Value rotation and rising inflation

Is now the time to back financials?

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Is now the time to back financials?

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Fintech has been behind some of the fastest-growing businesses in recent years, buoyed by increased connectivity and cutting-edge software. In contrast, traditional financial stocks such as the big banks and insurers have been out of favour, but with rising inflation and household savings at record levels1 could now be the time to back them?

The Association of Investment Companies (AIC) has spoken to managers about why financials could be best placed to capture the value rotation and reopening trade, the opportunities offered by fintech challengers versus incumbents, and the implications of rising inflation.

Value rotation and reopening trade

Nick Brind, Co-Manager of Polar Capital Global Financials Trust, said: “In the past nine downturns since the early 1990s, financials have outperformed wider equity markets from market lows over the following year. This time is no different, albeit the outperformance only started in November on the back of the news around the efficacy of vaccines, suggesting there is further to go. In our opinion, financials are the largest sector in value indices so remain best placed to benefit from the rotation into value and reopening trade. We therefore expect our holdings to perform well as a result.”

Tim Levene, CEO of Augmentum Fintech, said: “As the economy improves we expect fintechs to continue to grow the market shares they have won over the last 18 months. Reflecting this growth we are seeing an increase in investor appetite for fintech and we believe this trend will continue, in particular with institutional investors seeking access to this asset class.”

Thomas Moore, Fund Manager of Aberdeen Standard Equity Income, said: “The global recovery will be highly supportive for the sector. Specialist lenders should directly benefit from increased loan demand and reduced impairments, while asset management companies are likely to benefit from increased fund flows and higher market levels.”

The rise of inflation

Nick Brind, Co-Manager of Polar Capital Global Financials Trust, said: “To the extent that higher inflation leads to higher bond yields and interest rate expectations, then our holdings would benefit, as financials, in particular the banks, are the most sensitive sector to this issue. Banks today are even more sensitive to higher interest rates than they were previously. This is due to the actions of governments and central banks to cushion the downturn last year, which has led to a huge growth in deposits. As a result banks’ earnings may rise sharply, all things being equal, when interest rates rise.”

Thomas Moore, Fund Manager of Aberdeen Standard Equity Income, said: “Financial services stocks will tend to react positively to higher inflation, especially if interest rates remain pinned down. After a period of caution, retail investors are set to deploy pent-up household savings as it becomes clear that they need to protect themselves against inflation. This is likely to result in an exodus from cash which will be very helpful for asset management and wealth management companies.”

Preferred sectors

Sue Noffke, Portfolio Manager of Schroder Income Growth Fund, said: “Many businesses in this area have strong franchises in attractive, growth sectors with structural tailwinds. Some are niche and have strong moats with less competition, robust margins and sustainable attractive returns. We believe our holdings in fast growing alternatives asset manager Intermediate Capital, international infrastructure developer John Laing and mid-market private equity and infrastructure company 3i share many of these characteristics, whilst also trading at attractive valuations.

“Other stocks offer good income generation with high but sustainable yields, and help to build the income base of the portfolio. Our position in M&G, a more traditional savings and asset manager which was demerged from Prudential in late 2019, is such an example. We took advantage of the turmoil in the market with the onset of the COVID pandemic to opportunistically establish a new position in M&G starting in March 2020 and added to it in the autumn. Our view, in contrast to that taken by the market at the time, was that the company was able to pay the dividend and was likely to do so without intervention of regulators. This proved to be the case with the company paying a final and interim dividend of 18.23p with an additional 3.85p special dividend, relating to the timing of the company’s demerger from Prudential. Our expectations are that the company can maintain its dividend and possibly grow it modestly over time.”

Tim Levene, CEO of Augmentum Fintech, said: “We see a continued positive outlook for fintech and believe the momentum that has emerged from COVID will continue for the foreseeable future. Our view is that challengers are well placed to continue to grow market share and expand market reach in many areas including digital payments, wealth management, regulatory technology and digital banking services. We are also excited by the significant opportunity for collaboration between fintechs and incumbent firms with a growing number of examples demonstrating the value that partnerships can deliver to stakeholders across the financial services sector. There is also great potential in emerging areas of financial services such as decentralised finance (DeFi), where we are seeing a wave of innovation.”

