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Good morning. We are still thinking about the Fed’s balance sheet and, judging by the responses to Wednesday’s letter, readers are too. It’s a topic we will come back to soon. In the meantime: European value, bank stocks and wildfires. Email us: email@example.com and firstname.lastname@example.org.
The value trade in Europe is screaming
Value stocks are having a good 2022. The Russell value index is up 7 per cent year to date, beating Russell growth by 7 percentage points. That’s a lot in less than three weeks. But Unhedged’s friend Duncan Lamont, who heads up the research team at Schroders, points out that the value breakout is even more extreme in Europe. The MSCI EMU value index has outperformed its growth counterpart by a whopping 11 per cent year to date.
Here’s a chart of growth/value relative performance for the two pairs of indices (data from Bloomberg):
Value and Europe have underperformed growth and the US for well over a decade, and strategists have been pitching catch-up trades for almost that long. And now both are catching up at once, and fast. Perhaps this is evidence that a lasting factor or style rotation is finally happening?
Lamont is quick to point out that three weeks is too short a time to declare a durable trend. But he offers two thoughts about what might be behind this trendlet.
First, the European value index is more heavily weighted to financials and energy (25 per cent and 7 per cent of the index, respectively) than the US one (20 per cent and 5 per cent). This means more benefit from recent rate increases and the rebounding oil price.
Next, the valuation gap between value and growth had grown in both regions, but in Europe the gap has become extreme. The forward price/earnings ratio of the growth index at the end of last year was about 11, versus 27 for growth. That 16-point gap has expanded from 10 points before the pandemic. Says Lamont:
On valuations, the huge outperformance of growth vs value in Europe in recent years hasn’t necessarily been justified by changes in company fundamentals such as earnings. This pushed the valuation differential to extreme levels. It may just be simply that the elastic can only stretch so far before snapping back.
There may be a more general point to make, too. During the pandemic, there has been more lockdowns and less fiscal stimulus in Europe than in the US. Its economies, accordingly, have had a less robust recovery. Maybe what we are seeing is investors anticipating that when the pandemic eases, Europe may have a nice cyclical bounce, previewed in the US already, which will help European value stocks. A trade to watch in 2022.
Bank stocks find a new way to disappoint
US bank stocks are up 10 per cent over the past month, despite having endured a tough few days recently, and have solidly outperformed the S&P over the past year. They have risen mostly on fundamentals, too: the valuation of the KBW bank index, at about 11 times forward earnings, is right in line with levels of the past few years.
Bank profits are widely thought to be sensitive to the slope of the yield curve, on the grounds they fund themselves short and lend long. In fact, however, they are even more sensitive to short-term rates, which are rising fast. Furthermore, credit card loan volumes are continuing their comeback, and business loans are finally joining in. Data from the Fed:
In short, it’s tempting to bet that bank stocks will keep the momentum going. But while the big banks that reported this week — the likes of JPMorgan, Bank of America and Citigroup — showed strong revenue trends, the story was higher expenses. JPMorgan led the way. From the FT:
“We are in for a couple of years of sub-target returns,” Jeremy Barnum, JPMorgan’s chief financial officer, said on a call with analysts. Barnum said the bank would benefit from higher interest rates and greater loan demand but these would be offset by a decline in investment banking fees and more spending on new investments and pay.
The bank intends to spend an additional $3.5bn on technology, hiring, marketing and acquisitions to head off emerging fintech and non-bank rivals.
“It’s a lot of competition and we intend to win. Sometimes that means you’ve got to spend a few bucks,” said Jamie Dimon, JPMorgan’s chief executive.
The chief executive of Goldman Sachs has warned of “wage inflation everywhere” after a big jump in expenses hit fourth-quarter profits at the Wall Street bank.
In an interview with the Financial Times, David Solomon said that Goldman like other large companies was contending with higher wage demands from its employees. “There’s no question that inflationary pressures around compensation had an impact,” he added.
Things are finally going the banks’ way, but it seems, at least at the largest ones, investors are not going to see the money. In lending businesses, the money is going to technology; in investment banking, to the bankers. Brian Foran, an analyst at Autonomous Research, ruefully noted: “Somewhere there is a report with my name on it saying that banks’ investments in tech might lead to sub-50 efficiency ratios [non-interest expenses as a proportion of revenues] long-term. So far, we haven’t even figured out how to break 60.”
It will be interesting to see if the smaller regional banks, which report in the next few weeks, follow the same pattern.
Insurance and fires
It was good to see this article in The Wall Street Journal, about two of the largest US insurers, AIG and Chubb, pulling out of big swathes of the California home insurance market because they consider the wildfire risk uninsurable. There is a complex set of issues here, but the core point is this: insurance pricing sends important messages about the dangers of climate change, and government regulation and subsidisation in fire and flood insurance often stifle those messages:
Some insurers are frustrated that California regulators require them to set home-insurance rates based on their historical loss experience, not projections of future losses that are determined by catastrophe modelling. Such models can reflect detailed, location-specific data that the insurers feel they need amid escalating wildfire activity tied partly to climate change.
I have written about how climate change has rendered historical modelling obsolete, and made catastrophe modelling necessary, in the case of flooding. The same is true of wildfires. But even if regulations change, some things will still become impossible to insure profitably because of climate change. Chubb and AIG are providing a dose of reality that we need, demonstrating the real social benefit of finance. Expensive houses in California becoming uninsurable will send a much stronger message than another bank’s glossy ESG campaign. No one should have to risk losing everything in a fire. But at some point facts must be faced.
One good read
A Blackstone-backed landlord promising a free call option on your dream house — what could go wrong? The FT’s Mark Vandevelde digs deep on the rent-to-buy industry.
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