International Financials – What’s Behind the Recent Rally
Performance for the MSCI EAFE Financials Index has been characterized by two distinct phases in the first third of the year. Investment Principal Todd Edwards examines the divergence and provides his insights.
Over the course of the first third of the year, International Financials, as measured by the MSCI EAFE Financial index, have witnessed significant performance divergence from the MSCI EAFE. During the first quarter, EAFE Financials lagged the index by roughly 300 bps. Since that time there has been a notable shift as financials have outperformed for the month of April (and are now outperforming the EAFE index year to date).
The following graph shows the Q2 relationship. So far in the second quarter EAFE financials are outperforming the EAFE by a greater magnitude than their underperformance in the first quarter. In ballpark terms, the index is up 2.7%, while the financials are up over 6.2% for the month.
The next graph shows the full year performance comparison and the disappearance of financials underperformance relative to the EAFE.
Interestingly, this shift to financials outperformance began at the same time that the U.S. yield curve briefly inverted (not the whole curve, just the 3mo/10yr). The inversion happened on 3/22 and lasted for 5 days. The turn in the financials started four days later, on the 26th.
Obviously one would be hard-pressed to assert that curve inversion caused financials to outperform. Rather, we believe the financials outperformance and the “esoteric” yield curve inversion have been caused by the same thing: regime change in global monetary policy emanating from the Fed (the inversion reflected more than anything short-term moves to hedge by fixed income investors on the wrong side of the boat).
The Fed’s shift includes a dovish pivot in terms of further rate normalization, shrinkage of the balance sheet, and commentary about accepting higher levels of inflation. Similarly, Fed commentary about shortening the duration of the existing balance sheet has also helped as it points to potential steepening (and Fed dry powder) in the future—in effect, this equates to less buying at the long end and more buying at the short end with steepening the logical outcome. Together, we believe, this constitutes a commitment to support the business cycle, corporate earnings and indirectly, valuations.
There are a variety of interesting confirmations of this shift in behavior:
- Easing financial conditions in the US,
- The same pattern of financials outperformance in the US
- Higher copper prices,
- Improved inflation expectations,
- Rallying global equities
As the following charts on valuations illustrate, expectations are low, and we feel the combination of the Fed (and global) policy pivot + economic green shoots + distressed valuations should support solid performance from the financials for the next couple of quarters. In our view, we are already seeing signs of economic reacceleration in the US and China. Europe and Japan should eventually follow, perhaps aided by further fiscal and monetary stimulus.
Certain information contained in this communication constitutes “forward-looking statements”. Due to market risk and uncertainties, actual events, results or performance may differ materially from that reflected or contemplated in such forward-looking statements. Any characteristics included are for illustrative purposes and accordingly, no assumptions or comparisons should be made based upon these ratios. Statistics/charts may be based upon third-party sources that are deemed to be reliable, however, Cambiar does not guarantee its accuracy or completeness. Past performance is no indication of future results. All material is provided for informational purposes only and there is no guarantee that the opinions expressed herein will be valid beyond the date of this communication.
KBW Index – An index consisting of 24 banking stocks. The constituents of the index represent large U.S. national money center banks, regional banks, and thrift institutions. The KBW Bank Index is a benchmark stock index for the banking sector.
Goldman Sachs Financial Conditions Index – An index that consists of weighted average of riskless interest rates, the exchange rate, equity valuations, and credit spreads, with weights that correspond to the direct impact of each variable on GDP.