Thomas Moore, Fund Manager of Aberdeen Standard Equity Income, said: “We believe specialist lenders such as Close Brothers and OneSavings Bank are particularly well positioned coming out of the pandemic, with signs of improving demand and reduced competition. New business pipelines are growing across the board, with property-related loan demand exceeding even the most bullish forecasts. At the same time, competition is reduced as weaker competitors retreat. This helps specialist lenders to dominate specialist lending niches that are not being addressed by mainstream lenders, allowing their returns to remain elevated. The benefit of having a strong balance sheet is that it allows these lenders to accelerate loan growth on the way out of a recession, at the same time as paying attractive dividends.”

Nick Brind, Co-Manager of Polar Capital Global Financials Trust, said: “At present, we are most optimistic about bank shares. Their valuations remain attractive in absolute terms and relative to wider equity markets. Also as economies reopen they may continue to benefit from the tailwinds of falling loan loss provisions and write-backs, reflecting that the loan loss reserves they took in 2020 assumed a much deeper downturn than we have had. Furthermore, as regulators remove any remaining restrictions on capital returns, there could be an acceleration in buybacks and dividends from the sector which for some banks will be material. Any change in interest rate expectations adds further potential upside to the sector.”

Fintechs versus incumbents

Tim Levene, CEO of Augmentum Fintech, said: “Across the board fintechs have seen a step change in adoption over the last 18 months, and many are reaching scale efficiencies sooner than anticipated. Over this time downward pressures have continued on incumbents, saddled as they are with massive cost bases and structural inefficiencies. Fintechs remain nimble and able to respond to opportunities as they emerge in a post-COVID world faster than the incumbent institutions and we believe this positions them well for the medium to long term.”

Nick Brind, Co-Manager of Polar Capital Global Financials Trust, said: “There are some fantastic fintech companies that we like, yet financial incumbents are cyclically more sensitive and therefore have stronger tailwinds than their fintech peers at this point of the cycle, suggesting that their recent outperformance could continue. Furthermore, as you are more likely to get divorced than change your bank account, incumbents have an ingrained advantage over new entrants. That said, we are starting to see regulators remove the regulatory arbitrage that those new entrants have operated under.”

Thomas Moore, Fund Manager of Aberdeen Standard Equity Income, said: “Financial services businesses generally benefit from attractive niche market positions, whether these are specialist lenders, wealth managers or asset management companies. The pandemic has been the ultimate stress test and it is now becoming clear that it had little adverse impact on the earnings or dividends of most financial services businesses.”

Top 20 investment companies with highest exposure to financial services

Investment company

AIC sector

Portfolio held in financial services (% net)

Data as at

Polar Capital Global Financials

Financials

99.7

30/04/2021

Augmentum Fintech

Technology & Media

94.0

30/09/2020

Chrysalis Investments

Growth Capital

51.0

31/03/2021

Aberdeen Standard Equity Income

UK Equity Income

38.3

31/05/2021

Barings Emerging EMEA Opportunities

Global Emerging Markets

36.3

30/04/2021

VietNam Holding

Country Specialist

34.9

30/04/2021

JPMorgan Indian

India

34.7

30/04/2021

Middlefield Canadian Income

North America

34.5

30/04/2021

Vietnam Enterprise

Country Specialist

34.0

30/04/2021

JPMorgan European Income Pool

Europe

32.6

31/03/2021

JPMorgan Global Emerging Markets Income

Global Emerging Markets

32.4

31/03/2021

Ashoka India Equity

India

32.0

31/01/2021

Lowland

UK Equity Income

32.0

30/04/2021

Diverse Income

UK Equity Income

31.3

30/04/2021

BMO Capital & Income

UK Equity Income

30.4

30/04/2021

Dunedin Enterprise

Private Equity

30.0

31/12/2020

BMO UK High Income

UK Equity Income

29.4

30/04/2021

Aberdeen New India

India

27.8

30/04/2021

BlackRock North American Income

North America

27.2

30/04/2021

Dunedin Income Growth

UK Equity Income

26.8

30/04/2021

Source: AIC/Morningstar

 

-ENDS-

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Notes to editors

  1. In 2020 the UK household saving ratio reached a record high of 16.3% according to the Office of National Statistics’ Quarterly sector accounts, UK: October to December 2020, 31 March 2021.
  2. The Association of Investment Companies (AIC) was founded in 1932 to represent the interests of the investment trust industry – the oldest form of collective investment. Today, the AIC represents a broad range of closed-ended investment companies, incorporating investment trusts and other closed-ended investment companies and VCTs. The AIC’s members believe that the industry is best served if it is united and speaks with one voice. The AIC’s mission statement is to help members add value for shareholders over the longer term. The AIC has 360 members and the industry has total assets of approximately £249 billion.
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