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The global financial sector: where to now?
After three years of banking and financial sector turmoil, financial stocks still account for 20% of the world's top 5,000 stocks by number and $8.5 trillion of the global stock market capitalisation of $39 trillion. Finance remains by far the stock market's largest sector group and setting the right strategy in financial stocks remains one of the most important components to superior equity portfolio performance. If the sector's challenges over the last three years have been great, the uncertainty ahead is perhaps greater.
The changing financial landscape
Leading indicators in the US, Europe and Asia have all returned to their highest points in a decade; at the same time, policy rates in all four regions remain near zero (see Chart 1). While the persistence of unprecedented low interest rates may have averted a financial catastrophe, the policy is not sustainable and the direction of future rate changes is not in doubt, only the timing. The timing and magnitude of rate increases (and the economic performance determining the moves) will be the main influences on financial sector performance.
In 2009, the banking systems in Asia and Australia were still functioning and producing credit growth. As a result, capital flowed into the regions that had stable banking systems that could support asset price growth. The outlook for 2010 is very different. Asian central bankers, including the Reserve Bank of Australia (RBA), are actively engaged in a tightening cycle, which will serve to dampen credit growth. Conversely, the Federal Reserve (the Fed) is maintaining its easy monetary policy and the US banking system has $1 trillion in excess reserves! The combination of the Fed's easy monetary policy and the unprecedented level of excess US bank reserves could result in the US becoming the first developed market banking system to resume credit growth. Meanwhile, the Bank for International Settlements (BIS) is preparing a new round of capital requirements that will put more restrictions on banks and require them to hold higher levels of equity in their capital structure.
Chart 1: Leading indicators
Source: FactSet
Interest rate outlook - not if but when
The Federal Reserve continues to maintain a historically easy monetary policy. Despite a hike in the discount rate to 75 bps, the Fed Funds target rate remains 25 bps. In addition, the aforementioned $1 trillion in excess reserves limits the Fed's ability to directly control the Fed Funds target rate. Thus, the Fed is now recommending the paying of interest on reserves as a way to raise the Fed Funds target rate over time and to prevent a significant increase in lending from occurring when the economy normalises.
At the current junction, the Federal Reserve has two main options. The first option is to normalise interest rates in a pre-emptive fashion; a negative outcome for US banks that would be hit by both higher funding costs and lower credit growth. An even bigger risk would be the increased likelihood of the economy facing a double dip recession. In this scenario, Asian and Australian financials would likely outperform since they are maintaining credit growth and Asian domestic economic growth remains robust. The US, Europe and Japan would most likely underperform and a double dip outcome would result in another round of credit losses and additional capital raisings.
The alternative scenario would be for the Federal Reserve to maintain its current loose monetary policy until there are clear signs the economy is improving and unemployment declines significantly. Our internal view is that the latter scenario is more likely given the weak recovery taking place in the US. If the Federal Reserve remains on hold, US financials could outperform with Japan and Europe lagging. Asian and Australian financials would not necessarily be impacted negatively, since a rebound in US growth is generally positive for Asian economies.
In the US, we expect the Federal Reserve to remain on hold until there is a clear improvement in the unemployment rate or a spike in inflation. The scenario for Asian interest rates is very different. Central Bankers in Asia and Australia are already increasing policy rates as they try to control inflation.
Basel III: belt tightening at the banks
The Bank for International Settlements (BIS) will be introducing capital regulations by the end of 2010 defining measures of capital adequacy and the total amount of common equity a bank holds in its capital structure (core Tier 1). Although the revised regulatory requirements and appropriate leverage ratios are still being debated, the newly proposed ‘Basel III' regulations will affect all banks in all regions. A major lesson coming out of the credit crisis is that undercapitalisation can be catastrophic when combined with significant losses on the asset side of a bank's balance sheet. Consequently, banks will be forced to raise capital globally in preparation for the revised BIS standards. North American banks have already undertaken a significant round of capital increases in 2009 and are well positioned for the new regulations. The European and Japanese banks still appear undercapitalised and will be forced to raise additional capital, which will dilute earnings and inflate valuations. Asian banks (outside Japan) are also well positioned with strong core Tier 1 ratios and deep deposit franchises.
Based on the new regulatory framework outlined in Basel III, we favour North American and Asian banks. Australian banks also remain well positioned compared to European and Japanese peers from a Tier 1 ratio perspective, but still lag their Asian peers.
Excess reserves: as goes the US so goes the rest of the world
Required reserves are the amount of funds that banks must hold in reserve against their deposits. Reserves must be held as either vault cash or a deposit maintained with a Federal Reserve Bank. Essentially, banks hold reserves so they can pay depositors when they make withdrawals. Banks hold excess reserves if they believe there is a potential for a run. The current spike in reserves doesn't reflect bankers' fears of a run on deposits; rather it reflects a fear of lending due to the potential for further credit losses.
