Equity Market : Perspectives of the financial sector

There was a time, before the global financial crisis of 2007-08, when Western banks could offer the sort of return on equity that left other companies in the financials sector trailing in their wake. The regulatory clampdown that followed the near meltdown of the financial system has crimped those returns ever since as banks have been forced to hold more liquid and less leveraged balance sheets and have seen their compliance costs soar. Today, we now need to look elsewhere in the sector when seeking the levels of profitability that can put us in a position to deliver long-term returns investors.

Growing old can pay dividends

One of the most powerful themes driving our stock selection has been that of an ageing global population. By 2050, people aged over 60 are forecast to make up more than 20% of the global population, up from just 11.7% in 2013 [1]. This pool of more than 2 billion people represents an attractive opportunity for financial service companies providing products aimed at this growing number of retirees who need to make their savings work harder as life expectancy continues to rise. Some of the firms best placed to capitalise on this trend include wealth managers, US life companies and Asian asset gatherers.

Much of this retirement money, especially in the West, is finding its way into passively-managed products like tracker funds and ETFs. This investment trend has benefited companies like Blackrock, with its extensive range of passive funds but also firms like the London Stock Exchange or MSCI that provide the indices on which these funds are based.

Thirsty for credit

The big demand for credit in the fast-growing emerging market economies is another potentially interesting avenue that we continue to explore. In a country like India, where the economy grew at a faster-than-expected 5.7% in the second quarter, private banks have been stepping up to meet demand for loans. We favour private banks over the country’s state banks because of their better profitability and access to capital. These banks, unlike many of their Western counterparts, currently provide a high return on equity making them, in our view, good long-term stocks for our portfolio. India, though, is just an example as there are many emerging market countries where the financial services sector remains underdeveloped relative to the needs of the economy.

Taking the “through train”

On a shorter time horizon, there are a number of positives to focus on. The internationalisation of the Chinese financial system is one of these. Hong Kong banks, for instance, are likely to be beneficiaries of an agreement struck last April between the Hong Kong and Chinese governments to allow international investors to trade Shanghai ‘A’ shares via the Hong Kong stock exchange while giving mainland investors the ability to trade Hong Kong ‘H’ shares via the Shanghai Stock Exchange. The agreement, known as the ‘through train’ should be up and running by October. Further potential measures to integrate China into the international markets should offer additional opportunities for the banks.

Banking on the yield curve

Even if Western banks are unlikely to ever replicate the returns they generated prior to the financial crisis, the earnings outlook does appear to be brightening, notably in the US where economic growth is accelerating. US banks have gone further than their counterparts elsewhere when it comes to putting their house in order, cutting costs and generating loan growth. All they need now is to improve their profit margins to boost their return on equity. US banks more than most rely on a steepening yield curve to achieve that feat. An improving US economy should produce the desired effect, delivering a wider spread between the interest paid out to depositors and the rate charged to customers to borrow money. Some of our favourite US banks currently include Citigroup and JP Morgan.

Meanwhile, US consumer spending, such a bellwether for the US economy, should remain on an upward path despite an unexpected drop in July that appears to be temporary given confidence among households hit a seven-year high in August [2]. Rising house prices and an improving job market offer further grounds for optimism. Credit card companies like American Express and Mastercard could be some of the beneficiaries from this improving trend.

Staid Europe

For European banks, the cost of funding has continued to come down, helped by the European Central Bank’s recent decision to cut interest rates to a record low and start buying up asset-backed securities to boost a stagnant euro zone economy. Nevertheless, the return on equity capital remains low, with little prospect, of improvement whilst interest rates remain at current levels and capital requirements high. European banks may see their share prices rally over the next few months and we have taken a position in some of the more undervalued names. However, these stocks are not to our mind buy and hold investments but we view them more as offering up trading opportunities in special situations. In the absence of lending by the banks, small businesses in Europe are increasingly turning to alternative credit providers, such as leasing and invoice financing companies to meet their borrowing needs. This trend is likely to provide opportunities in specialist financing companies.