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May 10, 2023
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TPP Midweek Commentary:
Let’s talk about banks, in a good way.
The equity market is a bit of a funny place at the moment with a bank tug of war going on.
The banks remained the focus last month even though central banks and governments tried to shrug it off.
Federal Reserve Chairman Jerome Powell said: “There were three large banks, really from the very beginning, that were at the heart of the stress that we saw in early March — the severe period of stress. Those have now all been resolved, and all the depositors have been protected,”.
Great news, but then just hours after Chairman Powell reassured the public that the U.S. banking system remains “sound and resilient,” another regional bank—PacWest Bancorp—was hurtling toward danger.
Herein lies the conundrum. Banks were doing well at the start of 2023 as they are a good place to invest in as interest rates rise. Historically, banks do well in a higher interest rate environment as the lending spread becomes more appealing.
Let’s quickly look at why?
When interest rates rise, profitability in the banking sector increases. This can be due to the fact the interest rates usually rise during a booming economy, but I think we’re under no illusions that this is the case here.
In the current climate, banking profits should rise because they can earn a higher yield on every pound they invest.
Banks make money by accepting cash deposits from their customers in return for interest payments and then investing that money elsewhere. The bank's profit is the difference between the interest they pay their depositors and the yield they make through investing.
Higher interest rates increase the yield on their investments.
Consider a bank that has £1 billion on deposit. The bank pays its customers an annual percentage rate of 1% interest, but the bank earns 2% on that cash by investing it in short-term bonds.
The bank is earning £20 million on its customers' accounts but returning only £10 million to its customers.
If the central bank then raises rates by 1%, the yield on the short term bonds will increase and the rate may rise from 2% to 3%. The bank will then be yielding £30 million on customer accounts. The pay-out to customers will still be £10 million.
The bank may be forced to raise the interest rates it pays on deposits if higher interest rates persist but this can take time; it’s also fair to say that the vast majority of its customers won't go in search of a better return for their savings.
The best rates on current accounts right now are about 3% which means you’re probably getting around 2%. The yield on a 1 month government bond is 4.35%. This creates a spread of about 2.35% on average on all deposits.
Now, on top of this, rates on mortgage lending (and all other lending) go up too.
Let’s say the average mortgage is currently around 6%. If they’re borrowing off you at around 2% then this yield spread premium just gets wider (bigger) as rates go up.
This time lag beween what banks charge and what they offer as rates go up, is the perfect opportunity for them to maximise profit. The gap between how much a bank makes, and how much the depositor makes, just gets bigger with limited extra risk.
Therefore, buy banks.
BUT
Just as banks share prices were making good headway, we got word of a ‘banking crisis’ which quickly decided to test the markets; the gains that had been made over the last year or so, quickly started to turn around as the banking index started to collapse.
This leaves us traders with a bit of a conundrum? We want to buy banks for the mid-term because they should post great profits, but given what is happening at the moment, how sensible is this right now?
We always say ignore the noise and look at the numbers but unfortunately the noise was causing a run on several US banks.
Then last week’s earnings gave us the numbers we were looking for:
Headline: ‘HSBC has reported a trebling of first quarter profits, aided by higher interest rates’.
Europe's largest bank, which is based in the UK, said its performance meant it was able to pay its first quarterly dividend since 2019.
Pre-tax profits came in at £10.3bn between January and March compared to £3.4bn in the same period last year.
The figure even smashed financial market expectations of £7bn.
Revenue rose 64% to just over £16bn as net interest income shot up on the back of the interest rate increases.
HSBC also credited a "provisional gain" of £1.2bn on the acquisition, for £1, of Silicon Valley Bank UK in March when its US parent collapsed.
UK rivals NatWest and Barclays reported a similar benefit as central banks continue to bear down on soaring inflation.
NatWest recorded profits of £5.1bn before tax in its 2022 full-year results, a high not seen since 2007 and an increase from the £3.8bn booked a year earlier.
