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2014 Outlook: Financial Services

Unwrap some of the top themes that we believe are worth considering now.

  • By Chris Lee, Portfolio Manager
  • – 12/18/2013
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Continued penetration of electronic payments

One area of continued growth potential in the financial services sector is the increased use of electronic payment systems. During the past few years, a growing number of U.S. and foreign consumers have used electronic payment methods—credit cards, debit cards, wire transfers, and online banking—for their purchases (see Exhibit 1, below). The migration away from cash toward non-cash, electronic payment mechanisms has also been supported by an evolving demographic mix, because younger generations, which tend to be more comfortable with technology, represent a growing proportion of overall purchase volumes. At the same time, more businesses have adopted systems that will allow them to pay for services electronically, accept payment via electronic funds transfer (EFT), or automate their payroll.

This investment theme is global in nature, and is likely to be driven in part by the expanding middle class in developing countries. In some foreign cultures, there is still a local preference to transact in cash. However, this preference is likely to shift as the banking infrastructure becomes more developed and adoption of consumer technologies, such as smartphones, enables e-payments. The increased use of electronic payment systems can lead to improved efficiency in the flow of goods and services.

Going forward, I expect the increased adoption of electronic payments to continue, particularly in international markets, and it should remain an attractive and durable investment theme.

Regulatory arbitrage

In concert with the ongoing debate around “too big to fail,” many large financial institutions have faced an increasing amount of government regulation and oversight during the past few years (e.g., the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act). The unintended effect of this regulation has been the creation of new market opportunities—and thus pockets of growth—for companies operating outside the financial industry’s regulatory framework that have filled a void in the marketplace. For example, new banking regulations have placed curbs on certain profitable activities previously conducted by investment banks, such as proprietary trading. This has created opportunities for alternative asset management companies to absorb this activity. Not only have these alternatives been able to grow assets quickly, but they have also benefited from talent migration, given more attractive compensation opportunities and fewer regulatory constraints.

Elsewhere, many traditional banks have significantly tightened their lending standards, shutting out borrowers with weaker credit because of their higher risk of potential default. Basel III capital standards1 have made it economically less attractive to hold loans made to riskier borrowers (e.g., subprime borrowers). In addition, constraints on certain fee streams—which in part previously helped to defray the costs of providing bank accounts to smallbalance customers—have pushed many consumers out of the banking system. As a result, the universe of “underbanked” and “unbanked” consumers has expanded dramatically since the 2008 financial crisis, providing growth opportunities to alternative consumer finance lenders and driving innovation in some product areas, such as prepaid cards. The competitive environment is also quite favorable at present given the market void and, in certain cases, industry consolidation of legacy service providers.

Risks: What to watch in 2014

U.S. monetary policy: unwinding QE

One of the key sources of risk for the financial sector in 2014 will come from potential changes in the Federal Reserve’s (Fed’s) monetary policy. The unprecedented volume of asset purchases by the Fed during the past few years (i.e., quantitative easing, or QE)2 was designed to provide liquidity to the financial markets, keep interest rates/bond yields low, and, hopefully, spark increased bank lending and encourage more investors to buy assets further out on the risk spectrum. However, with the U.S. economy seemingly on firmer ground, the focus has shifted to when and how this unprecedented stimulus will be reversed. The installation of a new Fed chairperson at the helm makes the outlook even more unpredictable.

Clearly, engineering the Fed’s ultimate exit from its massive balance sheet will be tricky. It requires the central bank to strike a delicate balance in communicating its intentions while preserving flexibility to act appropriately if economic data points shift unexpectedly. All the while, the central bank will need to be mindful of investors’ expectations given the potential for market disruptions, such as the one that occurred in the spring/summer of 2013, when longer-duration3 bond yields rose sharply in response simply to the prospect of a slowdown in the pace of asset purchases (i.e., “tapering”).

Ultimately, the potential for interest rates to rise, which is typically associated with the unwinding of QE, is a nuanced consideration when thinking through the implications for investing in financial services, bringing with it both positives and negatives.

