Our latest investment soundbite is with Darius McDermott and Juliet Schooling Latter, managing director and head of research at FundCalibre. They discuss the banking crisis and the FTSE 100 before reviewing the best and worst performing sectors so far in 2023.
Published first on 30 March 2023
Tell us why the FTSE 100 was so strong at the start of the year and why it’s retreated a little since then?
Juliet Schooling Latter (JSL): The FTSE 100 is not really representative of the UK economy and it’s done well for a few reasons: it contains some energy giants such as Shell and BP, which have outperformed due to the increase in energy costs post the invasion of Ukraine. Shell, I think is up over 60% since the start of 2022. And also, the FTSE 100 is quite global looking, with 75% of its revenues coming from overseas. So, with the pound quite weak, the overseas earnings are worth more in sterling.
Darius McDermott (DD): January was a very strong month for markets as the gloom of 2022 looked to be behind us, and rate rises looked to be nearing an end. Then February was a very poor month. All global markets, including the FTSE 100, which had hit 8,000, went back to 7,200. That’s quite a big fall and it has now subsequently rebounded into the mid 7,500 type of range. Even though it reached a record high at index level, it wasn’t massively expensive on a valuation metric. Because of the earnings of some of those big companies in the index, the PE ratio itself was lower than it has been at other peaks.
US banks are in the headlines. What’s happened there?
JSL: Silicon Valley Bank (SVB) was a niche bank which focused on technology, which puts it in a special situation as it were. Mindful of the global financial crisis, there was a concerted effort to sort the situation out quickly, but the US is slightly different in that it has these smaller regional banks, as well as some of the big banks.
DD: I understand that there were two things broadly that went wrong. Firstly, a lot of the collateral that was held by the bank was in long duration US government bonds. These suffered big losses in 2022. Secondly, banks make money by taking deposits in from savers and lending that money to companies, to grow. And the technology sector had a tough year, particularly unlisted technology companies, so their requirement for funding became greater. This meant that SVB was lending to companies that were getting into difficulty and their collateral was going down because it was held in long duration bonds. So, very specific.
There has been some contagion in other US banks, which are already having to be rescued at the time of recording.
JSL: One key point is that, since the financial crisis, banks are now better regulated and more stable businesses. But they’re so dependent upon confidence, so, if depositors get nervous about the solvency of a bank, then they start to withdraw their money, and what happens is they then bring about the insolvency that they were concerned about. So, confidence is key here.
Moving on to Europe, what has been happening with Credit Suisse?
DD: As Juliet mentioned previously, banks are now better capitalised and better regulated. So, what does that mean? Firstly, the capital: if a bank lends a pound, it needs to keep about 15 to 20p of cash on its balance sheet. Regulators in Europe have insisted that banks should have more capital, so that if there is a run on the bank or a lack of confidence, they’ve got plenty of money to back them up, but that it is held in higher quality assets, if you like. What happened in the financial crisis was that capital was being held in what was thought to be high-quality assets: mortgages were packaged up, alongside other asset classes, to have AAA ratings. But when you have a housing crisis then mortgages don’t look so rock solid.
Credit Suisse has had a number of issues in recent years, which has led to the bank being fined, and it has been looking vulnerable for the last year. As that contagion from the US spread, Credit Suisse came in the firing line in Europe and confidence dwindled, depositors took their money out and to all intents and purposes, the Swiss have had to bail them out and have offered the hand of marriage of Credit Suisse to UBS, while saying there’s a nice dowry for doing so, to try and restore stability. Usually what happens in circumstances like this, is the equity holders are the first to suffer, and then the bond holders suffer depending on how senior your debt is.
Now, there’s a new type of bond which was introduced post the financial crisis called AT1s or Cocos [contingent convertibles]. And these were there to act as a buffer between the equity and the bond holder. Then the Swiss regulator decided that those bonds would be wiped out before the equity, which was unexpected, and it caused substantial instability in markets. The European regulator then issued a statement that that wouldn’t happen in European banks, and that restored stability.
Looking at what has done well and what hasn’t in the last three months, the best performing sector has been technology. Do you think it’s just been a relief rally? Is there too much uncertainty in the world for tech at the moment?
DD: For me, this is all about interest rates and whether interest rates are going to go up more or less than the market itself expects. Back in the early noughties and late nineties, we had the tech boom. It was a bit of a revolution, tech was just beginning, and lots of these companies weren’t profitable. Now the big tech companies make more money. They are huge cash generation companies and they also have this long duration view on those cash returns. And when interest rates go up, long duration assets do badly whether it’s a bond or equity. So, there was a substantial sell-off in technology companies last year because of this relationship between their long duration cash flows and rising rates. Although inflation is still a threat, there is still concern about a potential banking crisis playing out, alongside a number of other macro factors at play such as persistent inflation and interest rate rises. And that rally, where people actually thought rates were going to stop going up and potentially come down, it was a factor in the outperformance of technology. Also in uncertainty – and we definitely have an uncertain macroeconomic picture – these technology companies have rock solid balance sheets, huge cash flow earnings and could look quite defensive assets as well. So, a number of things going on there.
Why do you think both of the large cap and small cap sectors in Europe have done well so far this year?
JSL: Quite simply, they were oversold. I think there was a lot of fear surrounding how Europe would cope with gas supplies under threat and higher oil and gas prices, but with a relatively mild winter, it has managed to store quite a lot of gas and so the market’s just breathing a sigh of relief now. And European companies are having quite a strong earnings season.
Given what’s happened with Credit Suisse’s AT1s, are you still confident about bonds, if interest rates might have to go up a bit more?
DD: Whatever we know – or don’t know, more to the point – about the future rates, we’re definitely near the end of the rate-rising cycle, rather than the beginning, which is exactly where we were this time last year, which is why bonds did so badly. The actual starting yields on bonds are now attractive again; they’re even attractive versus cash rates, and they’re attractive versus dividend yields, so you’re actually getting paid something via the coupons, to hold bonds. Back when I started, [in this industry], that was the main part of the bond return – it was your coupon. And coupons got to a such a very low level. Now, they’re much more attractive with rates definitely near at the end of the cycle rather than the beginning. I think we can be fairly positive on corporate bonds as an asset.
Areas that have struggled in the last quarter have been healthcare, Indian equities and commodities. What’s gone wrong for those areas?
JSL: I think it’s quite simply they’ve done well and are having a pullback. I’m a long-term fan of India and it had done very well and was looking expensive, so I think investors have been taking profits. But I still like it for the long term.
DD: Commodities were very strong last year, as was India. And valuations got expensive. I’m slightly surprised about healthcare; healthcare is normally a sector that does well in uncertain times, and I’d be fairly confident that if we continue in this very uncertain economic background, that healthcare should be a sector that will outperform.
The full interview can be found here: https://www.buzzsprout.com/1890790/12539903-248-turbulent-times-a-banking-bailout-a-political-football-and-a-rate-rise.js?container_id=buzzsprout-player-12539903&player=small
