After producing a market-beating 35% return in 2013, stocks in the financials sector have cooled this year, even more than the market has overall.
Regulatory issues, low rates, and low volatility have been holding back earnings at some companies in the financials sector. But these issues could also create pockets of opportunity for investors. Fidelity Portfolio Manager and Sector Leader Chris Lee is looking for companies where today’s valuations will give him an edge if rates or volatility pick back up, including large-cap banks, asset managers, and financial exchanges. He is also looking for the beneficiaries of new regulations, including alternative asset managers who may be benefiting from changes in lending and trading as investment banks change their business models.
What has happened to stocks in the financials sector this year?
Lee: Bank stocks have basically been stuck in neutral. I think the issues are similar to what they have been in the recent past—regulatory overhang, negative headlines, and fairly lackluster earnings. A lot of the large-cap banks have trading operations that have suffered due to rule changes and declining volatility. And the rate environment has surprised people. I think the conventional wisdom at the outset of the year was that rates would rise, given the apparent strength of the U.S. recovery, but in fact rates have fallen. Falling rates are generally bad for bank earnings.
Somewhat paradoxically, performance leadership in the group has come from companies that have rate-sensitive businesses, including online brokers, trust and custody banks, and some regional banks. In these instances, the market seems to be anticipating that higher rates will benefit these companies, and the market has bid them up. Money managers have benefited from rising asset prices as well.
You mentioned the impact of a regulatory overhang on banks. What does that mean for investors?
Lee: For large banks, a new annual stress test is now the main determinant of whether regulators will allow the big banks to increase capital return in the form of higher dividends or stock buybacks. After this year’s test, it looks like regulators are inching permission slightly higher, but the spigot hasn’t opened.
From an investment standpoint, the consensus view seems to be that payouts won’t rise, or at least not significantly. I think this remains an area of opportunity. The banks are very profitable and they are already above the newly regulated minimum capital levels—in fact the big banks are probably better capitalized than they have been in more than 30 years. At the same time, payouts are below historic averages. So the case for rising dividend payouts continues to build. But to me, stock prices suggest investors think payouts won’t go up. I think that’s where the arbitrage may be—you buy a stock priced for today’s payouts, and if it does go up, maybe you benefit (see charts below).
Are other parts of the financials sector benefiting from these regulatory changes?
Lee: A second-order effect of regulation is that it’s caused a lot of activity to move out of the banks. Since the crisis, banks have largely avoided loans to anyone with lower credit, both because the capital rules really penalize them for making those types of loans and for fear of negative publicity. So the lending has moved to business development companies, commercial REITS, and some specialized lenders.
New regulations have also been the catalyst for the movement of proprietary trading from the investment banks to less regulated entities, including alternative asset managers. So, after the Volcker rule, for example, traders that used to do proprietary trading at Goldman Sachs or other investment banks could face new constraints, and some headed to alternative asset managers like Blackstone (BX). These alternative platforms have seen outsized growth while the trading platforms at banks have been shrinking. Investing in the potential beneficiaries of the shift is a form of regulatory arbitrage, and that’s a theme I continue to like.
Are there other reasons to think big banks may make attractive investments now?
Lee: There are other areas of optionality, including the potential for higher rates and increased trading revenue. Higher interest rates benefit revenues, profitability, and therefore earnings for banks. I think companies are trading at valuations that suggest higher rate scenarios are highly unlikely. That means there is limited downside if rates stay low, but potential upside if you think rates will rise.
At the same time, the outlook for the trading operations at the banks is being debated. First of all, volatility has been very low. Whether you’re looking at equities or other asset classes, volatility is anywhere between 10- and 30-year lows. Could things pick up? Historically, there has been a correlation between rising economic growth, trading volumes, and volatility. That relationship has broken down this cycle. But the potential for convergence in trend doesn’t seem to be priced into the stock.
Another school of thought says that bank trading operations have experienced a structural change—that new regulations mean that earnings from trading won’t return to higher levels.
From an investment implication standpoint, I look at where those stocks are being priced and think the market has adopted the thesis that it’s structural. But I don’t buy into the idea completely. That presents an opportunity to benefit if volatility rebounds.
In this environment, my focus is generally to look for higher-quality companies trading at valuation discounts. A company like JPMorgan (JPM) really captures a lot of those kinds of attributes. It’s a high-quality business that has compounded value over the past 20 years at a rate well above the peer group, and it could benefit from a lot of these things that we’ve talked about.
What other parts of the financials sector could benefit if rates and volatility tick up?
Lee: Financial exchanges have a very attractive business model with high barriers to entry, recurring revenues, and strong free-cash-flow characteristics. These stocks might benefit if trading volume and volatility picks up. Low volatility has hurt earnings, but if you normalize volatility back to average historical conditions, today’s valuations seem attractive to me.
Regulation has also migrated some trading activity, in certain instruments such as derivatives, onto exchanges. The exchanges may also benefit as investment banks need to move some of their activities onto exchanges. That means earnings could see an outsized recovery if trading picks back up.
Another spot to watch is the asset managers. These companies have been benefiting from the reflation of asset prices, and have what I think are the best business models in the industry.
What are the risks?
Lee: The bear case on banks is stagflation or even deflation, where rates stay low for a very long time. So we’ve gotten a whiff of inflation with higher gas prices and rents, but wage inflation has been more stable. That suggests there’s still some slack in the employment market, though there is some evidence that it is starting to turn. If that slack never gets pulled tight, the Fed may hold off on further tapering, or go the other way and reaccelerate stimulus. The risk is that they have inflated asset prices too many times, it doesn’t work anymore, and we end up in a recession.
But I don’t subscribe to that view. I think there’s way too much scrutiny around the pace of the recovery. People get excited when things pick up, and then people get disappointed when things slow down. Parsing signal from noise, I continue to expect a modestly improving economy that keeps grinding higher. My central view is that the recovery is a bit more self-sustaining than it has been getting credit for.
What should investors be watching?
Lee: One of the prevailing risks is the uncertainty around the unintended consequences of this prolonged period of low rates and quantitative easing. I think it’s created a lot of appeal for investments that provide yield. If you look at historical valuations of REITs, high yields, leveraged loans, and even some sovereign debt, they are puzzling. For instance, I am underweight REITs because of the valuations, which I consider high.
My suspicion is that if we have a conversation five years from now, the buildup of risk in income-producing assets driven by low rates will have left a mark in a couple of areas that maybe we haven’t recognized yet. What is clear is that it is creating pools of risk out there and investors need to be wary.
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