Positive implications. Higher interest rates would likely benefit banks’ net interest margins (the difference between the rate banks charge when they lend out capital and the interest rate they pay on deposits). Higher rates would also tend to benefit life insurance companies, providing a better match between their assets and liabilities. If the Fed does move to unwind its holdings and increase rates, it would imply that the central bank feels the U.S. economy is strong enough to withstand such moves, which could lead to an increase in risk appetite among investors and potentially trigger a migration from fixed income to equities. If such a shift in investor appetite transpires, it could boost the earnings of certain investment management companies.

Negative implications. On the flip side, higher rates run the risk of slowing, or even reversing, what has been a relatively modest macro recovery so far. Specifically, higher rates would likely lead to less home mortgage lending and less refinancing activity, which could hinder the earnings growth prospects of financial institutions with significant home mortgage lending operations. In addition, investment management companies that focus primarily on fixed income could experience lower revenues, particularly if there is a sharper-than-expected increase in bond yields.

In short, the Fed is essentially in uncharted territory, and how its policies evolve in the coming year or more will likely have significant positive and negative implications for different industries within the financial sector.

Slowing economic growth in emerging markets

A slowdown in economic growth in several emerging markets during 2013 put pressure on the revenues of many global financial institutions, and the state of growth in these markets bears monitoring in 2014. The global nature of the financial sector today means that positive or negative dynamics in one market can influence conditions in several other markets around the world. The U.S. subprime mortgage crisis, a set of event and market conditions that led to a global financial crisis and recession beginning in 2008, is a recent example of the linkage within the global financial system that exists today. Going forward, the economic slowdown in China that took place in 2013 is worth watching because of the country’s influence on the global economy. Many U.S.- and European-based banks either have operations in China or are driven by demand tied to China, and expectations of revenue and earnings growth for these businesses may need to be ratcheted down if the pace of economic growth remains at lower current levels.

Implications of global financial regulatory reform

Momentum behind global regulatory reform remains in place, posing continued risk and uncertainty for many financial services companies. For example, Basel III capital standards and the introduction of leverage constraints—both of which are designed to strengthen banks—may also run the risk of depressing returns relative to historical averages. In addition, the harmonization of global financial regulation remains uneven, and there could be significant competitive advantages and disadvantages to conducting financial business in different countries.

Finally, the unintended consequences of regulation need to be considered. Credit is likely to remain constrained as banks continue to operate in a world of uncertainty, and the risk of market disruption through lower liquidity has risen, which has negative growth implications.

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Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the author and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.
Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.
Past performance is no guarantee of future results.
Neither asset allocation nor diversification ensures a profit or guarantees against a loss.
Because of their narrow focus, investments in one sector tend to be more volatile than investments that diversify across many sectors and companies.
The financials industries are subject to extensive government regulation, can be subject to relatively rapid change due to increasingly blurred distinctions between service segments, and can be significantly affected by availability and cost of capital funds, changes in interest rates, the rate of corporate and consumer debt defaults, and price competition.
In general, the bond market is volatile, and fixed-income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed-income securities also carry inflation, credit, and default risks for both issuers and counterparties.
Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets.
1. Basel III: A global, voluntary regulatory standard on bank capital adequacy, stress testing, and market liquidity risk agreed upon by the members of the Basel Committee on Banking Supervision in 2010–11. This accord was developed in response to the deficiencies in financial regulation made evident by the 2008–09 global financial crisis. The intent of Basel III was to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.
2. The total assets of the Federal Reserve quadrupled from Feb. 2008 to Sep. 2013. Source: Federal Reserve Board, Haver Analytics.
3. Duration is a measure of a security’s price sensitivity to changes in interest rates. Duration differs from maturity in that it considers a security’s interest payments in addition to the amount of time until the security reaches maturity, and also takes into account certain maturity shortening features (e.g., demand features, interest rate resets, and call options) when applicable. Securities with longer durations generally tend to be more sensitive to interest rate changes than securities with shorter durations.
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