January 2024

“’Why do you rob banks, Willy?’ ‘Because that’s where the money is…’”  Willy Sutton

What was true for depression-era bank robber-cum-folk hero Willy Sutton, remains true for hard-pressed governments looking to plug budgetary holes.  After sustaining crisis era losses and redress, European banks suffered ten lean years of excess liquidity and artificially compressed interest margins as they restructured and recapitalized, keeping ROEs firmly mired in low single digits.  However, in the past two years, with a normalized rate structure, profitability and organic capital generation has returned, at least for those institutions with simple business models.  The sector now stands extremely well-capitalized, with attractive levels of provisioning and with a manageable set of exposures.  To be sure, this is not a universally applicable statement, as larger, more complex banks are still lumbered with underperforming investment banks and other capital-intensive activities.  But it is true to say that the sector is now overcapitalized while ROEs are still too low.  But thus far large-scale capital repatriations have been limited, partly because regulators are wary of the slowing economic cycle and partly because banks are sensitive to buybacks and dividends triggering the “one-time” bank taxes which are being mooted and implemented.  The UK recently announced a consultation process aimed at revamping its Bank Levy following on from the new taxes imposed by a number of EU countries recently.  Combined with structurally low growth now endemic to Europe can there be any wonder why, fifteen years after the Financial Crisis, banks are still trading at appallingly low valuations?  A meeting between finance minister and bank executives to discuss the subject should not be necessary and is nothing but panto theatre.

Elsewhere, the market’s focus was on economic data and the prospect for the rate cuts that so excited the market late last year.  Readers will recall our scepticism of the early cut scenario, especially in the US where key data remains firm.  There is a stronger case for cuts in Europe, but even there the ECB has been cautioning markets about timing, even as data softened.  It remains our view that barring a stress in the financial system (more about that below) it could be midyear before we see any action from central banks, and then we will probably only see a small ease.  A deviation from the aggressive cut scenario could prompt a considerable correction in risk assets, but that will reveal itself in the coming months.  For now, investors seem satisfied to go along with this year’s Davos consensus (a kiss of death if there ever was one!) that a soft landing lies ahead.

Markets responded in kind; equities were well supported, largely driven by the “Magnificent Seven” tech stocks, while rates were largely unchanged, despite selling off midmonth on the strong economic data.  The reason for the late month rally in bonds was the news that NY Community Bancorp (NYCB) posted large provisions for CRE exposure, once again triggering concerns about the health of the regional banking sector.  Notably, this retriggered selling of German real estate lender Deutsche Pfandbriefbank (PBB) securities, reviving a trend which commenced last February.  While we await further announcements of CRE exposures from other institutions it is worth noting that PBB’s own results aren’t scheduled to be released until March, which is an awfully long time in the future for a bank that may face questions of an existential nature.  This is a story we’ve heard little about thus far, but which might become more topical in the coming weeks.

Elsewhere, financials had a benign start to the year as Q4 momentum carries both credit and equities higher for the month.  To be certain, performance was mixed, with smaller institutions outperforming in both asset classes, a trend mimicked in results announcements, where the drag of CIB divisions impacted earnings in the US and Europe.  A bigger consideration was the volatility in the rates market, a factor which will become more important if the market’s fundamental narrative coming into this year – namely that cuts were just around the corner – proves to be misguided.  Against this backdrop the fund’s A shares rose 2.01%, with fixed income contributing +221bps gross and equities +14bps.  We continued to trim risk in January, consistent with our strategy maintaining dry powder in a market we believe will be volatile.  We expect our securities to continue to outperform, with results announcements to serve as catalysts for action.  We came into the year with the view that the best returns will be generated by having the flexibility to react to events and current markets reaffirm this conviction.