Cover story: Banking on financials

Banks have already benefited from the so-called reflation trade in financial markets sparked by the US election – and some believe they have much further to run.

US president Donald Trump’s pro-growth policy pledges coupled with oil and commodity price growth, better-than-expected economic data and rising US interest rates – a third hike last month took them to 1 per cent – have led to a reflationary outlook. That has caused investors to pile into shares and sell “safe” assets such as treasuries, sending equity markets up and bond prices down.

“Interestingly, the opportunity in financials is in both bonds and equities,” says Ben Yearsley, a director of Shore Financial Planning. “Banks are big winners of the reflation trade. They continue to improve their capital base and risk continues to improve. There’s a real opportunity to see re-pricing of banks and insurance companies despite a strong run over the last six months.

“And, while I’m not a bond bull at the moment, if I had to buy bonds, financials would be the sector I’d look at. The shoring up of balance sheets is excellent news for bond holders; again, they look decent value.”

Back to black
Ten years after the onset of the financial crisis most banks in the western world have either finally returned to health or are in the latter stages of repair.

In January, JP Morgan Chase & Co and Bank of America Corp, the two largest US banks, kicked off the corporate reporting season on a rosy note, each with healthy increases in fourth-quarter profits.

The improvements came on the back of trading revenue gains, higher interest rates, healthy loan growth and cost controls.

A month later, Britain’s Lloyds Banking Group unveiled pre-tax profits of £4.2bn for 2016 – its best result for a decade and more than double the £1.6bn reported for 2015 when it was hit by a huge bill for payment protection insurance (PPI) misselling.

Some of the more complex restructuring stories are still dealing with the effects of the crisis. Two days after Lloyds’ results, Royal Bank of Scotland reported losses of £7bn for 2016 – its ninth consecutive annual loss and more than triple the previous year’s £2bn.

Its plunge deeper into the red was caused by £10bn of one-off items, including £5.9bn set aside for looming fines and legal costs largely related to a forthcoming penalty from the US Department of Justice for misselling mortgage-backed securities in the run-up to the financial crisis.

Its core business, however, generated £4.2bn in adjusted pre-tax operating profits and chief executive Ross McEwan expects the bank to return to the black by the end of 2018.

Regulatory reform
Regulatory reform since the crisis has been sweeping; banks around the world have made corresponding progress in improving their balance sheets.

“Much of the heavy lifting has already been done, with equity capital ratios several times higher than the pre-crisis era,” says David Griffiths, co-manager of the Kames UK Equity Absolute Return fund.

“While there are still issues to be finalised, such as risk weights on certain categories of lending and the accounting treatment of loan-loss provisions [International Financial Reporting Standard 9], the public position of regulators is that the sector now has about the right level of capital.”

On average, US banks now have capital ratios of around 10 per cent, while European banks have around 13 per cent. That is compared with around 4 per cent globally prior to the 2008 crisis.

“Higher capital ratios may be more justified in Europe given pockets of weakness in regions such as Italy, where a large scale public sector recapitalisation never occurred,” says Peter Bentley, head of global credit at Insight Investment. “However, European capital ratios are still significantly improving, while they appear to have peaked in the US.”

There are even signs that some regulatory constraints in the US may be relaxed under the Trump administration. It has pledged to repeal the Dodd-Frank Wall Street Reform and Consumer Protection Act, a 2,300-page law passed in 2010 that notably restricts the ways banks can invest, limiting speculative trading and eliminating proprietary trading.

“Investment banking is a hugely profitable area of finance and an improved regulatory backdrop would be beneficial to investment banking divisions of UK banks as well as US institutions,” says Nathan Sweeney, a senior investment manager at Architas, the multi-manager.

“However, the attempt to repeal financial regulation in the US is not guaranteed and is likely to be watered down when it passes through the political process.”

Equity opportunities
Financial stocks, notably banks, have hugely underperformed the wider market over the past decade and many fund managers have had little to no exposure. Now, says Ben Willis, head of research at Whitechurch Securities, they are rightly returning.

He says: “Despite a strong recovery in financials which began in the summer of 2016, the opportunity is far from over. For value and contrarian investors, banks are offering some of the best opportunities over the medium to long term.”

Griffiths is among those who have turned positive, adding to the sector over the past six months to give a net long position of 1.4 per cent. Holdings in his long book include Virgin Money and Standard Chartered.

“The stage is set for a continuation of the bank sector’s recovery: the final piece of this would be better commercial loan demand and trade flows that we normally associate with this stage of the global economic cycle and that are not yet captured in analyst forecasts,” he says.

As traditional banks have withdrawn from niche areas like second charge mortgages, car financing and buy-to-let loans, challenger banks have been moving in. Georgina Hamilton, whose Polar Capital UK Value Opportunities fund launched in February with £110m, owns Aldermore, for example.

Sweeney at Architas believes challenger banks “look undervalued” and that asset managers also “appear attractive”, particularly given the scope for further mergers and acquisitions following the proposed mega-merger of Standard Life and Aberdeen Asset Management.

“With the sector still relatively fragmented this is unlikely to be the last deal of its kind, especially as the fall in sterling has made UK-based business more attractive to foreign buyers,” he says.

