Contrary to expectations, the best performing sector for the year to date is not technology, but financials. The short-term catalyst has been a surge for the banking sector in the wake of the election of Donald Trump, as investors anticipate deregulation and merger and acquisition (M&A) activity. However, the roots of financial sector strength go deeper.

The MSCI World Financials index is up 43.8% over one year, and 22.5% for the year to date. That compares to 33.7% and 16.5% for the MSCI World Index. It has outpaced the MSCI World at a time when the strong performance of index heavyweights Nvidia, Apple and Amazon has made it difficult to beat. A lot of this strength has come from the banking sector, which comprises around one-third of the index.

Part of its success has been the expectation of a reversal of the regulatory constraints that have hung over the banking sector since the financial crisis under the incoming US administration. The S&P 500 Financials index is up over 10% since the election[1], almost double the return of the S&P 500 over the same period.

Tom Dorner, fund manager on the Polar Capital Global Financials Trust says: “It’s pretty clear Donald Trump would like to roll back some of the regulation that has been in place since the financial crisis.” This has been effective, as demonstrated by the limited fall-out from the failure of Silicon Valley Bank and Credit Suisse in early 2023.

Dorner’s view is that this sector has passed peak regulation, though how far it will go the other way is open to debate, “it’s not in anyone’s interest for the system to become more risky,” he says. Nevertheless, there is scope for change: “The sector has been in the regulatory sin-bin, but the Silicon Bank failure has had almost no consequences for the wider financial system.”

There is also some hope that the environment will encourage more M&A activity. M&A accelerated under the last Trump presidency. There are also some signs of this among the European banks. Italy’s UniCredit has made a €10.1bn bid for rival BancoBPM[2]. It comes shortly after its announcement that it had amassed a stake in Germany’s second biggest lender Commerzbank. This would be ground-breaking because it could usher in a new era of cross-border transactions in Europe, says Dorner.

Global strength

There is also a longer-term story for the financial sector. In the UK, for example, there is no prospect of deregulation, but financials have had a strong year. Among the top 10 performers in the FTSE 100 for the year to date, four are financial companies, including three banks (NatWest, Barclays and Standard Chartered). The MSCI Europe Financials Index is up 20.2% for the year to date, compared to just 8.0% for the wider MSCI Europe Index[3].

Dorner points to a confluence of positive circumstances: “The economic backdrop has been pretty favourable. The interest rate environment has been less punitive than it was in the past, and that has coincided with buoyant capital markets.”

The team on the Merchants Trust sees ongoing value in financials and particularly in the banking sector. Andrew Koch, a manager on the trust says: “Now banks are making money on the deposit side but less on their loans, so all of the start-up banks that were going to wipe out high street banks aren’t doing as well. We’ve gone back to a normal banking environment, and banks need to make money on both sides of the equation. If they don’t have a deposit base, it makes life tough.

“The structural headwind of very low interest rates has been cleared. Looking around Europe, lots of the regular banks have very profitable current accounts on which they pay no interest, but where they can make 3-4% in wholesale markets. The changes to interest rates are a structural change that really advantages them. These banks are trading at big discounts to book value. There’s a real valuation and structural change here that makes the sector very attractive.” They hold Barclays and Lloyds.

For the time being, falling rates seems unlikely to derail this strength as long as rates stay within a ‘normal’ range. The team believes that UK banks in particular have a delayed response to the interest rate cycle. Other markets may have seen the benefits more quickly. In Europe, the banking sector has already beaten expectations on earnings for much of 2024, with a promising rebound in fee income[4].

Alex Crooke, manager on the Bankers Investment Trust is also a supporter of the sector: “We’ve switched a lot of holdings from ‘fee-paying’ financials into net interest margin financials. We believed interest rates would stay higher for longer and that’s coming through. A lot of the traditional banks – Morgan Stanley and Unicredit – have been among our best performers.” Financials remain the largest overweight position in Bankers, alongside consumer discretionary stocks.

Interest rate sensitivity

Dorner is clear that they do not need higher interest rates for financials to do well: there is sufficient choice in the sector – asset managers, insurance companies, payment companies – to do well in a range of market conditions. “Banks are rate sensitive, but insurance companies are not. Asset managers tend to be sensitive to equity markets. Our benchmark includes payment companies as well, which are beneficiaries of lower interest rates because it facilitates spending.”

However, it’s helpful that interest rates are likely to settle at 2-3% rather than zero where they have been for a long time. Dorner says that for the banks, it’s a better operating environment. The team is leaning into the higher rate environment and has more interest rate sensitivity in the Polar portfolio than in recent history.

He says there is a clear bull case from here: “The macro is good and getting better, the regulatory environment is more benign, that’s good for everyone particularly smaller banks where there could be consolidation. The issues around commercial real estate are effectively parked, because the Fed is cutting rates. When you piece all of that together, it’s quite a series of tailwinds.” It’s been a strong period for the banking sector, but there may be more to come.

[1] https://www.spglobal.com/spdji/en/indices/equity/sp-500-financials-sector/#overview

[2] https://www.ft.com/content/435e2bae-66a2-4f26-8ca6-73034b0878ea#post-ee6ad9bd-de2e-49ae-b8e9-470ab4e655fa

[3] https://www.msci.com/documents/10199/8826a446-bba3-448c-919b-d8a795f133bf

[4] https://www.ey.com/en_gl/insights/financial-services/emeia/how-european-banks-defied-expectations-to-show-resilience-and-growth