Chart 2: Excess reserves held by US banks
Source: FactSet, the US Federal reserve H.3 report
According to the Fed's most recent H.3 report (Aggregate Reserves of Depository Institutions and the Monetary Base), US banks are holding approximately $1.1 trillion in excess reserves (see Chart 2). This amount is astonishing not only due to its absolute value but for the implications it has on the growth in money supply. There is a common misperception that the central bank in a modern economy creates money. Although central banks control the supply of money through reserve requirements and control of interest rates, it's the commercial banking system that creates money through fractional reserve banking.
The Federal Reserve clearly understands the potential inflationary impact of the unprecedented increase in reserves and as a result, announced in October 2008 that it would pay interest on both required and excess reserves. The New York Fed has even created a marketing document to explain why banks are holding excess reserves.
The Federal Reserve is only paying 25 bps in interest on both required and excess reserves. It won't be long before bankers realise that they can earn much higher yields by taking a little credit risk. Furthermore, the paying of interest will only compound the problem as banks continue to build up excess reserves. It's possible that the Fed will be able to successfully reduce excess reserves in the system without impacting overall lending, but the process may be sloppy given the unprecedented nature of the current environment and growth in reserves. Ultimately, the Fed may not be able to remove the excess liquidity before inflation becomes a problem.
Investment strategy for the banking sector
Major banks: Bennelong SGI covers 16 major banks in North America, with a total combined market capitalisation of $1,121 billion. North America's major banks have re-rated from the March lows but are still trading below historical valuation levels. We have a positive outlook for the major US banks and believe the biggest risk is regulatory pressure.
The current rate environment is highly conducive to bank profitability. Furthermore, the first signs of re-leveraging are occurring in North America as merger and acquisition (M&A) volume begins to pick up dramatically. The surge in M&A volumes is being driven by strong corporate cash flows and a defrosting of credit markets. The resumption in banking sector M&A signals that corporations are willing to borrow against assets, a positive indication for credit growth.
The outlook for European banks is less attractive as Eurozone economic growth remains exceptionally weak. The Japanese banks appear to be the biggest losers in the new regulatory environment and the mega cap banks have been forced to come to the market multiple times to raise additional equity capital. Furthermore, the fundamental problem in Japan remains a lack of credit growth. Japanese consumers and corporations are still deleveraging and the market remains overbanked. We are more positive on the Australian banks as the resource sector continues to be a driver of economic and employment growth. Furthermore, Australia's mortgage sector continues to be a lending growth engine.
Regional banks: Regional banks typically provide credit and related services to small businesses and consumers. The industry is highly sensitive to the overall economy, with economic growth being a key driver of overall loan growth. Despite the weak outlook for US GDP growth in 2010, US regional banks have a unique opportunity to grow their balance sheets and loan portfolios through Federal Deposit Insurance Corporation (FDIC) sponsored auctions. The FDIC is an independent agency created by Congress to maintain stability and public confidence in the US financial system. FDIC assisted transactions involving the assets and liabilities of failed banks are paradoxically leading to ‘once in a generation' return opportunities in the regional banking space. Stronger banks that participate in deals are able to boost near-term earnings, improve liquidity and possibly long-term growth potential through a single transaction. These opportunities set US regional banks apart from their peers globally. In particular, we're looking for banks that have sufficient capital, above average credit quality and are geographically positioned to become regional consolidators.
Conclusion
Under Basel III, common equity will become regulators' core focus. As a result, banks' capital levels will still be the main constraint for loan growth going forward. In developed markets, the US banks stand out as being better capitalised than their European or Japanese peers. The large-cap banks with strong capital markets businesses will benefit from a potential M&A boom led by strategic buyers as opposed to financial buyers (private equity firms). The main negative for this segment is the growing desire within the US Congress for a return of Glass-Steagall legislation, which seeks to split commercial and investment banking. We also have a positive outlook for US regional banks that will benefit from participation in FDIC sponsored deals. From an emerging market perspective, the Asian banks also look attractive due to their strong capital positions, solid deposit franchises and fast growing economies.
About Security Global Investors
US-based Security Global Investors (SGI) is a multi-disciplined asset management firm that seeks to deliver ‘Best-in-class' investment options for institutional investors and financial intermediaries. The firm manages approximately $21 billion in assets (as of December 31, 2009), and offers a broad spectrum of investment strategies that span five distinct disciplines - actively-managed specialty fixed-income, value, growth and global equity strategies, as well as quantitative investment management solutions. Founded in 1962, SGI has 256 employees (including 44 investment professionals) with specialised investment teams in Topeka, KS; Irvington, NY; San Francisco, CA; and Rockville, MD
Security Global Investors, LLC (SGI)does notguarantee the sequence, accuracy, completeness or timeliness of the data contained in this document. AlthoughSGI believes the information contained in this document is reliable, it cannot, and does not, guarantee or warrant its completeness or suitability for any purpose. This document is provided for information and illustration purposes only. The contents are neither designed nor intended and should not be considered as, or relied upon as, investment, legal, tax or accounting advice or as a recommendation of any specific security or strategy. The opinions and forecasts expressed are those of David Whittall and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or strategy. The securities discussed may not reflect actual investments made by SGI. SGI provides investment advisory services to the Bennelong SGI Global Equities Fund.