value for global banks has narrowed from 30% to 10% but Brind sees 20% upside in the US and 30% globally, with asset values boosted by the release of provisions as well as by earnings. Given how well the banks withstood this crisis, it is even possible, he thinks, that they could be rerated in a more benign regulatory environment.
Exposure to emerging markets has been reduced despite the structural growth opportunities and a sector that is “more profitable and more dominant than in developed markets”. Financial technology companies have benefited from an acceleration in the shift of transactions online while pricing in insurance markets is firm. Covid-19 losses are estimated at $60bn-$70bn but balance sheets are strong and valuations moderate.
Financials usually out-perform by 23% in the 12 months from market lows, says Brind, “but have barely outperformed since the Covid-19 low and have halved relative to the MSCI World index since 2006”. Given the encouraging outlook the trust is geared, with borrowings of 9% of net assets.
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