Tuesday, July 8th, 2014

Second Order Explanations

In these Strategy Notes, we frequently write about things we do not fully understand. Our job is to highlight the issue as soon as we identify it, and then let the specialists take over. If we waited until we had a perfect explanation, we would always be behind the curve. In this spirit, we focus on the Financials sector which is now rated Underweight in every region, following our downgrade of the sector in the Eurozone this week. The worst ranking is Japan, where it is #9. It is #7 in the US, and #8 in Pan-Europe (which is split #7 in the UK and #6 in the Eurozone). In every region the relative trend is either sideways (US, Japan) or down (UK, Eurozone, Pan-Europe).

As stated in our recent note on the Energy sector (Desert Storm, 24th June 2014) it is rare for any sector to be at the top or the bottom of the ranking in every region, and when it is there is normally some all-powerful explanation, like geo-political risk. The situation in Financials is certainly not as dramatic as Energy, but there is enough synchronicity for us to be puzzled. Some of the obvious explanations do not stand up. Government bond yields (7-10 years) are on an upward trend in the UK, and are stable in the US, but they are falling in Japan and the Eurozone. The real estate cycle (commercial and residential) is not synchronised across these regions, and there is no evidence of a global increase in default rates. There is no general financial or currency crisis that we are aware of.

In order to make sense of these development we have to fall back on a series of second-order, local explanations. Thus we blame the underperformance of the UK sector on the threat of rising interest rates. For the Eurozone we blame the upcoming ECB stress tests in mid-sized periphery banks and the vengeful attitude of the US regulator for BNP, Credit Lyonnais and Deutsche Bank. In the US, the investment banks are set to announce weak results in their FICC trading divisions, but that is hardly news. In Japan there are concerns about the pace of loan growth and the possible disruption of investment and lending patterns, if the proposed reform of corporation tax goes through. In both the US and Japan, these concerns need to be set against a robust rally in the equity market.

In short, we are not convinced that these second-order explanations offer a complete or coherent reason for the global Underweight on the Financials sector. It could just be a co-incidence, or the market could be trying to tell us something. One issue we have not mentioned so far is the shadow banking system in China. Like everyone else we read the stories about the chronic over-supply of residential property in second- tier cities. Like the commodity-collateral scandal, this story has been around for at least three years, if not longer. One day, there will be a very big bust – in that sense, China is no different from Spain, or the US, or Japan – and a banking crash in China would certainly be big enough to send the financial sector to the bottom of each regional model.

The current “co-incidence” could be an early warning, but we have all been warned about China, many times. As always, if we completely understand the story, it is too late to act.

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