How worried should investors be about financials?

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How worried should investors be about financials?

Fund managers give their assessment of the real strength of the financials sector after a turbulent few months.

beesley-matthewMatt Beesley, head of global equities, Henderson Global Investors

Looming risks

Despite falls in UK financial stocks year to date, economic, market and political developments have altered the sector’s risk/reward profile. Concerns around the UK housing market are building – especially in London, where affordability is most stretched.

Furthermore, the upcoming hike in stamp duty is equally bound to dampen the buy-to-let market, which has been a source of higher margins for the large mortgage lenders.

Another key reason for the sector’s dismal performance has been the rising cost of funding linked into growing concerns around credit. While PPI charges are the nightmare that will not go away for the sector – and there will be more provisions needed here – the bigger looming risk is around Brexit.

Never forget banks are highly leveraged cyclical stocks. If there is a pre-referendum economic slowdown, or a larger dislocation as a result of a ‘leave’ vote, then expect this to be just the start of the sector’s woes.

davis-nick-nov-2015Nick Davis, manager, European Income fund, Polar Capital

Cash returns could grow

We continue to invest in the dullest banks we can find. Retail banks face earnings pressure from low/negative rates, but we would be more sanguine around the current balance sheet worries.

Where we think a retail bank can generate double digit returns on equity through the cycle, and it is trading below book value, we see selective value. The investment banking businesses look more challenged to us.

While many companies in the utilities, food retail, commodities and resource sectors have cut their dividends, we see financials as one of the spaces where cash returns can actually grow over the next few years.

We are sceptical about some of the more aggressive cash return assumptions, but the direction of increasing cash returns is very clear. Last year, we had questions about why we bothered still owning Nestlé. It is all about a portfolio approach.

Photo of Simon Gergel of Merchants TrustSimon Gergel, manager, Merchants Trust

No cause for concern

The key issue is to what extent the sell-off reflects a deterioration in the underlying economic outlook, rather than simply investors taking risk off the table.

Although there are rising signs of stress within parts of the mining and energy sectors, we are not seeing a significant pick-up in bond defaults generally. UK banks and insurers are unlikely to be particularly impacted by stress within the resources industries.

With higher levels of capital in the banking industry than before the last downturn, we do not see any reason, at this stage, to be especially concerned. Insurers are more sensitive to bond defaults than higher yields, as they can typically own bonds to maturity.

As we are not seeing a material rise in defaults, insurers look relatively well positioned. Overall, we would see the recent sell-off in financials as an opportunity to buy good companies at cheap prices.

wright-alex-2016Alex Wright, portfolio manager, Fidelity Special Values fund

A contrarian call

Global financial stocks are down more than 20% over the last six months, underperforming even the energy sector, which is still reeling from the oil price collapse. European banks have been particularly hard hit with share prices trading at levels seen during the sovereign debt crises.

Valuations at many UK banks are now at similar levels to 2011 and 2008. However, the financial strength of the businesses is radically better than it was then, with significantly less leverage, and in some cases, double the Core Tier 1 Capital ratios.

Returns have been rising, meaning valuations are very attractive on price to book, price to earnings and, especially in the case of Lloyds, next year’s potential dividend yield. UK banks stand out in the market as a compelling contrarian investment opportunity.

It is also important to remember the financial sector is much broader than just banks, and I continue to find good contrarian opportunities across the sector.

rodgers-chris-2016Chris Rodgers, senior UK fund manager, Sanlam FOUR

Recession unlikely

Financial stocks have fallen sharply in all markets this year. Plausible causes include the pressure on bank and insurance company balance sheets from commodity-related losses, the potential squeeze on profitability from negative interest rates and flatter yield curves or, simply, the generalised risks from a global recession.

While some weakness might certainly have been warranted, one suspects share prices may also have suffered unduly from the heightened fear factor among investors.

With memories of the 2008 financial crisis still prominent, it is possible skittish investors might have simply reacted to the initial weakness by assuming the market 'knew’ something they did not, so better to join that panicking herd by selling and then ask questions later.

Banks are leveraged plays on the global economy, but balance sheets have strengthened and a recession is not imminent, heightened risks notwithstanding. Financial shares are now undervalued and should recover from here.

Photo of Neil VeitchNeil Veitch, manager, SVM UK Opportunities fund

Need perspective

Despite the turmoil in the share prices of financial stocks, we are not convinced the equity markets’ response has been proportionate. If we assume the market response has been correct, what are the share price declines telling us? Either that bank business models are completely broken, or a global recession is imminent.

Banks clearly face significant challenges and returns on capital will be markedly lower than they have been in the past, but some perspective is called for. Negative interest rates may not be the death knell for the sector. Some banks, such as Danske, a Danish bank, have thrived in a negative interest rate environment.

