On the Local Financial Sector and the Pandemic | Barita Insights | June 7, 2021

Background

Throughout the COVID-19 pandemic, the performance of many companies has been altered considerably – some have benefited immensely while others have faltered. In aggregate, the stock market has not only “priced in” the financial performance of these companies, but the uncertainties surrounding their trajectory. Notwithstanding, after 15 months of the “new normal”, uncertainty has somewhat dimmed and many companies have learned to maneuver within the new circumstances and in some cases, even thrive. The Junior Market, for instance, which is Jamaica’s marker for the performance of small-cap stocks has appreciated by 26.3% since the start of 2021; thereby returning to its pre-pandemic range. Noteworthy, however, average volumes traded remain below the 2019 period by 24.5%, signaling that a fairly sizable share of the investment community remains on the sidelines, despite the rebound. Further to this point, the overall market remains subdued (down approximately 15.6% relative to its pre-pandemic level), largely on account of the financial sector which represents the majority of the market’s capitalization. This performance has been within the context of a weak economic backdrop, constrained by the pandemic. However, with the expectation of a more buoyant economy going forward, it’s important to determine if the financial sector has untapped value to be unearthed by investors.

The Strength of the Financial Sector

According to the Bank of Jamaica’s (BoJ’s) March 2021 Quarterly Monetary Policy Report, “The financial system has remained generally resilient throughout the pandemic.”. Consistent with this statement, the Aggregate Financial Stability Index (AFSI) demonstrated improvements, increasing to 0.51 at the end of the September 2020 quarter, from 0.46 at the end of June. As it relates to the commercial banks, the main area that has shown some weakness relates to asset quality wherein Non-Performing Loans (NPLs) as a percent of gross assets has increased to 1.4% as at March 2021 relative to 1.1% pre-pandemic (Dec 31, 2019). Notwithstanding, liquidity has remained elevated with the ratio of average liquid assets as a percent of average prescribed liabilities strengthening to 27.2% as at March 2021 relative to the pre-pandemic level of 25.7%. Further, as at March 2021, Capital Adequacy remains in line with its pre-pandemic level at 13.6%, despite the effects of the pandemic.

Pre-empting the Market

A strengthening of the financial sector sets the stage for more robust earnings performance, which is what drives markets. Already, the aggregate data suggests an improvement is underway with pre-tax profit margin for the March 2021 quarter amounting to 14.88% for commercial banks, ahead of the 2020 calendar year’s 11.00%, as reported by the BoJ. Further, in the June and September 2020 quarters, pre-tax profit margin fell to 7.52% and -0.82%, respectively. Benchmarking against these two quarters implies that the profitability over the upcoming June and September 2021 quarters should be more robust, supported by an improving economy. Now, herein lies the opportunity –for comparison purposes, if we take an international perspective, we notice that stock markets in developed nations are typically touted as a “discounting mechanism”; a phrase that sums up the nature of market participants to pre-empt earnings. As such, prices typically move before earnings – rarely after. Broadly speaking, this is lacking in our local market as investors seem to position on lagging data which, creates obvious winners and losers, depending on who buys first or last, which is a flaw. Furthermore, if we consider the current pricing, Financials are priced at an average P/E and P/B of 18.5x and 1.7x, respectively. This compares favorably to the Manufacturing sector that is priced at an average P/E and P/B of 30.8x and 4.4x, respectively, suggesting that financials are cheaper. With that said, by pre-empting the market as is done overseas, an intelligent investor could gain far more.

Cyclicality in a Recovery – International Perspective

Continuing with the international comparison, at this stage, the United States has new daily COVID-19 cases averaging 14,124 per week, in line with March 2020, long before the pandemic became dire. It’s important to highlight this because the US is now at the initial stages of its economic recovery, fuelled by its vaccination efforts coupled with strong fiscal and monetary policy intervention. Importantly, the result has been rapid growth in the financial sector. Specifically, since the start of 2021, the S&P’s financial sector has grown by 30.04%, second only to the energy sector. Why does this matter? Well, we believe this could also transpire in Jamaica on the back of an economic recovery. Essentially, while most companies benefit from an economic recovery, the financial sector benefits far more due to its cyclicality. This expectation for a recovery is further enhanced by the GoJ’s own efforts to catalyze growth through the SERVE programme which should inject$60 billion into the economy, $31.1 billion of which will be targeted towards growth-inducing infrastructure programmes.

Concluding Thoughts – The stage of the Recovery

Based on the BoJ’s forecast, real GDP is estimated to have contracted in the range of 5% – 7% in the March 2021 quarter, markedly better than the three previous quarters. The bank projects that following this contraction, the economy should rebound in subsequent quarters. Consequently, for FY2021/22, the BoJ projects real GDP growth in the range of 5% – 8% and a return to pre-pandemic real GDP by the March 2022 quarter. This indicates that, barring any material adverse event such as a catastrophic hurricane, Jamaica is on the cusp of an upward growth trajectory. Within that vein, the economic recovery should serve to improve the performance of the financial sector. Similarly, the underlying risks that have persisted such as slightly elevated NPLs, should be tempered within this economic backdrop. Along those lines, we believe a pre-emptive addition of financial services stocks to an investor’s portfolio is beneficial, ahead of the economic recovery.