NatWest has reported bumper first-quarter profits on the back of a rise in UK interest rates but said persistently high prices were causing some customers to dip into their savings.
The banking group said it was largely unaffected by the banking turmoil that resulted in the collapse of Silicon Valley Bank and Credit Suisse last month, and despite uncertainty, managed to report a 50% jump in profits to £1.9bn in the first three months of the year. That was better than the £1.6bn forecast by analysts.
Barclays’ profits jumped by more than a quarter in the first three months of the year as rising interest rates buoyed its retail banking and credit cards business, offsetting a mixed performance at its investment bank.
Net profit increased to £1.8bn in the first quarter from £1.4bn in the same period last year, beating analysts’ expectations, the bank said on Thursday.
Revenue rose 11 per cent to £7.2bn, exceeding the £6.8bn estimate.
Metro Bank said last Wednesday that it had reached underlying profitability for the second consecutive quarter, as net inflows picked up pace in March on a revival in demand for mortgage loans.
For Metro Bank, which in 2010 became the first lender to be granted a high-street banking licence in Britain in 150 years, the profitability status caps over two tumultuous years after an accounting scandal in 2019 prompted probes by UK regulators.
"March has been our strongest month of performance since the turnaround commenced," Chief Executive Daniel Frumkin said in a statement.
So, these are the numbers. How are the shares doing?
At the close of play on Friday, UK high street banks’ share prices had dropped significantly from their February highs:
Barclays Bank is down nearly 19%.
NatWest is down around 17% even though they recently stated that they were ‘largely unaffected’ by the illiquidity of the US high street banks.
Lloyds is down a little over 15%.
Metro Bank is down slightly over 35% even though March was their best month on record.
Virgin Money is down 25%
Are these sell off’s justified? In short, no. The discount in prices is due to the fear that the crisis gets worse and more banks collapse. Just how many American Banks have to fold before it becomes an issue over here is unknown.
The problem should be contained, but short sellers will do whatever it takes to cause panic, and start a run on another bank: a person is intelligent, but people are stupid and the herd could cause problems.
We do think the situation is contained. That doesn’t mean it’s over, but it does mean that there is an opportunity.
If more banks do start to fold, and more stress is found in the system, then TPP will be there to capitalise and make money for our users. This year has so far been one of the most profitable yet for all those who have subscribed to the next generation of investing.
Albert Einstein was attributed with saying ‘In the midst of every crisis, lies great opportunity.’
While we don’t want crises, without them TPP wouldn’t stand out from the crowd. When times are tough, and your investment manager is sitting on his hands losing your money, just look at what you could have done.
For us at TPP, this volatility has proven to be the fantastic opportunity we were hoping it would be. We ask our traders to just try and beat their benchmark year after year, and once again, we’ve done that in Q1 and at the start of Q2. Several have already lodged decent sized double digit returns. Long may that continue and we hope your portfolios are giving you the profits you’ve come to expect from us.
The time to buy is when others are panicking. That’s why professional traders will always have the edge over the fund managers.
This is the main reason that active fund managers have always underperformed their benchmarks. Our traders and their strategies have always outperformed theirs; but trading and wealth management are two different worlds.
The current TPP market bias:
The majority of our strategies are doing excellent this year.
It seems that many of the ‘buy or flats’ and the ‘active’ strategies have timed many of the short/mid term moves fantastically well.
This current level in many global stock markets most likely provides a great long term buying opportunity. This banking issue is not the same as 2008 and shouldn’t be treated as such. There isn’t a problem within the banking system itself, just a few mismanagement issues in a couple of places.
For most portfolios globally the recent drops have been painful, and the drops have been big, but ultimately, at TPP we like these drops so that we can buy in cheaper or buy back the shorts. Picking the bottom or the top is just not an option, but making money from something close is.
One thing is for sure, our traders will be looking to continue recent momentum in Q2.
If you have an underperforming portfolio or are sitting in cash waiting for an opportunity- contact our team for a FREE consultation.
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- London Stock Exchange 2020