A return to the 70s?
You would have to go back to the late 1970s to find a time when the yield on 10-year US Treasury bonds last increased by 200%+. A decade that will forever be remembered for punk rock, power cuts and of course ubiquitous brown flares, but also economically for the high levels of inflation that raged following a period of sustained economic growth throughout the 1960s. Today, while fashions have changed, the 230% rise in this key barometer’s yields since July last year has reawakened the debate on inflation, which has lain dormant since the global financial crisis (GFC).
Figure 1: The sharp jump in US 10-year Treasury yield was last seen in the late 70s
Source: FTSE Russell, FactSet, HSBC, 22 April 2021.
A shift in gear: can a cyclical recovery become a longer-term reflation rotation?
Vaccine breakthroughs and unprecedented fiscal stimulus have driven this change in market outlook. In addition, this improved visibility around the shape of the recovery has catalysed a reversal in fortunes of cyclical sectors that were badly impacted by the pandemic in 2020.
As the momentum of the economic recovery continues, it has led market participants to envisage a world in which inflation could return to levels not witnessed for some time. This has seen more inflation-sensitive areas of the market, including financials, join the strong market recovery.
Banks had a difficult 2020, as rapidly falling interest rates hampered margins and the near economic standstill saw provisions materially rise ahead of what appeared to be a very deep credit cycle ahead. At the same time, regulators fearful of the impact of higher provisions on bank balance sheets restricted capital returns, which further compounded sector underperformance. Putting this in context, in the nine months to the end of September 2020, banks fell over 30% (in US dollar terms1) versus a marginal market gain.
Fast forward to the end of March 2021 and it has been a different story: the MSCI All Country World Index gained 20%, whilst banks outperformed significantly, rising nearly 50%. The sheer scale of monetary and fiscal stimulus and the resulting positive impact on economies has seen bad debt fears subside and open the door to a resumption in capital returns – which together with steeper curves – has made banks investable far quicker than the market could ever have envisaged. New accounting regulations born out of the GFC (for example International Financial Reporting Standard 9 – or IFRS 9 – came into force in early 2019 and Current Expected Credit Losses – or CECL– at the end of that year) require banks to provision for expected bad debt losses upfront, which has meant that the provisions they took in early 2020 now look overly conservative, and is already leading to write-backs as evidenced by Q1 results. With this trend expected to continue, earnings momentum looks set to be supported through 2021.
Banks, although cyclical by nature, typically lag other economically sensitive sectors as economies and markets recover. This trend played out in 2020, as the spectre of rising bad debts, very low rates and capped pay-outs still weighed on the sector. Although vaccines and stimulus mean we now have greater visibility on bad debts and returns, we only need to look at the aftermath of the GFC to understand the consequences of persistent low rates on long-term bank profitability.
Steeper curves are positive, but short-term rates matter most for bank profitability
An environment of low, or in some cases negative, interest rates lowers the margin on banks’ lending and deposit activity (the spread between what they charge for their loans and what they pay on their deposits). The rapid rise in inflation expectations that we have seen has the potential to alter this outlook, which the market has responded to by accelerating bank performance further.
While steeper curves notably help banks’ investment portfolios and trading activity in the first instance, the more fundamental question now being asked is whether central banks can feasibly start to tighten monetary policy and raise short-term rates. This will in turn be pivotal for bank profitability as banks’ net interest income is more sensitive to the level of short-term rates. Therefore, with curves remaining anchored at or below zero globally at the short end, the case for banks’ share prices to rise materially from here remains inextricably intertwined with the outlook for central bank policy. Though there are certainly regional pockets of potential rate rises on the cards, the overall message from policymakers is that rates will remain low for some time to support rising government debt burdens. With little confidence that short-term interest rates will rise, it makes it more difficult to construct a bull case for banks’ net interest income in the near term, and indeed the Q1 2021 results season has highlighted continued downward pressure on this line of profits, tempering the outlook for sales momentum.
4Factor steer becomes positive on banks, but a selective approach is key
This is why we believe it’s important to take a selective approach to investing in the sector. Harnessing the steers from our 4Factor investment philosophy, we remained very underweight banks for the most part of 2020 in the 4Factor Global Core Equity Strategy, as earnings expectations fell heavily and the prospect of rising bad debts led to balance sheet concerns and a halt to capital returns. However, over the past six months, we have seen an improving steer towards the sector with a number of interesting investment opportunities coming through which has seen us close this underweight position. In the 4Factor Global Dynamic Equity and 4Factor Global Strategic Equity Strategies, exposure was added to banks and the portfolios have overweight exposure to financials. The strong economic recovery and front-end loading of bad debts has led to a strong recovery in earnings expectations, with banks now having among the most positive earnings revisions in the market.
Figure 2: Banks’ earnings revisions among the strongest in the market
Overweight/underweight steer (Proportional to universe)
Source: Ninety One, 27 April 2021.
Not relying on higher rates: taking a bottom-up perspective
While we have increased overall exposure to the sector, we are avoiding companies that are solely reliant on rising interest rates to make their investment case successful. In the 4Factor Global strategies, we prefer companies that have demonstrated prudent balance sheet management; are highly capital generative; are well digitalised; and importantly have a more diversified revenue mix than their peers, in case low interest rates prevail for some time. For example, while Silicon Valley Bank2 is one of the most sensitive US banks to interest rates, our purchase decision was instead driven by the strong growth in its underlying business. It is a major player in providing finance to the global innovation economy – an area with strong structural growth. Nordea2 is another example of a bank that is geared to a rising interest rate environment in Norway, but where our investment case is predicated on its diversified business mix and potential for industry-leading capital returns. Nordea is also embracing sustainability issues, both in terms of the ESG credentials of the products it sells via its wealth and asset management divisions as well as its commitment to moving towards net zero targets. In the 4Factor Global Strategic Equity Strategy, the team has focused on banks where they believe a degree of internal restructuring could help lift long-term profitability.
So, rather than relying solely on rising interest rates, we believe our focus on bottom-up fundamental drivers of companies within 4Factor leaves us well placed to select bank stocks with strong investment cases whether or not current rising inflation expectations are sustained and ultimately lead to rising interest rates.
1According to the MSCI ACWI Index.
2These stocks are held in 4Factor portfolios.
No representation is being made that any investment will or is likely to achieve profits or losses similar to those achieved in the past, or that significant losses will be avoided.
This is not a buy, sell or hold recommendation for any particular security.
Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. insolvency), the owners of their equity rank last in terms of any financial payment from that company. Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Derivatives: The use of derivatives is not intended to increase the overall level of risk. However, the use of derivatives may still lead to large changes in value and includes the potential for large financial loss. A counterparty to a derivative transaction may fail to meet its obligations which may also lead to a financial loss.
All investments carry the risk of capital loss. Past performance is not a reliable indicator of future results.