Evolving financials universe will transcend this crisis-revisited

The rapid rise in nominal interest rates and the sudden reversal of a three-decade bull market in US Treasuries have acted as a live stress test for banks and financials across the world. Most have passed, and are enjoying some of the fruits of the zero interest rate policy (ZIRP) exit in terms of higher margins for banks, and better asset-liability structures for insurance companies. In March 2023 however, the hiking cycle claimed its first victims, in the US with Silicon Valley Bank, and other mid-size lenders, and then to Switzerland and Credit Suisse. In our view these issues are very specific to the geography, or in CS’s case, a bloated, incoherent franchise that we didn’t own. While there are risks to financials, especially if the global economy slows and credit quality deteriorates, we do not regard them as systemic.

Why are we so sanguine about these events and what if there are more problems ahead? On the latter question we can’t be sure and we can only engage with the reality, that to our knowledge most of the companies in our universe are profitable in this higher interest rate environment. There are well-known concerns over some asset classes like commercial real estate, or opaque risks like so-called ‘shadow debt’, but as much as possible we try to take into account such exposures in our investment decision-making. Banks specifically always depend on the confidence of their depositors, customers and peers to operate. That will never change, and we think there is no reason why profitable, well-run franchises, with high-quality assets should see deposit flight today, any more than one year ago or one year hence.

The echoes of 2008 were real and visceral in March 2023. A franchise previously considered solid with a distinct niche (SVB) suddenly forced to sell assets at a loss, and tumbling into insolvency in a few days. Closely followed by Credit Suisse’s rapid unraveling and shotgun marriage to UBS, these events left market veterans with a sense of déjà vu. That said, there are important differences with 2008:

• SVB was brought down by mismanagement, not fraud. There were eager buyers for its assets wheras in 2008 it was supposed triple-A assets being marked to zero that brought the solvency of the whole financial system into question.

• US depositors moving to rivals and into money market funds seamlessly is a new phenomenon that is squeezing margins at US banks and putting pressure on the small and midsize players. That’s rational behavior on the part of customers, who are seeking yield, not fearing collapse. This is also a symptom of traditional business models being undermined by technological advancement and cultural change (people now having accessible online tools and choosing to manage their own money). Creative destruction therefore, rather than some kind of mini-Minsky moment.

• European banks are much better capitalized than in 2008. Deposits barely moved during March so the issue was US (and Swiss) specific.

• Credit Suisse was attempting an ambititious, expensive restructuring after years of mismanagement and underperformance. Many investors, assuming it was in the ‘too big to fail’ category, were prepared to wait for that revival process to unfold, just as with Deutsche Bank, which is now firmly back in profit. The combination of SVB troubles and the SEC coincidentally announcing it was looking into accounting irregularities at CS, proved too much. Bad management, bad timing, bad luck, call it what you will, but without the SVB backdrop, which had no direct implications for CS, its demise was not inevitable.

The other reason we aren’t buying into the crisis talk is because we built the New World Financials strategy in the aftermath of 2008. After the giant interventions that bailed out the sector, two things were obvious; banking regulation would get more strict, and technology would enable more innovation and more competition in the financial sector. We then identified the underlying trends – demographic, geographic and technological – that would drive change and invested accordingly. The big takeaway is that we went from a sector-oriented strategy focused on traditional finance to a much more broader-based universe. So for us the fact that growing life insurance brands, cash-flow generating fintech names, payment processors and tech infrastructure providers should be hurt by what are essentially traditional banking failures, makes little sense.

The strategy’s exposure to banks and diversified financials was at 35% in March 2023, against 55% for the index we benchmark against, MSCI All Country World Financials (see Figure 1 below). Within this 35% we have increased exposure to banks that we think could benefit from the the demise of CS by expanding their Private Banking business, especially in Asian financial capitals like Singapore and Tokyo. Clients of both UBS and CS are likely to seek to diversify risk and given CS’s market share in Asia, we regard this as a solid play on both undervalued local names and some global banks that are already well-positioned in this market. As part of our Emerging Finance theme we are overweight banks in emerging markets with exposure in Indonesia, India, Brazil and Mexico.

In Japan we believe an immediate winner from the exit from deflation will be the Japan’s financial sector. Valuations have been beaten down to a huge discount to global peers since outgoing Bank of Japan Governor Kuroda was appointed in 2013. Banks and life insurers are trading at significant discounts to book and embedded value and we believe they will trend higher as profitability improves. In the US we are underweight banks anticipating ongoing weak sentiment, squeezed NIMs, and potentially a firmer regulatory approach in the aftermath of the SVB collapse.

After the events of March 2023 we are neutral on European banks. We think they are well-capitalized and in a much healthier condition than back in 2008, but the boost from rising NIMs has run its course as deposit rates rise, and we do not see further short to medium-term catalysts in a still slow-growing Eurozone economy.

After a violent de-rating in 2022, fintech and payment companies are proving immune to the weak sentiment caused by the banking instability, barely moving in the month of March 2023. This makes sense if, like us, you don’t believe the current stress in the banking sector is systemic. Although some fintech names hold banking licenses, that’s usually to allow them under the regulatory umbrella in order to provide a specific service, rather than taking in deposits and lending. Fintech as a sector is positively exposed to strong and structural growth dynamics, like the still expanding e-commerce market. We expect modern payments, embedded finance and online lending solutions to continue to grow fast and generate good free cashflow along the way.

The nexus of finance and technology received a sentiment boost on 17 March 2023 when post the close of trade MSCI revised their Global Industry Classification Structure (GICS) and shifted some technology and payments from the information technology sector to the financials sector. This move validated our long-held belief that companies like Mastercard and Visa should be considered more like a fintech than just a tech company, just like other credit card network companies such as Discover Financial Services and American Express which always were part of the financials sector. The MSCI indices will be changed accordingly at the end of May 2023.

As part of our Aging Finance theme we continue to believe demographic trends in developed markets and the global life insurance sector’s increasing exposure to emerging markets, which are generally underinsured, will generate steady and reliable growth in the coming decade. Combined with the exit from zero interest rate policies which are improving solvency and making it easy to manage risk, the set-up is overwhelmingly positive for the medium and long term, and we remain overweight this sector relative to the benchmark.

Life insurers have pulled back in February and March as sentiment has soured in the overall financial sector but we regard this as an entry opportunity for companies capable of delivering above-average returns in a normalizing environment for rates and corporate profits.