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Thursday, September 17, 2020

US Banks vs UK Banks

By Century Financial in 'Investment Insights'

US Banks vs UK Banks
Microsoft 3 Month Accumulator with Partial Knock Out

*This performance is only observed with historical backtests and not traded by the company.

Equity market across the globe, especially the US, has staged a strong come-back from their March lows as the Central banks pumped ample liquidity into the markets and the economic activity continued to gain traction. However, one sector which is still in deep losses is the banking sector. The near-zero interest rates in the US and as a matter of fact, negative rates in other parts of the world have seen banking stocks plunge drastically this year. The median U.S. banking stock is down close to 30% for the year, and many international banks are posting steeper losses.

With attractive valuations on one hand and lower for longer interest rates on the other hand, investing in banking stocks can be a tricky decision for investors. In the current perplexing environment, pair trading strategy can allow investors to participate in the market and keep a check on the losses.

However, it is important to note that Trading pairs is not a risk-free strategy. The difficulty comes when prices of the two securities move contrary to the positions taken resulting in losses. Thus, it is important to adhere to strict risk management rules when dealing with such adverse situations.

| Strategy

This year the US banks have seen a much better recovery from the March lows than has been the case for its UK and European counterparts. This has probably been a result of rebound in US economic data, and most importantly because US banks operate in a positive interest rate environment, and also have sizeable fixed income and trading operations, which are able to supplement for the tighter margins of general retail banking. Besides US banks have also taken more aggressive steps to strengthen their balance sheets against large levels of loan defaults.

On the other hand, UK banks have underperformed, given Bank of England’s refusal to rule out negative rates, which has pushed down and flattened the yield curve further eroding the ability of banks to generate a return in their everyday retail operations. Meanwhile, Brexit uncertainty has compounded the misery of the UK stocks.

The figures in the table have been derived by undertaking long positions the US banks share basket while simultaneously shorting the UK banks share basket with equal exposure on both sides. Barring one year, US banks have outperformed UK banks in every other year since 2010 with the total return being 125% and average return being 11.5%.

With all the uncertainty surrounding the Brexit drama and with US interest rates unlikely to drop into the negative territory, US banks are expected to continue to outperform the UK banks.

Max drawdown
Year US Banks share basket Return UK Banks share basket Return Long US Banks Short UK Banks Naked US Banks share basket Naked UK Banks share basket Pair strategy Long US Banks Short UK Banks
2010 24% 16% 7%
2011 -23% -36% 13% 23% 36% 0%
2012 31% 47% -16% 0% 0% 16%
2013 39% 18% 21% 0% 0% 0%
2014 7% -5% 12% 0% 5% 0%
2015 -1% -17% 16% 1% 22% 0%
2016 31% 5% 25% 0% 16% 0%
2017 15% 11% 4% 0% 5% 0%
2018 -19% -22% 3% 19% 27% 0%
2019 32% 11% 21% 0% 16% 0%
YTD -32% -49% 17% 32% 65% 0%
Sum 125%
Average 11.5%

The above table is for illustrative purpose only

Note: The strategy has been back-tested on the constituent weights as on 31st Dec 2019 and hence the results are subject to backfill bias and selection bias. Besides, data for few stocks were not available from the start as they were not listed and, in such instances, their weights have been distributed among other stocks on a weighted average basis.

Past performance is not indicative of and does not guarantee future results. Trading in markets may involve loss of capital.

Data Source: Bloomberg

Arun Leslie John
Chief Market Analyst

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