March continued to put markets into flux with news of SVB collapsing and Credit Suisse being taken over. There was some reprieve locally at the start of April with rates going on hold - so can this be a sign financial contagion fears have entered the system?
This month Paul breaks down contagion risks to Australian banks, his view on April’s rate announcement and where he’s finding bright spots in financials.
This episode was recorded 11 April 2023.
All information is current as at its published date unless otherwise stated.
This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (‘Fidelity Australia’). Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity International. Prior to making any investment decision, investors should consider seeking independent legal, taxation, financial or other relevant professional advice. This document is intended as general information only and has been prepared without taking into account any person’s objectives, financial situation or needs. You should also consider the relevant Product Disclosure Statements (‘PDS’) for any Fidelity Australia product mentioned in this document before making any decision about whether to acquire the product. The PDS can be obtained by contacting Fidelity Australia on 1800 044 922 or by downloading it from our website at www.fidelity.com.au. The relevant Target Market Determination (TMD) is available via www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated about specific securities may change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. You should consider these matters and seeking professional advice before acting on any information. Any forward-looking statements, opinions, projections and estimates in this document may be based on market conditions, beliefs, expectations, assumptions, interpretations, circumstances and contingencies which can change without notice, and may not be correct. Any forward-looking statements are provided as a general guide only and there can be no assurance that actual results or outcomes will not be unfavourable, worse than or materially different to those indicated by these forward-looking statements. Any graphs, examples or case studies included are for illustrative purposes only and may be specific to the context and circumstances and based on specific factual and other assumptions. They are not and do not represent forecasts or guides regarding future returns or any other future matters and are not intended to be considered in a broader context. While the information contained in this document has been prepared with reasonable care, to the maximum extent permitted by law, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. Past performance information provided in this document is not a reliable indicator of future performance. The document may not be reproduced, transmitted or otherwise made available without the prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is Fidelity Australia.
© 2024 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity International and the Fidelity International logo and F symbol are trademarks of FIL Limited.
Andrew
Welcome to Fidelity Soundbites, a straight to the point monthly podcast where you will learn from some of Australia's leading portfolio managers on what's happening in markets, how they're positioning their portfolios and the outlook ahead. I'm your host, Andrew Dowling, and in this episode, Paul Taylor shares his insights on some of the key events in March at both a local and global level, and we'll also explore risk correctly priced in markets.
Now Paul, welcome and thank you for joining us again.
Paul
Andrew, great to be here as always. Great to talk to you.
Andrew
Another interesting month beckons again and we've certainly experienced some fairly unusual events in global markets, particularly in the banking sector with the failure of Silicon Valley Bank and Signature Bank failing. Then it was literally beware the Ides of March with Credit Swisse collapsing then swiftly acquired by UBS. Do you think there's a possibility of financial contagion hitting our shores?
Paul (01:44.470)
Yeah, Andrew, first of all, it was a really interesting start to the year and a fascinating March. I think it's really, you know, this is when markets are, you know, at their most interesting. You know, financial contagion, I don't think Australia is immune to financial contagion, but I think our banks are in an incredibly strong position. I think that's the first point to make. If you look at what happened in the US market, if we compare it, is a very fragmented market. Lots of little community banks and small regional banks. The big banks don't really dominate like they do in Australia. So in Australia, we've got a very concentrated market, not a lot of regional or smaller banks, highly regulated market in Australia as well. So if I look at the US and what went wrong, it was really the rise, very aggressive rise of interest rates that caught Silicon Valley Bank out. As those rates rose, the assets, the bonds that they bought at the peak of the bond value and I guess the lowest level of interest rates back in 2021, they significantly deteriorated through 2022 and into 2023. Now, because of the regulation in the US also, so the smaller banks are regulated differently from the large banks in the US, and there was an exclusion put in place that the smaller banks didn't have to mark to market on any of those held to maturity bonds. Now the big issue in Australia is that for regulatory capital, the Australian banks do have to mark to market any of their securities as well, so that they're completely on top of where their position is. Whereas in the US, because they were held to maturity, they didn't have to revalue them until they started selling them. And then they tried to do a capital raise, because they basically wiped out their capital because of the significant move in those bonds. And they tried to do a capital raise and that failed. So that put them in a really tough position. I think when interest rates do rise aggressively, like we saw in the US, it does expose poor management decisions, weak business models, weakened companies. And they become very vulnerable in that environment. That's what we saw SVB and Signature Bank. They had poor management decisions, they really weren't doing what they should be doing. Even groups like Credit Suisse they had got caught up in a range of scandals, probably also a bit of mismanagement and then forced into the tie-up with UBS as well. So I think it’s a very different scenario to what we have in Australia. As I said, we have, banks in Australia have some of the highest regulatory capital in the world, highly rated banks, some of the highest credit ratings in the world, very strong balance sheets, and just a better system that's in place. And, like I said, not the same number of small regional community banks as well. So much better position, but now, that doesn't mean that you're immune to any financial contagion. But it does mean that Australian banks are in a much stronger position to withstand any issues within the financial markets.
