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Investing in banks and the bond market

07 July 2017

Have you changed your stance on investing in banks?

Banks have had a bad press since the financial crisis; a series of massive fines for past misdemeanours, tighter regulation, a weak economy and low yields weighed on share prices. However, we have started to see bank share prices recover as fines for past mistakes are nearing their end, Trump’s promise to deregulate, the economy is recovering and the Federal Reserve (“Fed”) has been raising interest rates. While Trump’s promise of deregulation has been slower to come through and is likely to be significantly diluted, the other factors are in place and last week there was a significant change that encourages us to be more positive for bank share prices going forward.

The Fed has changed its regulation that had required banks to retain a proportion of earnings; they will now be able to distribute up to 100% of excess capital from here on. While earnings may be volatile this is likely to increase the pay out in terms of dividends and share buy backs in years to come. This makes US banks much more attractive going forward and within direct equity portfolios we suggest increasing the weighting to this sector. UK banks which have significant operations with retained earnings in the US will also benefit from this.

The gilt market has started to sell off - is this the start of the long awaited bear market for bonds?

Since the end of May, the ten year gilt yield has risen from 1.05% to around 1.30% as I write. This upward move followed a divided Monetary Policy Committee where three members voted for a rate rise and warnings that interest rates could rise if the economic data was strong enough. Inflation in the UK, as measured by Consumer Price Inflation, currently stands at 2.9% which is well above the 2% Bank of England (BoE) target. As far as the sell off is concerned, this just takes gilt yields back to where they were in January. We have been expecting inflation to be above the BoE target this year due to the impact of the post-Brexit sterling sell off and the rise in oil prices from the lows of last year. Although the impact of the devaluation may continue to feed through for a few months more, this is likely to be a temporary effect and should only be repeated if the pound dips significantly lower. The oil price dipped sharply in late 2015/early 2016 and since has only recovered modestly, however it would appear to have found some relative stability in recent months. As a result, we see this spike in inflation as temporary. While inflation is high, wages are failing to keep pace and real earnings are falling. This constrains the ability of the consumer to spend and we have seen indications of weaker consumer demand. The UK household savings ratio, which measures the amount of disposable income that is put into savings, has fallen sharply since the middle of last year from 5.9% to 1.7%. This is the lowest level for over 50 years.

So, why is the BoE talking about a rate rise at this time? Firstly, following the Brexit vote the economy has been more robust than they initially anticipated. At that time they cut interest rates and instituted a bond buying programme (and other measures). The weakness of the currency has raised inflation and they may be concerned about the weakness of the pound. Another concern could be that the market had become over complacent about central bank support and wanted to instigate a more balanced view. The election has resulted in a Tory/DUP alliance that is likely to try and negotiate a softer form of Brexit, but this will be very difficult to negotiate and the EU position seems to be as far as ever from the UK stance. Our view is that there is a chance that they will take the additional post-Brexit stimulus back at the end of this year if the economy remains strong, but more likely a rate rise will have to wait until next year along with greater clarity on Brexit and the economic impact. As a result the selloff in Gilts is likely to be limited at this time.



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