The hunt for red October

by | Oct 18, 2018

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Donald Maxwell-Scott, technical investment manager at Rowan Dartington reflects on the financial crises, and shares his thoughts on the future of banking

Everyone seems to get excited about October and the heightened probability of a market correction based on history (October 1987 and October 1929).  Well, those on the hunt have now been rewarded. Billions being wiped off the FTSE 100 in one day is always an eye-catcher for a headline, but in reality, it means very little unless you are a day trader or short-term speculator.

Corrections happen all the time, and they are always more pronounced when the markets have been performing strongly, which they have been doing. However, most major stock markets have been submerged for the month of October:

(Source: FE Analytics 2018)

It is not something that investors should be too concerned with at this stage, and last Friday most markets did stage some form of recovery. What seemed to set off the rout last week was an increase in the benchmark US 10-year treasury yield. A spike in October did mean the yield crossed 3.25% for the first time since 2011

Interest rates are going to go up because economic data in the US has been positive, however, an increase in borrowing costs could be the straw that breaks the camel’s back when it is factored into the broader narrative of trade wars and an overheating US stock market.

Overall the fact remains that the US economic fundamentals are still strong, so we don’t see this being anything other than a small correction, and certainly if things fall any further, this should present investors with a buying opportunity.

Banks – the gift that keeps on giving

A slightly misleading title if you have been a long-term investor in the banking sector. Prior to 2008 the banks could do no wrong, they were the engine room of the British economy, churning out hundreds of millions of pounds in profit for their shareholders and taxes for the government.

As well as enjoying robust growth in the UK, many banks also targeted aggressive expansion polices overseas. The most famous of these was the ill-fated takeover of ABN Amro by Royal Bank of Scotland (RBS), just prior to the 2008 financial crisis.

When the financial crisis did hit it was very much a game of pass the parcel, whereby mortgages were pooled together as one tradable mortgage-backed-security (MBS). The only trouble was that many of the underlying mortgages were subprime and highly risky, and therefore completely worthless. This means that when the music stopped, the banks which had significant exposure to this asset class found themselves in a precarious position. Liquidity dried up and suddenly they went from hero to zero.

However, these banks were too big to fail and therefore, with begging bowls in hand, some secured the largest bailout in history. The trouble is their fortunes have not improved since and their rap sheets have continued to grow; the manipulation of the London Interbank offered rate (LIBOR), payment protection insurance (PPI) and money laundering are several of their most recent transgressions.

Billions of pounds in fines by both UK and US regulators, as well as compensation to customers, have left investors in the banks wondering whether there will be any significant recovery.

(Source: FE Analytics 2018)

All the major UK banks have underperformed in the FTSE 100 and, while some are in a better position than others, we don’t see any bank staging a major comeback, and the reason for this is regulation. Of course, it was the deregulation of the banking system that led to the financial crisis in the first place, but, as with any human behaviour, the tendency to overcorrect mistakes of the past leads to the pendulum swinging too far in the other direction in the future.

The capital requirements of the banks are now so stringent that many have not been lending money the way they should. Banks best fulfil their role in society when they provide capital on the basis of a sensible risk and return policy. This is the reason we need a strong banking system, so finance can be extended to businesses to grow and create jobs.

However, overregulation seems to have reduced bank lending and the fines issued to some of the banks do seem excessive; it seems to be based on the ability to pay rather than their original transgression. For example, the US department of justice issued RBS with a $4.9 billion fine in May this year, only a matter of months after RBS reported its first annual profit in a decade.

It does seem that many governments seem to be using the banks as their cash cows. This is perhaps understandable given the public anger towards banks, however, it is probably not heathy in the long-run.

Take the bank levy for instance. Introduced in 2011, it is simply a tax on a bank for being a bank. Looking at the 2017 annual reports, the UK bank levy raised the following: Lloyds £231 million, Royal Bank of Scotland £215 million, HSBC $180 million, Standard Chartered £220 million and Barclays paid £365 million.

It will raise billions every year for the foreseeable future and is not deductible under corporation tax, so is payable regardless of the financial state of the bank. The government introduced this in order to discourage the banks from relying on risky forms of borrowing that led up to the financial crash. However, it could be argued that the regulators also have a part to play.

Investors not concerned with overregulation might be concerned about the rise of Bitcoin or online challenger banks.

Is a decentralised currency such as Bitcoin a reliable replacement to traditional banking? No, it isn’t, and while some promote the use of the currency, it is often the same people trading the currency for profit rather than for what it was originally intended. Speculation has led to increased volatility in Bitcoin, so it becomes useless as a currency.

The very people advocating the use of this currency to replace the reckless banking system are perhaps unwittingly engaging in the same reckless speculation that led to the banking crisis in the first place. After all, who wants to receive payment in a currency that could half in value the following day; one day you might be running a profitable business, the next you are calling in the administrators.

Perhaps challenger banks are the answer? Again, no, they are not. Some do have some unique features that the traditional banks don’t, however, their main selling point seems to be promoting that the future of banking will be exclusively for your smartphone or tablet.

However, what they may have failed to notice is that the majority of ‘high street’ banks are in fact no longer on the high street! They have been closing their high street branches at an alarming rate. According to Which?, since 2015 at least 2,961 bank branches have closed, a rate of 60 branches a month (Sept 2018). And, according to UK Finance, 71% of adults use online banks, while 22 million people use mobile banking apps (Sept 2018).

It is hard to imagine that the traditional banks are simply going to ignore online competitors, especially when their only presence will be online as well!

In conclusion, we do think that the banks will be around for a while yet, but it may take some time before they make a worthwhile investment.

 

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