Andrew
Reassuring to hear, Paul. Back to staying in locally, there was a welcome pause on rates by the RBA for April. What does that now mean for markets and what's your view on how that plays out from here?
Paul
Yeah, that was an interesting decision. And I think it also showed you that now, I mean, we're at 3.6%, the RBA could continue to increase interest rates, but it just means now that it's more balanced, the argument is more balanced. I think SVB and Signature Bank and potential financial contagion played into that, at least the RBA probably wanted just to wait and see. I think we are at an interesting point where we started to get some of that global volatility come through. And I think it's just probably sensible to wait and see and watch what happens in markets rather than to continue to push it. Inflation is still elevated but it's coming down. So once again we're in a better position on that side of things. There is a bit more pain coming. Once again, consumer activity, consumer sales are coming down as well. They're still once again elevated but they are declining. So things are heading in the right direction. Whether it's the end of more interest rate hikes in Australia or not, I think that's still undecided. But it probably is the right time to pause. You know, risk-free rates now in Australia are somewhere between 3% and 4%, that's a much more sustainable, reasonable level going forward. I think the RBA will base any decisions on data. So they'll just follow and they'll indicate where the data is heading and they'll follow that. And I think also how the volatility of markets plays out because of SVB and Signature Bank and Credit Suisse, etc. They'll just wait and see, which is, I think, exactly the right thing to do.
Andrew
Right. Yeah, that's, it's certainly a welcome relief for a lot of people in terms of where rates are currently sitting, if they're not going further. But we’ll see.
Paul, prior to returning to Australia to establish the Australian equities fund 20 years ago, you were based in our London office, you were based in our London office. You were leading the Fidelity's global financial research, also managing Fidelity's Global Financial Services Fund. What did that experience teach you in light of recent events? I mean, we've had these financial ups and downs over the years. Certainly you've seen a lot for your career. What does that mean and what does the outlook?
Paul
Yeah, Andrew, that has really helped me through a whole range of different periods. So even if you go back to the global financial crisis, I think having that background and that experience with those companies really put me in a strong position. But fundamentally, as the equity analyst on banks, I spent a lot of time with my fixed income counterparts. Now, people might know that Fidelity is a very large equity investor, but we're also a very large fixed income investor. I think that's probably less well-known in markets. And we were a funder of a lot of the Australian banks. And actually, as the equity analyst spending time with my fixed-income counterparts, getting to know my fixed income counterparts because they're incredibly important in financial services. So, you know, the Treasurer of banks get their funding from a whole range of different sources, mainly from the fixed income market. Now, as I went into the GFC, I was spending a lot of time talking with our fixed income colleagues who were helping me come to grips with as the commercial paper market was closing and there were significant ructions in those markets, that really helped us get ahead of the game in the global financial crisis. Now that's also having those links and understanding the fixed income markets, understanding balance sheets. Anthony Bolton who was one of our very senior portfolio managers in London, and you know I learnt an incredible amount from Anthony. He'd always say equity investors are great at the profit and loss, but it's fixed income, but it's fixed income investors who know the balance sheet best, because that's what they're focused on. And I think that's a really important lesson. And that's one I've taken through the whole time, that you really need to spend a lot of time on the balance sheet and having those linkages to our fixed income analysts, or our private credit analysts, I think is really important in these sort of periods. And it gives you a much better holistic view on a company and where markets are closed. What's happening in all these different listed, unlisted markets? What's closed? What's open? What's the fixed income investors view of Australian banks or different institutions around the world? So look, that is an invaluable linkage and an invaluable bit of information when you're looking at these sort of companies, especially in tough periods or uncertain periods, I should say, whether it's the GFC or this most recent potential contagion from SVB and Signature Bank.
