How does NIRP impact European financials?

With ongoing mentions of negative interest rates policies (NIRP) in the media, we’ve received questions around how these policies may affect the investments in our global funds. Here is a brief look at our view and positioning around NIRP and our investments in Europe.

What is a NIRP?

A NIRP is a rarely used monetary policy tool that sets target interest rates below zero. To employ negative rates, central banks set the rate at which banks can deposit funds – the deposit rate – at a negative level. This results in banks paying the central bank a fee for holding their reserves.

What is the goal of a NIRP?

Negative deposit rates are supposed to complement quantitative easing programs by encouraging large financial institutions to loan money out to consumers, businesses and investors in an effort to stimulate the economy. Negative rates may also lead to currency weakening, which can potentially spur export growth.

What is the impact on banks?

Benchmark interest rates are a key driver for banks, as they influence their net interest margins. The spread between what banks earn on interest earning assets and what they pay for deposits and other sources of funding is called net interest income.

Generally, bank profits improve when the yield curve steepens and interest margins expand. When policy rates turn negative on the other hand, banks have to pay interest on the reserves held with the central bank. In theory, this provides banks with a greater incentive to loan capital to businesses (and receive interest), rather than hold reserves (and pay interest), provided there are adequate lending opportunities.

Negative rates could adversely impact bank profitability in Europe given that banks in the region generally have excess reserves due to weak loan demand and therefore may be unable to reduce reserves under negative rates, causing banks to bear the costs of the negative rate on reserves. Further, negative rates will drive market yields on loans down and given that banks will be reluctant to push rates on many deposit accounts below zero, the banks would then experience further net interest margin compression.

What countries have negative rates?

In June 2014, the European Central Bank (ECB) became the first major central bank to adopt a NIRP (as at March 31, 2016, the deposit rate was at -0.40%). Japan, Sweden, Denmark and Switzerland also have rates below zero. As NIRP use spreads, market participants are becoming increasingly wary over the profitability of financial institutions, which is reflected in the underperformance of the MSCI Europe/Financials Index relative to Trimark Europlus Fund (Sources: FactSet Research Inc. and Morningstar Research Inc., between June 1, 2014 and March 31, 2016).

How is Trimark Europlus Fund positioned?

The Fund’s sector exposure is strictly a by-product of our bottom-up investment approach and where we are finding opportunities at any given time. However, we do tend to be attracted to certain sectors based on our quality focus.

The Fund has consistently held a lower weight in European financials (e.g., banks and insurers) relative to peers, the MSCI Europe Index and market-capitalization weighted ETFs because we believe European financials tend to have lower growth profiles and ROIC along with a tendency to sell undifferentiated products that consumers are unwilling to pay a premium for. Overall, Western European banks and insurers tend to fall short of our measures of a quality business, and we have no qualms about differing from the index in this regard.

As at April 30, 2016, the Fund held 6% in financials versus approximately 20% held in the MSCI Europe Index and 16% in the Morningstar European Equity category average.

Sources: Invesco Canada and Morningstar Research Inc., as at March 31, 2016.

^† Represents the time frame over which the current portfolio management team has managed the Fund. You cannot invest directly in an index. Quartile rankings are comparisons of the performance of a fund to other funds in a particular category and are subject to change monthly. The quartiles divide the data into four equal segments expressed in terms of rank (1, 2, 3 or 4).

Trimark Europlus Fund, Series F provided the following performance returns as at April 30, 2016: 1-year, 2.22%; 3-year, 12.82%; 5-year, 13.20%; and 10-year, 5.46%. The MSCI Europe Index (Net, C$) provided the following performance returns as at April 30, 2016: 1-year, -9.59%; 3-year, 2.64%; 5-year, 1.60%; and 10-year, 2.40%.

Note: Series F is available only to advisors who have signed an Invesco Series F dealer agreement.