Market Outlook - Global Financials - Guy de Blonay
Nervousness about potential fallout from the US sub-prime mortgage crisis and the subsequent credit crunch hit financial stocks particularly hard over the summer months.
As investors became increasingly risk-averse, the European banking sector suffered, falling more than 13% from its summer peak in mid-July to its mid-August low. The sell-off among banks appeared largely indiscriminate, however, with little differentiation of performance across the sector. Wholesale banks such as Credit Suisse and Société Générale were among the worst hit but retail banks, especially those exposed to ‘hot’ property markets such as Ireland and Spain, also suffered.
The New Star Global Financials Fund had significantly reduced its previously large holdings in Credit Suisse and Société Générale although the remaining exposures did affect performance in August. The fund has minimal holdings in Ireland and Spain and reduced its exposure to Western European banks in general through the second quarter of 2007 in favour of those in faster-growing emerging markets. These generally fared better during the summer correction, with the fund’s holdings in Greece and China making notable contributions.
While the stockmarket sell-off made for an uneasy summer for investors, the resilience of the world economy has provided some reassurance for those prepared to take a longer-term view. The correction so far has been driven by sentiment and financial market liquidity trends, with robust global economic growth continuing to support profitability.
To date, there has been no widespread deterioration in companies’ interest cover ratios and equity market moves have been exaggerated by the thin trading typical of the summer months. Inflationary pressures have been dampened by the correction, much as the world’s central banks would have hoped, and stockmarkets are likely to regain their poise as market activity picks up again in September. With longer-term prospects intact, the fund used the market weakness in August to top up existing holdings such as Schroders and Julius Baer and add new positions such as China Life Insurance.
The pain from the credit market dislocation will be concentrated in fixed income divisions. Within those, heavy exposure to mortgages, with limited exposure to international markets, will accentuate the pain. Origination volumes for corporate debt and structured products will be down sharply. And there may be trading losses to take. That leaves investment banks such as Bear Stearns in the centre of the storm, made worse by its exposure to two exploding hedge funds, with Lehman Brothers a close second.
Insurance companies, debt management firms and asset managers with hedge fund operations all have the potential to benefit in rising or falling markets. Insurance companies, in particular, generally have large amounts of cash on their balance sheets and should perform well in the current climate.
The fund’s increased exposure to faster-growing markets includes significant weightings in Asia. Banks, insurers and property investment businesses in the region appear particularly attractive. The property markets in China and Hong Kong, in common with much of the rest of South East Asia, appear reasonably valued compared to growth in wages while the long-term liberalisation trend provides numerous investment opportunities. Meanwhile, the arrival of consumer banking, rising wages and the wealth effect of rising property values and share prices create a potent mixture. As restrictions on Chinese capital flows overseas continue to ease, China’s pools of capital are likely to pour into offshore investments, with Hong Kong and other mainstream Asian markets the potential beneficiaries.
Turkey also has potential. The re-election of Recep Tayyip Erdogan as prime minister provides the long-term political stability for which international investors had been hoping. Garanti Bank in particular is well positioned to benefit from increased consumer lending, particularly mortgages, once interest rates begin to fall.
In Latin America, Brazil looks attractive, with interest rate cuts expected and demand for consumer loans likely to rise. Economic growth forecasts for 2007 and 2008 were raised at the end of August amid confidence that turmoil in global credit markets would not affect the Brazilian economy. Demand for the country’s commodity exports is expected to remain strong while inflation is likely to stay well below the central bank’s 4.5% target.
At first glance, it looks as though financial stocks represent a good value opportunity. They are usually valued by their multiple of book value (the total value of the assets on their books, minus their liabilities). On this basis, they are their cheapest in more than a decade. Due to the lack of confidence about the stated book values, however, until the market shows signs of stability the opportunities will stay vague.
The short-term outlook for financial stocks will depend on data released in September. This should help signal the levels to which banks are exposed directly or indirectly via derivatives to the US sub-prime mortgage crisis. Once facts replace rumours about the seriousness of the problems, confidence among investors may improve. Comfort can be taken from the maintenance of healthy global economic growth through the stockmarket turbulence, demonstrating that the US is no longer the sole engine of global trends. Positive signals also include the level of share buying by company directors and the increase in confidence towards the end of August. Finally, further encouragement comes from the statements by central bankers about their commitment to help in stabilising financial markets.
Stock specifics
Banco do Brasil
This state-controlled agricultural bank, which offers subsidised loans to farmers as well as retail and commercial banking services, should benefit from the healthy credit environment in Brazil. The bank’s second-quarter profits more than doubled as low interest rates and high crop prices led to increased borrowing by consumers and farmers wishing to finance expansion. The bank’s earnings were up 126% to 1.46 billion reais, beating analyst expectations. Earnings per share were 59 centavos, up
from 26 centavos last year. The Banco do Brasil’s loan portfolio grew 28% in the second quarter from a year earlier, with total assets up 22%.
Hellenic Bank
This Cypriot bank announced record profits for the first half of the year, exceeding stockmarket expectations. First half profits of €70.3 million were up 169% on those of the same period last year. In Greece, the company’s branch network reported lending up 32% and deposits up 51%. The bank also issued a revised three-year strategic plan that included the extension of the Greek branch network and the strengthening of international operations, notably in Russia and the Balkans. The fund used market weakness to buy into Hellenic in July and August and benefited from a subsequent share price rally in late August in response to the strong third quarter results. Hellenic has recorded an average return on equity in recent years of about 20% and the long-term prospects appear strong.
Schroders
This UK asset manager offers diversity in product range and geographical spread. This is likely to prove important if more challenging conditions are coming in equity and fixed income markets. Schroders posted encouraging first half net profits, up 42% on the same period last year. These were boosted by fund inflows and profitable private equity stake disposals. The asset growth came from performance gains across the fund range, including stocks, bonds, property, private equity and hedge funds. Retail net inflows for the first half were £3.6 billion.
Past performance is not necessarily a guide to future performance. The opinions expressed here represent the views of the fund manager at the time of preparation and should not be interpreted as investment advice.
The value of investments in the fund may fall as well as rise as a result of market or exchange rate movements. This document is for professional advisers, professional investors and financial institutions only and is not to be relied upon by private investors. Issued by New Star Investment Funds Limited.
