Part III: Global financials – Looking forward to 2021 and 2022

Looking back to look forward.

• Economies are cyclical, with recessionary phases a healthy part of these cycles.
• Recessions tend to follow similar patterns. Our analysis of the financial sector through previous recessions shows that the market tends to over-react and that share prices have always bounced back.
• It’s clear that the market’s fears of bad debts and capital losses are once again exaggerated – banks’ capital provisions are healthy and valuations still offer considerable upside. The same goes for non-life insurance companies, which offer strong fundamentals and are adequately capitalised against unforeseen losses.

Financials are undervalued based on expectations of low interest rates and inflation.

• Financials trade at a 62% discount relative to the broader market. We attribute this to the above fears of bad debts as well as the effect of low interest rates on net interest margins.
• The cycle should reverse, as the disconnect in valuations becomes increasingly more apparent especially considering the valuations of in vogue technology shares.
• Central banks have been stimulating the economy with low interest rates, but this could increase inflationary pressure, leading to a steeper yield curve that the market isn’t pricing in.
• Speculation about the Fed possibly increasing interest rates is already opening the way for higher inflation (beyond the 2% target). If these expectations turn into real inflation, this will be positive for financials.

Even if interest rates remain low, the absolute value of financials will still favour investors.

• Banks’ overall cost-to-income ratios in 2020 are high.
• Covid-19 has been an important catalyst to leverage digital strategies. Banks have invested in their capacity to prevent money laundering, improve efficiency and reduce branch overheads with digitalisation, which has increased their value and should improve profitability.

Despite the uncertainty, banks have made adequate provision for bad debts.

• Provisioning standards are stricter than before and banks have, in general, been very prudent.
• In fact, actual bad debt charges are still as low as 2019 and many banks are still delivering positive returns on equity despite experiencing their worst year.
• All this means valuations are currently very attractive given the market’s scepticism of potential bad debts.
• Bad debts are more than accounted for per our stress testing, even in the case of a strong resurgence in Covid-19.
• While the next three months are uncertain, we believe the current holdings in the Denker Global Financial Fund show strong rerating potential.

The recession will be cyclical, and current valuations haven’t considered that growth is likely to continue into 2021.

If you have any questions, please contact me at nigel@denkercapital.com

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