Financials: Looking for winners in choppy markets

Slow growth, low rates, and heightened regulation mean it is time to be selective within the financials sector.

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Today’s environment is tricky for financial stocks, which face low interest rates, tepid economic growth, and tight regulations. Viewpoints spoke with Chris Lee, manager of Fidelity® Select Financial Services Portfolio (FIDSX), to ask about his outlook for the sector. His message: The market for financial stocks looks likely to get choppier—and its returns ultimately will depend on the direction and performance of the economy.

What is your outlook for financial services?

Lee: Three main factors inform my outlook—economic growth, credit losses, and interest rates. On the economy, there are indications that the cycle is getting a little long in the tooth. In other words, we are in an extended mid-cycle and are entering the late part of the cycle. I’m not calling for a major deceleration in growth, but I think the growth rate is likely to soften from here, as is typical in the late cycle. The credit cycle has been a bright spot, as commercial and consumer loss rates have fallen from very elevated levels during the financial crisis to near all-time lows today. I don’t expect credit losses to climb rapidly anytime soon, but, again, this factor is likely to get somewhat worse before it gets better, given conditions today are essentially what I consider “as good as it gets.”

Interest rates have obviously been in a downtrend globally—and I think any increase in rates would be positive for most parts of the financial sector. Conventional wisdom remains that rates will rise eventually, but we don’t know when or by how much. So, combine that uncertainty with the prospect of weaker economic growth and tightening credit, and the overall environment for financials looks a bit choppy to me.

The key factor in my opinion is economic growth, because it affects the other two: If GDP growth slows, rates won’t rise much and access to credit will get worse.

As of September 1, real estate, formerly part of financials, was broken out into its own sector. How does the change affect the remaining financial sector?

Lee: The newly defined financial services sector will be narrower than before. With the exclusion of real estate, I expect slightly lower yields and slightly higher volatility. The sector could be a bit more cyclical, because it will have lost the influence of REITs (real estate investment trusts), which have historically been countercyclical. At the same time, any increase in rates should have a marginally greater—and likely positive—impact.

How much is the current regulatory environment affecting the sector?

Lee: Regulatory concerns continue to weigh on sentiment. The regulatory environment remains intense, but I don’t think it’s getting any more severe; however, it’s hard to say how long the current climate will last. One well-known bank CEO aptly described it as a baseball game where we’re in the seventh inning, but not sure how long the game will be.

Regulatory developments have been especially profound for larger banks. Banks classified as global and systemically important (GSIBs) have been forced to hold effectively twice as much capital on their balance sheets, which limits their ability to grow, make loans, and take risks. At the same time, large banks have incurred tremendous regulatory and compliance costs, which naturally eat into profits.

Another effect of the new rules is that brokers are holding less inventory—stocks and bonds that the brokerage companies buy in their own accounts and make available to customers. That has restricted liquidity for all markets, including equities, Treasuries, and corporate credit.

How might the upcoming election affect the environment for financial stocks?

Lee: There is a growing populist drumbeat, not just in the United States but globally, and that connects to bank regulation. In fact, continued pressure on the banks is an area of common ground for the two candidates.

For example, both parties are talking about possibly reintroducing the Glass-Steagall Act. Setting aside the merits of that proposal, I think it could be disruptive for the economy and the banking system in general. More broadly, the trend toward populism suggests that regulatory pressure on the sector isn’t going to ease anytime soon.

I don’t think one candidate is clearly better or worse for financial companies. Ultimately, the next president will affect the sector mainly by the way his or her policies affect economic growth.

How is financial technology changing the sector?

Lee: I think the first question to ask is “To what extent will new technology disrupt existing processes?” It doesn’t get a lot of press, but the banks themselves are some of the biggest and most aggressive adopters of financial technology. Banks are establishing virtual infrastructures, using mobile applications, and expanding their online functionality. At the same time, they are rationalizing the physical bank infrastructure by reducing the number and square footage of branches and increasing the use of automation in place of direct help by customer service representatives. I think these trends are going to produce some winners and losers in the traditional banking space. The bigger banks may be at a slight advantage, because they have the resources to invest and can amortize the costs of these investments over a larger customer base.

The next important question is “How will the arrival of online and other nontraditional lenders change the sector?” I have been a little skeptical that new technologies are fundamentally changing the business. Some nontraditional lenders came out in the past year with a lot of fanfare that they were disrupting the banking business, but their models at the core look quite similar to traditional banking and lending institutions. Lending is lending and underwriting is underwriting, regardless of how you interact with customers or deliver services. That said, these new players are bringing innovation in terms of customer delivery mechanisms and new product features, so we’re keeping an eye on them.

How are you approaching the sector today?

Lee: As I said earlier, I expect returns in the financial sector to be fairly choppy. Given that expectation, I think it’s important to seek out businesses that have durable earnings growth and can sustain high return on equity. As a result, my fund is focused on relatively high-quality companies. That’s an extension of my overall approach to financials. The key to financials, in my opinion, is to compound consistent, albeit sometimes unexciting, returns over time—but the most important thing is to try to avoid the big losses. I believe active management can add value, particularly when markets are more volatile.

I’m currently emphasizing defensive positions such as property and casualty insurers and insurance brokers. I also like shares of companies that are less dependent on macroeconomic growth. For example, I think credit card processors could benefit as more people shift from cash to electronic and mobile payments. Conversely, I am being careful with companies that are very credit sensitive and firms that are tightly linked to the economic cycle.

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Before investing, consider the investment objectives, risks, charges, and expenses of the fund, exchange-traded fund, or annuity and its investment options. Call or write to Fidelity or visit Fidelity.com for a prospectus, or if available, a summary containing this information. Read it carefully.
Christopher Lee is a portfolio manager and research analyst for Fidelity Investments. He currently manages several financial sector portfolios and subportfolios. Mr. Lee is responsible for covering global investment bank and universal bank stocks within the financial sector. He joined Fidelity in 2004.
Views expressed are as of September 29, 2016, 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.
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