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Trading at multi-year lows, banks are the key reason why the financial sector has underperformed underlying equity markets over the past few years. September 2019, however, highlighted how exposed investors are to any change in sentiment as banks, seen as value stocks, were the biggest beneficiary of the rotation out of growth stocks and into value stocks sparked by a rise in bond yields. Many investors lost out as banks’ share prices jumped sharply.
Lower interest rates are a negative for the banking sector as their net interest margins (the difference between what they receive in income on mortgages and other loans they have made, and what they pay out to savers) have come under pressure. There is the fear these margins will continue to fall to unsustainably low levels, making banks less and less profitable. However, there is much banks can do to offset this and maintain profitability.
If interest rates remain at their historically low levels over the coming years, banks will need to change their business models to adapt to this environment. We would expect a shift to banks keeping less loans on their balance sheets while increasing their fee income from arranging/structuring loans which would be positive for their ability to continue to return a significant amount of capital to shareholders, either via share buybacks and/or dividend payments.
Fears over a recession have also negatively impacted sentiment on the sector. This is understandable against a background of weaker economic data, however we feel that assumptions based on the last financial crisis are excessive. Instead, we expect a mild deterioration at worst and therefore question the low level of valuations that the banking sector is trading at relative to the broader equity market. For US banks, we believe one would need to see an increase in provisions for loans that borrowers have defaulted on, of 2-4 times their current levels to justify current share prices.
Banks have significantly strengthened their balance sheets over the past 10 years at the behest of regulators and have been more cautious in their appetite to grow their loan books, therefore reducing risk to investors from the next economic downturn. What is surprising, therefore, is these exceptionally low valuations price in some, if not all, of a risk of a recession over the coming months. In this low growth environment, they also offer investors very high dividend yields as well as a geared exposure to interest rates.
Markets currently assume interest rates will remain low for some time but as the economist JK Galbraith said about economic forecasting: “There are two kinds of forecasters: those who don’t know [how to forecast] and those who don’t know they don’t know [how to forecast]”. If and when interest rates start to rise again the banking sector will be one of the biggest beneficiaries while other sectors are likely to suffer. Anyone wanting to own a diversified portfolio of equities/funds ignores banks at their peril.
Nick Brind
Fund Manager, Polar Capital Global Financials Trust
31 October 2019
Disclaimer
This document does not constitute an offer or solicitation of an offer to make an investment into any fund managed by Polar Capital. Polar Capital LLP is a limited liability partnership number OC314700. It is authorised and regulated by UK Financial Conduct Authority and registered as an investment adviser with the US Securities & Exchange Commission. A list of members is open to inspection at the registered office, 16 Palace Street, London, SW1E 5JD.
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