Polar Capital Global Financials (PCFT ) fund managers Nick Brind and George Barrow believe interest rate cuts could spark a recovery in the derated US banking sector as investors become less fearful of loan losses.   

Commenting on the trust’s annual results, which showed a 2.8% drop in net asset value in the year to 30 November largely caused by the market response to the collapse of four US regional banks, the managers said lower interest rates would shore up sentiment that has assumed a more subdued and weaker outlook than earnings and valuations suggest.

‘Underlying operating performance is good and will be underpinned at much higher levels unless interest rates return to the levels seen two plus years ago,’ said Brind and Barrow. ‘Consequently, we remain very constructive on the outlook for returns from the sector over the coming year.’

Textbook bank mismanagement

The pair said a second global financial crash was unlikely, noting that the failure of US regional banks First Republic, Signature Bank and Silicon Valley Bank (SVB) last March was down to a sharp move in interest rates, leading to significant unrealised losses in banks’ portfolios, spooking markets and triggering a sharp outflow of deposits. In the 2008 crisis outflows were a result of toxic assets on weak balance sheets.

They added that the three banks had the largest concentration of uninsured deposits across the entire US banking sector, meaning that they were vulnerable to any loss of confidence. First Republic’s uninsured deposits totalled 67%, while those of the other two were both 90%, well above the 40% sector average.

They pointed to the Federal Reserve’s report, which said the SVB failure was a ‘textbook case of mismanagement by the bank’, with the senior leadership failing to manage basic interest rate and liquidity risk, while Fed supervisors failed to take forceful enough action. The report added that regulation had been relaxed under the Trump administration.

Credit Suisse, which had seen large outflows of deposits in the final few months of 2022, saw further outflows following the collapse of SVB, which ultimately forced it into a sale to UBS Group.

The fourth US bank to collapse, Silvergate, was much smaller with a larger exposure to the crypto industry, said Brind and Barrow. 

‘We did not see this as another global financial crisis as the profitability of the banking sector is vastly improved with the rise in interest rates supporting earnings, greater capital cushions and the somewhat anaemic growth in loan origination in recent years,’ the pair wrote.

Life without Yakas

The 12 months to November saw the £467m trust lag its MSCI ACWI Financials index benchmark, which gained 0.3%. While the fund managers avoided Credit Suisse, First Republic and Signature Bank, a small position in SVB detracted from performance.

They also sold out of cross-border payments company CAB Payments at a loss shortly after its disastrous UK flotation last July.

Outside the US, banking sectors proved stronger. Japan was the top performer on the expectation that the Bank of Japan will increase interest rates from the current -0.1%, bringing an end to its negative interest rate policy in place since 2016. European banks, meanwhile, had a more positive second half on the back of positive earnings revisions, as analysts factored in higher interest rates.

Brind and Barrow, who are without co-manager John Yakas following his departure last summer, remain positive on reinsurance given that low valuations make up for the sector’s cyclicality, as well as UK medium-sized financial stocks, such as Intermediate Capital Group (ICP), which remain cheap and could be taken private.

They’ve held on to alternative asset managers, such as Ares and EQT, given the sector’s strong inflows in recent years and strong growth in profits derived from little pressure on fees, while banks in emerging markets India and Indonesia are attractive, especially given a weaker US dollar lower bond yields.

Top individual positions include a 6.2% weighting to JPMorgan, 5.1% to Mastercard and 3.9% to Visa, with banks making up 39% of assets, financial services 34% and insurance 18%.

The shares dropped 7.5% as their discount to net asset value widened to 12%, despite the board buying back 5.1% of the shares at the start of the financial year. 

Since the fund’s reconstruction in April 2020, it has grown asset value by 69%, just ahead of the 68% from the MSCI ACWI Financials index.

On the current 9% discount, however, the shares have underperformed under all time periods with shareholder returns of 13.7%, 40.9% and 105.1% over three, five and 10 years that are below the financials benchmark’s 40.9%, 58.2% and 157.4%.