Market review
Global equity markets succumbed to profit-taking in December as Fed Chair Jerome Powell made hawkish1 comments about the outlook for US interest rates leading to a sharp increase in yields on 10-year US Treasuries. Financials were not immune and fell 2.3%, as illustrated by the Trust’s benchmark, the MSCI All Country World Financials Index. Against this background the Trust’s net asset value fell 2.5% with an underweight to China and holdings in RenaissanceRe Holdings, a Bermudan reinsurer, and Allfunds Group, an investment platform, being the biggest drags on performance, offsetting stronger performance from European bank holdings such as Erste Group.
US financials fell 3.9% in December, following a 12.2% rise in November, with US insurance stocks counterintuitively seeing the greatest pullback, down 6.4% over the month, although banks were also weak. Insurance stocks have materially underperformed the wider sector over the past three months largely due to investors rotating away from defensive and into cyclical stocks as the outlook for the US economy has improved and the consequences of the election of Donald Trump are understood.
European financials rose over the month while Asian financials were also relatively resilient, supported by strength in China and to a lesser extent Japan although the latter was offset by weakness in the yen. Chinese financials, up 9.2% over the month, reacted positively to a series of government announcements detailing both fiscal and monetary stimulus measures to revive the economy.
Outlook
Global financials, as per the Trust’s benchmark, rose 26.5% in 2024 compared to the wider equity market which rose 19.6% as investors bought into the soft-landing narrative for the US economy. This is the third year out of the past four that financials have outperformed and the sixth best calendar year for performance going back to 1995, as per MSCI data. Similarly, on a calendar year basis, one has to go back to 2007-12 to find a five-year period where the total returns would have been negative, not surprisingly reflecting the impact of the global financial and Eurozone crises on share prices.
This is the third year out of the past four that financials have outperformed and the sixth best calendar year for performance going back to 1995.
From a valuation perspective, the closing scores at the end of December had the sector trading on a forecast calendar year 2026 P/E2 multiple of 12.6x compared to global equity markets on 18.1x while the US equity market (the S&P 500 Index) was on 21.7x. The discount at which the sector has traded relative to wider equity markets increased materially in the lead up to the pandemic, reaching its peak of around 45% in October 2020. Today, the discount has reduced to just under 30%, which is where it was trading before the pandemic, compared to c15% in July 2013 when the Trust was launched, albeit today profitability is higher than at the end of 2019 and in 2013.
Within the sector, banks and insurance companies are the biggest contributors to that low P/E multiple, at 10.0x and 11.6x respectively, but it is within European banks, which trade on 7x, where some of the deepest value continues to be found. However, one has to go outside developed markets to, for example China, Brazil or Mexico, to find banks trading on lower valuations. At the other end of the spectrum, while one can find banks in India and Indonesia that trade on much higher multiples, albeit for good reason, in developed markets it is Australian banks on 19.2x which are at odds with fundamentals.
The Trust’s largest exposure is to US financials that should be beneficiaries of a lighter regulatory regime and a more favourable environment for M&A in 2025 due to the election of Trump. Lighter regulation has its risks, but the increased regulation that financial services companies have been hit with over the past 15 years has led to a level of complexity and regulatory overlap that damages economic activity and often increases costs for little or no benefit. There were proposals in 2023 for a substantial increase in US bank capital requirements. We saw these as misplaced and unsurprisingly they have been watered down since, and after Trump’s inauguration we would expect to see further revision.
We continue to like European banks and, selectively, some Asian banks. Our reticence for not owning more of either is motivated by the headwinds for anaemic growth in Europe and Asia with tail risks from US tariffs. Similarly, while we like Mexican banks, we are happy to sit on the sidelines for now until we see better risk/reward. Also, we do not like Australian banks on their current valuation multiples. Not owning them was a drag on performance in 2024, but we do not believe the laws of gravity have changed and expect their shares to continue to perform poorly.
The move higher in interest rate expectations and government bond yields over the past month and into the New Year, particularly in the UK, will have positive and negative consequences for the sector. All things being equal, most banks and insurance companies will be more profitable than they would if interest rates were cut as expected. However, banks and insurance companies are exposed to credit risk so conversely there will be added concern around the potential for an increase in bad debts, with the former much more sensitive to this issue.
We have long argued that there is a correlation between loan growth and loan losses. With banks having not grown their loan books materially over recent years, it would take a significant economic downturn to generate losses that could justify the current multiples that some bank shares trade on. A UK banking analyst from research firm KBW summed it up succinctly in a recent note, with an analogy that can be extrapolated to other banking markets: “In recent years, UK banks have survived a fall in GDP of 10%, interest rates rising by 5% and inflation peaking at more than 11% with zero credit problems.” Consequently, we continue to believe the market is not giving the sector the credit it deserves for that reduction in risk.
1. Comments in support of higher interest rates to control inflation, which can slow economic growth
2. P/E stands for price-to-earnings ratio, which relates a company's share price to its earnings per share
