In our last commentary, we focused on health care as an important sector that we favor across global equity markets. This month, we’re focusing on another segment that we rate highly in terms of expected return: banks.
In the low interest-rate environment that followed the global financial crisis, financial firms have experienced lackluster earnings. With all the buzz about high-growth stocks in technology and health care, and about the impact of trade tariffs on manufactured goods, it could be easy for investors to overlook financial stocks. But we believe that the financial sector offers attractive opportunities for equity investors. In this commentary, we’ll concentrate our attention on the opportunities we see among US and Chinese banks.
So far in 2018, improving net interest margins – driven, in turn, by rising interest rates – are accelerating growth in forward earnings estimates and in trailing earnings among US banks. (See Figure 1.) The situation is quite different in Europe, Japan and emerging markets, where earnings growth is decelerating.
Figure 1. Forward earnings estimates are accelerating among US banks.
Source: Bloomberg Finance L.P. As measured using MSCI Banks indices for US, Japan, Europe and emerging markets.
Because stock-price moves have not matched this earnings growth, price-to-earnings (P/E) multiples have contracted in US banks. This presents a buying opportunity.
Attractive valuations are just one dimension of the current opportunity in US banks; investor sentiment is another. Our sentiment metrics – which measure, for example, how hedge funds are positioning, how analysts are revising their top- and bottom-line earnings estimates and how price trends have been moving – show that investors are beginning to reward and pay attention to US banks. We also view management’s opportunism in managing capital positively for US banks. From a quality perspective, banks in the United States do not score quite as highly in our analysis compared to banks in other regions, because Tier 1 capital ratios in US banks are less strong than ratios elsewhere. The valuation opportunity in the US, however, outweighs their slightly lower capital ratios.
Another area where we see opportunity is Chinese banks. Unlike US banks, our measures of investor sentiment are not currently favorable to Chinese banks; however, banks in China present an even more attractive valuation opportunity than US banks. Chinese banks are currently trading on a P/E ratio of around 6 on average, compared with around 13 for Chinese stocks more broadly and for emerging markets. Most Chinese bank stocks are trading at a discount to their book value.
Figure 3. Valuation metrics for banks in China are compelling.
Source: Bloomberg Finance L.P. as at 28 September 2018, as measured by MSCI Indices in US dollar terms.
Why are banks in China apparently undervalued? Chinese banks have been out of favor for many years, with investor concern centering on the potential for non-performing loans, reportedly bad lending practices, and the high overall leverage in China’s financial system. Despite these fears, the Chinese government seems to have sufficient liquidity and a big- enough regulatory toolbox to bail out any pockets of instability. Annual GDP growth in China is currently expected to continue to hover around 6 per cent, which also tends to support the banking sector. Chinese banks are generating a return on equity (ROE) as high as any other segment in the emerging markets (around 13 per cent on average). ROE among Chinese banks has remained steady, in contrast with other emerging market segments, where banks’ ROE has been dropping since July. While investor sentiment is poor vis-à-vis Chinese banks, earnings forecasts are starting to turn upward as of Q3 2018. We believe that the resulting valuation gap among Chinese banks – especially when viewed together with favorable quality attributes in this segment – presents a margin of safety for investors. Nonetheless, we are keeping an eye on our risk factors for any emerging signs of weakness in the sector.
The bottom line
We believe that banks in both the United States and in China present opportunities for investors. A diversified exposure to highly ranked stocks in these segments is worth investigating.
Portfolio Positioning and Performance
During September, the State Street Global Equity Fund outperformed the benchmark on a gross and net of fees basis. Developed market outperformed again during the month, led by momentum in US equities. Globally, higher oil prices led energy to outperform the most, while higher yields saw REITs underperform. From a portfolio perspective, Industrials was by far the biggest contributor towards relative performance, led by Japanese distributors trading at attractive valuations. On the other hand, Consumer Staples was a key detractor (Royal Ahold Delhaize and Conagra Brands).
During the past year, good stock picking within Health Care and Staples were more than offset by our relatively lower exposure to IT (not holding Microsoft and Apple) and negative stock selection within Discretionary (not holding Amazon). While we have been increasing our cyclical exposures since 2016, higher market risk and frothy valuations in certain cyclical sectors have been driving our more defensive positioning of late (particularly since Q2–2018). The most notable change to the fund over the past 12 months was our increasing exposure to Health Care and decreasing exposure to Materials and Utilities.
Olivia Engel, Chief Investment Officer, Active Quantitative Equity
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