Wednesday, July 12th, 2017

Financial Rotation

Over the last two weeks several clients have asked whether we can find any evidence of a broad rotation into Financials in response to a co-ordinated tightening of monetary policy by central banks around the world. We are naturally sceptical of this idea, because this is the sort shock to financials markets they have been trying to avoid for the last five years. It is, however, possible that they may each have decided for their own specific reasons to move in the same general direction at the same time but at a different pace, and that they may not want to advertise this in advance. Rather than constructing elaborate theories, we prefer to look at the evidence.

During this time, our equity sector models have increased their exposure to Financials everywhere, apart from China. In the US, we have upgraded the sector from neutral to overweight; in the UK and Pan-European models we are challenging the sector’s highest exposure over the last four years, and in the Eurozone, we have just broken through it. It all sounds very impressive, but the alternative facts are that in the US and Japan we are well below the highest recent exposures, set in March and February of this year respectively. The strength of Pan-Europe is primarily down to an explosive move in the Eurozone. This has happened before, but it has nearly always been followed by an immediate and complete retracement. In other words, the ECB has form when it comes to miscommunicating monetary policy, as do investors in over-discounting it.

We have also looked at the most important stocks to see if we can identify any patterns. In the US, the recent strength has been led by the universal banks like JP Morgan Chase and Citigroup, rather than the investment banks like Goldman Sachs, Morgan Stanley and Bank of America, which did so well in Q4 of 2016. However, none of the banks has a higher recommended weighting now than it did three months ago. In Financials as a whole, only Bank of New York and All State are doing better than they were at the end of Q1.

In Europe, there are several banks with a higher recommended weight than three months ago. The most important are BBVA, Caixa, Commerzbank, Intesa Sao Paolo, and Unicredit. We think this a result of the successful recapitalisation of smaller banks in Italy and Spain, rather than an indicator of future ECB policy. Looking at the rest of the Financials sector only Allianz, Deutsche Boerse, Munich Re, and Sampo are more highly rated than at the end of Q1. In the UK, none of the banks, including HSBC, are more highly rated, but the life insurers like Legal and General, Standard Life and Prudential are.

Our conclusions are as follows. (1) In the US, enough banks have higher exposures than a month ago to support the idea that investors are once again anticipating a steeper yield curve, but it is definitely second time around, and the move will not be as powerful as it was from Q4 2016 to Q1 2017. (2) In the Eurozone, the main driver of recent outperformance has been the recapitalisation of the smaller Italian banks, and the consequent reduction of systemic risk. (3) In the UK, the strength of the financials sector comes from other financials, not banks, and we don’t see a clear link with UK monetary policy. Overall, we have no problem with an overweight recommendation on the sector, we just don’t expect it to get much bigger.

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