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Banks on the rise and US fixed interest

06 January 2017

Why are banks doing so well?

After a long period of poor performance following the financial crisis, bank shares have been performing very well in recent weeks. This is for a number of reasons.

Firstly, bond yields have begun to rise - particularly in the US. Banks who take short term deposits and lend for longer periods suffer if they cannot charge higher rates of interest; if bond market yields rise, this then generates further opportunities for them. Since 2008 banks have been heavily regulated in an effort to prevent another financial crisis. Donald Trump has talked about reducing this burden of regulation. Regulatory fines and compensation claims following the misdeeds of the past have weighed on banks’ share prices but these are beginning to be settled. In Italy, the world’s oldest bank, Monte dei Paschi di Siena was in trouble but has received a government bailout.

Bank share prices had priced in a lot of bad news and with much of this now resolved there has been room for a bounce back. Many investment managers who had been underweight financial equities have now moved to reverse this position. Whilst this may be the start of better times for banks, the US banking sector has begun to price in a lot of good news and we are taking a more cautious stance at these levels. With that said, we still suggest selective exposure to UK banks which give good dividend yields.

Given the recent rise in yields since Donald Trump’s election victory, is it likely that this trend will continue? What does it mean for fixed interest markets? And how have you positioned your portfolios in relation for this change?

The US Federal Reserve raised interest rates in December; this was well flagged before the election and was neither a surprise nor a response to the Trump victory. We do not know with any degree of certainty what Trump will be able to do but his intentions appear to be for deregulation, anti-free trade and for an increase in spending on infrastructure. Trade tariffs and returning production from cheap emerging markets is likely to be inflationary, as could be the infrastructure spending. The rise in oil price, however, is not Trump related and his views on making it easier for oil companies may increase onshore production and dampen the effects of OPEC (Organization of the Petroleum Exporting Countries) production cuts.

The important question to ask for bond markets is not ‘will rates rise?’ but ‘will they rise faster or slower than is expected?’ At the moment the market expects two further rate rises in the next year and we believe this is about right. If there is to be a rate rise it will be on higher than expected inflation. While there remain long term deflationary forces at work, we believe that in the short term inflation may rise. With this in mind, we have for some time favoured Inflation Protected Treasuries over conventional fixed income. The 10 year expected inflation rate moved up from a low of 1.2% in February last year to just over 2% today and our view is that this trend may continue. This week it was announced that the US ISM Manufacturing Prices Paid Index rose to 65.5 in December from 54.5 the previous month showing a rise in short term inflation expectations. We therefore continue to favour index linked bonds for US dollar investors.


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