Ahead of the curve | Friday, 26th February

News from financial equity.

Global interest rates on the rise.
It started with rising inflation expectations, but real interest rates are now moving in size, globally. Higher real rates indicate global growth expectations are on the rise as populations get vaccinated and economies reopen. Importantly, central banks are taking this rise in yields in stride. The Fed sees it as affirmation that their policies are working, while the ECB has taken no strong actions as of yet.

Growth vs Value – Worst month since 2000.
The month of February 2021 will be the worst month for growth vs value stocks since 2000. Unlike then, however, the global economy is emerging from a recession and inflation expectations are rising. As bond yields rise, this scenario is creating headwinds for long-duration/high-multiple sectors, and tailwinds for short-duration/low-multiple sectors. Despite this rally, however, positioning in value-oriented sectors remains uncrowded – indications are that while there have been higher flows into value sectors from macro investors focused on the reflation theme, active equity managers remain significantly underweight. This is likely to cause performance pain as growth sectors continue to lag.

US financials at the heart of the global reflation impulse – and responding accordingly.
Fiscal stimulus in the US is doing more than simply filling a hole. Cumulatively the COVID crisis has cost US households $400 billion in income, but they have already received more than $1 trillion in transfers – even before both the late December and forthcoming stimulus packages. Buoyant asset prices in addition have caused households to accumulate $1.5 trillion in excess saving, with this set to rise to $2 trillion (9.5% of GDP) by early March once the additional stimulus is enacted. US bank shares are responding to this sudden pull-forward in Fed-hiking expectations. However, with valuations approaching normalized levels and loan growth likely to suffer as businesses and households are flush with cash, US insurers will likely be the next big beneficiaries of the reflation trade. In fact, rising rates benefit life insurers to an even greater degree than banks, via both the income statement and balance sheet – this has largely been overlooked by the market thus far. In addition, US insurers are flush with capital and not subject to distribution restrictions, and public valuations remain dislocated from private transactions, suggesting potential for significant value-creating M&A catalysts ahead.

Path forward for European Banks – multiple drivers over next 24 months.
European banks are off to a strong start for the year, but valuations at 0.62x TBV remain distressed, underscoring the extremely low base from which they have risen. After all, the last time reflation took hold of markets this sector traded above 1.00x TBV. And with many management teams announcing ROTE targets north of 10% there is no reason for the sector not to trade at those levels again. Our base case scenario over the next 24 months is for reflation to continue driving multiple expansion during 1H21, followed by significant capital distributions in 2H21 after the stress test results and full lift of the dividend ban, followed by 30%+ earnings growth in 2022 as loan losses normalize.