Head - Equity Strategy
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We became tactically more positive on US banks at the end of August, which turned out to be timely.
Out of 24 S&P 500 industry groups, banks were the second best performers during September, returning 7.5% as the S&P returned 1.9%. However, banks started October on the back foot, retracing roughly half of September’s gains as worries over recession resurfaced amid softer survey based data. Recent weakness could provide an opportunity to revisit the sector. Two main factors support our view that banks can outperform on a tactical horizon (3-6 months): the pricing out of imminent recession fears and further yield curve steepening.
Despite weakening ISM data, we do not believe a US recession is imminent. Weakness in manufacturing is a global phenomenon, largely as a result of trade uncertainty. While this is weighing on the non-manufacturing parts of the economy, we do not believe it to be sufficient to pull the services sector into contraction. If the market adopts the view that a recession can be pushed further out, banks should be a prime beneficiary. A broadening out of the recently announced ‘Phase 1’ trade deal between the US and China would clearly help.
Linked to this is the shape of the yield curve. Banks’ outperformance in September came as the 3m10y curve steepened from -50 bps to -16bps. We expect this steepening has further to go. Indeed, on the back of the recent tumult in short-term funding markets, the Fed announced that it will begin to purchase T-bills in an effort to increase reserves in the banking system, driving a rally in shorter-dated Treasuries. Before the financial crisis, the Fed held over a third of its portfolio in Treasury bills, and Fed leaders appear biased towards shortening the average maturity of the central bank’s Treasury holdings going forward. Coupled with our view that the Fed will ease further in the months ahead, we expect that a shift towards adding T-bills at the expense of longer-dated Treasuries in the Fed’s balance sheet will drive the yield curve steeper from here. The figures within this note show that banks benefit from a steeper curve.
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