And although banks may face a tougher future, the sector is much better capitalised than it was prior to the financial crisis. At the macro level, we continue to expect low global growth but no recession.

All this argues for a greater dispersion of returns, rather than a sector-wide problem.

robin-milway-efgamRobin Milway, manager, New Capital Dynamic European

Equity fund value in many stocks still

Despite the sell-off, financials are currently the most interesting sector from a valuation perspective. We bought ING Bank earlier this year, which looked too cheap following the sell-off, and last year we started to build positions in independent Italian asset managers, as Italian banks were starting to move away from their in-house asset management arms in favour of outsourcing to third parties.

We also believe Solvency II, which will impose stricter capital rules, will prove to be a game changer for European insurers. The winners will be the better-capitalised insurers, as capital can be returned to shareholders and this could also result in M&A activity.

While Solvency II has been discussed for many years, it is not hard to pick the stocks that are over-capitalised compared to their peers, yet it is remarkable the market is surprised when a management team confesses the business has excess capital.

So even though this information is out there, it does not appear to be priced into the market.

young-simon-2016Simon Young, co-manager, Aviva Investors UK Equity fund

Sentiment swings

The health of the financial services sector is paramount for any functioning economy, whether it is the UK or wider EU. Without solvent banks and trust in them, the economy will just grind to a halt – and policymakers and regulators are all too well aware of this. After the near-death experience of the financial crisis, it is clear ante has been upped on banks and insurers.

From a balance sheet perspective, we see the UK financial sector as well-capitalised, and now much more able to withstand any future recessions without resorting to tapping the public coffers.

From an earnings point of view though, we are less enthused, given that the demand for credit remains anaemic and constant downward pressure on margins is hurting banking profitability.

In an environment where profitability remains under pressure and confidence in an economic recovery remains fragile, sell-offs in financials are likely to recur periodically. Sentiment will swing from fear to greed without warning.

To use a medical metaphor, it is as though the financial sector has spent the last five years undergoing one long operation. It is out of intensive care and recovering slowly, but inevitably it will have setbacks from time to time.

van-hove-xavierXavier Van Hove, partner and fund manager, THS Partners

Good banks are cheap

The twin causes of this crisis are a slowing Chinese economy and the sharp fall in oil prices. The market reaction, particularly for European banks, seems to imply we are facing another financial crisis. This is simply not the case.

The Chinese slowdown impact will largely be contained to Chinese banks; the knock-on effects on European and US companies exporting to China will be material, but generally not life-threatening. Therefore, the knock-on effect on banks will be small.

The impact of the oil rout is more severe – but with loss estimates ranging from $30bn-$100bn, we are an order of magnitude below the subprime crisis.

Certainly banks in Texas may not be a good idea for those who wish to sleep soundly, and there will be some isolated surprises (for example, Credit Agricole’s $34bn of exposure), but for careful investors this likely short-dated panic offers an opportunity to buy good banks on the cheap.

colswm-63-compressedStuart Mitchell, manager, SWMC European fund

Pre-crisis return levels possible

We have been a little surprised by the severity of the recent market downturn.

Some investors believe the apparent slowdown in the Chinese and American economies will ultimately undermine the nascent recovery in the European economy. We have witnessed little sign of this from our extensive meetings with company managements this year.

Against a background of uncertainty about the economic outlook for the emerging world, we continue to find the best opportunities in the more domestically-orientated areas of the European markets – with banks representing our most significant cyclical exposure.

We still believe the market has failed to appreciate the benefits of rising financial margins, coupled with draconian cost cutting, and easing regulatory pressures. More recently, we have also been pleasantly surprised by the Bank of England’s welcome announcement there will be 'no Basel IV’. 

We continue to focus on the strongest retail banking franchises, such as BNP and Intesa, where we believe returns should rapidly go back to pre-crisis levels.

We are also invested in Banco Popular and Commerzbank, which are in the process of disposing of significant amounts of non-performing assets in order to refocus on industry-leading core businesses.

riley-willWill Riley, co-manager, Guinness Global Money Managers fund

Focus on asset managers

We believe investors should be paying attention to the asset management sector, with a number of asset managers selling off as sharply as the banking sector, despite most of the issues which have affected banks not being relevant for these companies.

We saw a similar situation in 2011, when underperformance from the banks amid the eurozone sovereign debt crisis dragged asset management stocks significantly lower, setting up a healthy rebound from the sector in 2012.

Asset managers typically enjoy clean balance sheets, strong free cashflow and above-average dividend yields. Clearly their fortunes are linked to the performance of the broader markets, and those investors who remain sceptical about equity and debt markets may wish to wait on the sidelines; while for those who think the market risk is exaggerated, the four-year low in valuations in the asset management sector offers an attractive entry point.

Click here to read part II of this special Big Question

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