Market review
Financials were little changed in June despite global equity markets putting in a reasonable performance. Elevated political risk in France weighed on European equity markets following the strong performance of Marine le Pen’s Rassemblement National (RN) in the European parliamentary elections early in the month and President Macron’s surprise decision to call a snap election. Mexico also suffered from the scale of president-elect Claudia Sheinbaum’s victory which raised concerns about the possibility of constitutional reform that could challenge institutional backstops.
Against this background financials, as illustrated by our benchmark index, the MSCI All Country World Financials Index, rose 0.1% while the Trust’s net asset value fell by 1.0% as holdings in Mexico and Europe weighed on relative performance.
Politics
Elections, as we have seen in France and Mexico, have increased the tail risk for investors. France has a hung parliament which, while unhelpful for pushing through reform, is better than the alternative of a far-left or far-right government and the uncertainty and potential disruption that could create. We have no direct exposure to France, but unsurprisingly European financials were weak over the month as investors contemplated the risks and took profits with a recovery seen after the month-end as the probability of an RN majority receded.
“Events, dear boy, events”. Harold Macmillan’s phrase neatly sums up how we view the risk. For the most part, governments are reactive and have little impact on financial markets as a whole and rarely on sectors. Utility stocks in the UK underperformed in the previous two years to the election of New Labour in 1997 when they enacted a windfall tax in response to the anger of the profits the companies had made. However, they then went on to significantly outperform the wider UK equity market reflecting their underlying operating performance and defensive characteristics.
Conversely, while UK banks were left lightly regulated in the runup to the global financial crisis by a Labour government, it was a Conservative government that increased tax on the banking sector – not the first time they have done so – and oversaw a significant and understandable increase in regulations. However, the poor performance of UK banks in the 2010s had much more to do with the legacy issues than any changes in taxation, in particular the cost of customer redress for PPI (payment protection insurance), low growth and an interest rate environment that put pressure on profitability.
The incoming Labour government has difficult choices but we do not expect to see the sector targeted outside the fat goose of private equity executives. The fact that Rachel Reeves, the Chancellor of the Exchequer, has already ruled out the low-hanging fruit of reducing the interest rate paid on bank reserves held at the Bank of England, something two former deputy Governors of the Bank of England support as well as the Financial Times, we believe is telling. A review of a sharp rise in motor insurance costs will unsurprisingly find that the reasons relate to the increased costs of repair.
It is in the interests of the Labour government to make changes that promote growth. Any improvement in planning rules could be highly beneficial if they can be achieved.
However, we would not be surprised if there is some sleight of hand to raise more taxes that is not understood by the Man on the Clapham Omnibus, albeit many of those have already been used up, such as the abolition of tax credits for pension funds in 1997. It is also hard to see where any windfalls could come from, similar to the sales of 3G licences in 2000 that raised £22.5bn. Nevertheless, as we saw with the volatility around the election of Georgia Meloni in Italy and her attempts to increase tax on Italian banks and the UK budget under Liz Truss, Labour will have little room for manoeuvre fiscally.
From a regulatory standpoint we see limited risk of increased regulatory headwinds for the sector as a great deal of regulation is already ‘gold-plated’ with the UK asset management industry being described as the most regulated in the world. It is in the interests of the Labour government to make changes that promote growth. Any improvement in planning rules could be highly beneficial if they can be achieved. Net net, we are positive on the UK following the election and positioned accordingly with the pickup in M&A activity highlighting the value in many UK companies shares.
In the US, there is undoubtedly a greater divide between the Republicans and Democrats around regulation with the sector seen as one of the biggest beneficiaries of a Trump presidency. Regional banks, especially those with between $50bn and $100bn of assets, would be expected to benefit with a more lenient stance on M&A activity boosting consolidation but consumer finance stocks and alternative asset managers would be expected to benefit as well albeit less dramatically. Assessing the path of interest rates is much harder, as is the outcome for geopolitical events, but an added reason for our caution on Mexico in the short term.
Concerns last year around the so-called Basel Endgame proposals which would result in a significant increase in capital requirements for some US banks, have been criticised by not only Republicans but also some moderate Democrats and regulators too. Consequently, it is expected that they will be watered down. Nevertheless, it has led to an advertising campaign titled ‘Stop Basel Endgame’. One advert is titled ’Good for hedge funds. Bad for working families’, another says ’Tell Congress to stand up to the Fed and protect Americans from costly new capital rules’ – something yet to be tried by the UK financial services industry.