Rising dividends
The prospect of rapidly rising dividends among financials is also exciting fund managers.

JO Hambro’s Clive Beagles and James Lowen look for companies with above average dividend yields in which investors do not fully appreciate the potential for future earnings and dividend growth. This usually leads them into out-of-favour areas of the market.

Their JOHCM UK Equity Income fund has 36.6 per cent in financials, 10.9 per cent overweight its FTSE All-Share benchmark. Lloyds, Barclays and Aviva are among its top five active bets.

Architas highlights the fund as a beneficiary of Trump’s presidency. It is one of three UK equity income funds with significant exposure to financials that it holds within it portfolios and that it increased exposure to last year, the others being Majedie UK Equity Income and JPM US Equity Income.

Meanwhile, for the past year, Eric Moore has been slowly bear closing in banks. His Miton Income fund now has an 8 per cent holding, 2.8 per cent underweight the FTSE All-Share.

“Nearly 10 long years since queues were forming around Northern Rock, the UK bank sector is finally beginning to look interesting from an equity dividend perspective,” he says.

The fund’s largest holding in the sector is Lloyds, which Moore recently topped up. It increased its 2016 full-year dividend by 13 per cent and served up a small special dividend on top.

He also holds Barclays and Standard Chartered in the belief they are income stocks of the future. “These are higher risk than Lloyds, but both trade on a discount to tangible net asset values, which means the markets are pricing in permanent value destruction. That strikes me as harsh,” he says.

Overall, Miton Income’s largest overweight position is Legal & General, which “looks like a winner in the shift from defined benefit to defined contribution pensions”. It also runs a large position in Standard Life on the strength of its multi-pronged distribution strategy, though this has been diluted by the proposed Aberdeen deal and the holding is under review.

Other holdings of Moore’s in the wider financials sector include St James’s Place and Investec as pension freedoms tip more people into the advice gap created by the retail distribution review.

Banking on bonds
Investing in financial company debt is attracting many bond fund managers too, given that financials still offer a yield premium over non-financials.

“The spread is only 0.57 per cent at present and if you go back five years it was 1.91 per cent, but in a low return environment half a per cent is still worth having, especially since the risk is massively reduced from the height of the financial crisis,” says Yearsley.

While investment grade non-financial debt is typically yielding 2-3 per cent, subordinated financial debt, such as additional tier 1 capital and “cocos” (contingent convertible bonds), are offering yields in excess of 6 per cent, says Willis at Whitechurch Securities.

“The beauty of these bonds is that not only are they providing a high relative yield, many of them are still investment grade (BBB) and are shorter duration than the average benchmark, so have less sensitivity to rising interest rates,’ he adds.

Richard Woolnough, manager of the M&G Optimal Income fund, moved back into financials in the second half of 2016, when he was buying subordinated debt from “national champions” in the US, and again in early 2017, when he turned positive on European financials.

“Scepticism around Europe’s economic recovery, which we do not share, has affected valuations,” he says. He closed a protection position in European senior financials, and established long positions on the iTraxx Subordinated Financials index and the iTraxx Senior Financials index, on which the portfolio had previously had a small short position.

In February, he mainly bought subordinated debt of French banks and insurers, whose valuations looked particularly attractive as a result of continued uncertainty over the country’s upcoming presidential elections.

Invesco Perpetual’s bond desk is also keen on subordinated debt of large European banks, hitherto out of favour due to its ineligibility for central bank quantitative easing programmes. Its managers favour debt issued in the early part of the financial crisis that is now being phased out.

For Jeremy Smouha, chief executive of Atlanticomnium, the rating of the issuer matters more than the rating of the particular bond.

“Junior or hybrid bonds are often rated below investment grade, but if the issuer is investment grade, then the probability of default of all bonds in the capital structure is very small. We can, therefore, capture a much higher income for the same small default risk.”

Atlanticomnium’s GAM Star Credit Opportunities fund owns the HSBC coco yielding 5.03 per cent, for example, which compares very favourably  with a similar duration senior HSBC 2022 bond yielding 0.84 per cent.

‘Short-term opportunity’
Others, however, are less convinced by the case for investing in banks and asset managers, particularly in the western world.

Colin McLean, managing director of SVM Asset Management, which remains underweight banks, says: “The potential for further bank re-rating looks like a short-term opportunity over the next year.

“M&A such as Standard Life/Aberdeen is the result of margin pressure and weak organic growth. Many other asset managers and financials have similar characteristics. Mergers may allow cost cutting, but value creation could be short term and temporary.”

Other entrants from a background in fintech or big data serve to send traditional business models into decline, while blockchain technology could revolutionise the market for financial transactions, he adds.

Newton Investment Management’s Paul Flood also remains cautious, pointing to the US banking sector pricing in much of the anticipated benefits from rising interest rates and possible deregulation. It is now trading on a 16.4x forward price/earnings ratio versus an average of just over 12x historically.

“As global investors we see better opportunities in other markets with higher growth and more attractive sustainable returns which are not fully reflected in current valuations,” says multi-asset manager Flood.

These include health insurers in Asia where GDP per capita levels are just reaching the point where insurance penetration rates tend to accelerate, banks in Georgia and mortgage finance companies in India where credit penetration is low, “providing a long runway for future growth”.