Financials’ continued outperformance should not be a surprise

Financials globally rose by an impressive 28% (in sterling terms) in 2024, the third year of outperformance relative to the wider equity market in the past four years – something we suspect few investors realise.

This performance is somewhat reminiscent of 2002-06 when financials outperformed global equities for five years in a row. The big call to get right was to be overweight US financials and underweight most emerging markets during that period. More recently a combination of favourable macroeconomic conditions and Donald Trump’s election as US president drove very strong returns from US financials (34%), led by banks (41%) as well as diversified financials (33%) and insurance (29%).

Despite greater political volatility, European financials delivered solid absolute returns (21%) but lagged relatively, although European banks had another strong year (29%). In Asia, there were strong returns in Japanese financials (41%), due to higher policy rates, and mainland Chinese financials (51%), reflecting stimulus and underweight investor positioning. Emerging markets were relatively weak, including India (9%), Saudi Arabia (4%), Hong Kong (0%) and Brazil (-33%), which partly reflected the impact of US policies.

Overall, 2024 was another fantastic year for the financials sector.

How are we positioned for 2025?

We are overweight US financials, in particular banks and insurers which provides a good balance to the portfolio. We think Trump’s presidency should be positive for US business confidence which should drive improved capital markets activity and loan growth. A less onerous regulatory backdrop would be a step change for the sector and could trigger increased mergers & acquisitions (M&A). We see US banks as a clear beneficiary of these trends. US insurers have been a longstanding overweight as we seek to capture the high returns on offer in the commercial (re)insurance market. Even if conditions in these markets have passed their cyclical peak, we think returns will remain attractive and could be supplemented by a wave of consolidation. We also have holdings in US payment networks which we think will continue to exploit their favourable market positions to deliver attractive returns.

In Europe, we remain constructive on banks which present a clear valuation anomaly relative to RoEs (Return on Equity¹). We continue to monitor how shifting interest rate expectations could change leadership in this subsector. We are generally underweight Asia but have positions in Japanese banks where the potential for rising central bank rates and corporate governance reform should sustain attractive levels of growth. We have no exposure to Chinese financials due to the risk of continued geopolitical uncertainty. We also have several turnaround holdings in various subsectors and regions where we think the market is underappreciating their idiosyncratic rerating potential.

Fundamentals are better for financials

The strong performance of global financials in recent years is underpinned by improved fundamentals. RoEs are a key measure of value creation and they are higher than they have been for many years: JPMorgan’s RoE was 10% in 2014 and is expected to be c17% in 2024; Arch Capital’s was 11% in 2014 and is expected to be 17% in 2024. These businesses are delivering attractive returns at the same time as having built strong capital positions, allowing many companies to make distributions to shareholders in the form of dividends and share buybacks which should continue to attract investors.

The shock of the US regional banking crisis and issues at Credit Suisse in 2023 have not had a material lasting impact on the sector. We have transitioned from over a decade of close to zero interest rates to a period of higher interest rates which are positive for the attractiveness of many financial services products and the ability of companies to generate better RoEs. We could also be past the peak of regulatory pressure on the sector, which has long been a drag on returns and could trigger more consolidation.

Overall, we think that the global financials sector continues to look very attractively positioned going into 2025.

What is the bull case for financials from here?

Despite several years of strong absolute and relative performance, we think there is a compelling case to allocate more to financials from here. Financials are more diversified than many investors realise, which provides attractive opportunities for stockpickers like us. The operating environment and macroeconomic backdrop are positive, as evidenced by the high RoEs that many financials are generating.

Financials have outperformed the broader equity market in three of the past four years, and valuations remain very attractive. The sector trades on 12.6x 2026 price-to-earnings (P/E²) which remains a significant discount compared with global equities on 18.4x and the S&P 500 on 22.8x. The Polar Capital Global Financials Trust (PCFT) is even more attractively valued on 12.4x P/E.

Investor positioning in financials also remains underweight, despite it being the second largest sector within global equities. We think it offers a great way for investors to diversify their growth-oriented investments and have better fundamental prospects than many other value-oriented sectors.

Increasing regulation, most notably since the global financial crisis, has had an adverse impact on the valuation of US financials, particularly when compared to other sectors such as technology. The increasing regulatory burden on financials (higher capital requirements) has been a challenge for the sector and a drag on returns which has ultimately weighed on the sector’s valuation.

We expect the Trump administration to provide a positive tailwind to financials as his administration is likely to unwind some of this regulation, reducing the burden and encouraging growth and innovation. As this headwind turns to a potential tailwind, we believe this should support a higher valuation for the financials sector, making the second largest sector with global equities to offer far more attractive opportunities to those looking for long-term equity returns.

1. RoE stands for Return on Equity, a measure of financial performance calculated by dividing a company’s net income by the value of shareholders' equity. 

2. P/E stands for price-to-earnings ratio, and relates a company's share price to its earnings per share.