Andrew
So Paul, given our conversation on banks, how are you currently positioned for financials?
Paul
So in financials we are underweight banks, we are underweight real estate, but we're overweight insurance. We really think insurance is the standout within the financial sector. I am underweight banks, but it's not as though I'm very nervous about the Australian banks in the current environment. Like I said, we think Australian banks are still incredibly well positioned and in the best position to get through any of this sort of potential contagion. But it's just that they probably moved from the environment where they had a tailwind to increasingly we're seeing longer term headwinds.
Now as interest rates have gone up, that has improved their net interest margin because banks effectively ride the yield curve. They borrow short, lend long. But the other thing that happens as interest rates go up, initially you get the benefit from the net interest margin, which improves their income. But what happens in the longer term is that you start to see loan loss provisions increase because interest rates will start to have a negative impact on the broader economy and potentially more bankruptcies which negatively impact the banks. So I think in the longer term, we're going to see more of a headwind.
We do prefer insurance because we're actually in a strong premium rates cycle at the moment. I'm sure everyone's seen their home insurance rates go up, their car insurance rates go up. So the insurance companies are actually well positioned and relatively cheap as well.
But within the banks while we are underweight, we are overweight CBA. We think CBA is a standout bank within the sector. Stand out from a quality franchise, strength of balance, strength of balance sheet, attractive positioning. And also we think it's got the best technology platform. So increasingly also in the longer term, probably the banks will come under more challenge from technology companies, rather than necessarily other banks. And CBA is probably in the best position to withstand that technology challenge given their existing platform. So underweight banks, CBA is our preferred play. Underweight real estate, but really the preferred play within financial services is the insurance sector.
Andrew
So Paul, so with all the different forms of risk facing us at the moment as we look across markets, how are you taking that all in and how are you thinking about your portfolio?
Paul
Andrew, it's a very good point. It's actually something, a concept I've been thinking a lot about more recently. And it's really, you know, it's sort of a longer term, it's actually sort of stepping back and thinking a little bit more about the longer term. It's like we seem to be faced with so many risks at the moment. We've got increased geopolitical risks. We've got increased interest rate inflation risk. Potential recession risk, increased taxation, increased regulation. There's a lot of things to worry about, but the interesting thing is actually, when I think about my job, my job really is not to eliminate risk from the portfolio. In fact, often it's to take risk. But my job really is to correctly price risk. So take risk, but take it at the right price. And I think the interesting thing at the moment is that as more and more risk enter into the market and markets being impacted or it's getting priced into markets, it actually makes the longer term more interesting. So while there's a lot to worry about in the short term, I'm getting more excited about the longer term. And what we find from history is that when there is a lot of risks that have entered markets, they tend to, at that time, it tends to offer, the market tends to offer the best expected longer term returns as well. So they're getting priced in. And I always think investing in markets, equity markets, you know, that should be about the next five, seven, probably next 10 years. You know, if you need the cash in 12 months time or even three years time, equity markets are probably not the right place to be putting your money. But if it's for the long term, that's, you know, you should be, that's a great opportunity is investing in the equity markets. And at the moment with all the risks, I think it's really interesting that it's almost providing us with much better longer term expected returns. So I just think it's an interesting concept that a lot to worry about, but that actually provides the opportunity.
Andrew
Fantastic, thank you Paul. Thanks again for joining us this month. We certainly appreciate it. And for those, if you've enjoyed this episode, please share it with a friend and subscribe to the podcast by your favorite streaming platform. And we look forward to having you join us next month. Thanks, Paul.
Paul
Thanks. Great to talk to you
Disclaimer
Some important information on today's podcast. This podcast is issued by FIL responsible entity Australia limited AFSL number 409340. This podcast is intended as general information only and has been prepared without taking into account any person's objectives, financial situation or needs. You should consider the Product Disclosure Statement and target market determinations for Fidelity Australia products at fidelity.com.au. Please click the link in the show’s description to read the full disclaimer.
