Financial Services: Accounting for Brexit and the Fiduciary Rule

• The financial services sector remains reasonably undervalued and recently traded at a market-cap-weighted price to fair value estimate ratio of 0.88.
• We see Brexit as having negative implications for the U.K. economy and bank moats. We are currently reviewing our fair value estimates and economic moat ratings for affected financials.
• We believe that Brexit effects on interest rates, currency exchange rates, asset price levels, and capital market volatility will likely be more material to capital-markets firm earnings than the potential disruption caused by relocating operations out of the United Kingdom to other European Union countries.
• In terms of advised retirement assets, we initially estimated that the fiduciary rule primarily affected $3 trillion of advised, commission-based IRA assets. In addition to the $3 trillion of IRA assets, we further estimate that advice services are being offered to approximately $4 trillion of private, defined-contribution-plan-participant assets, and there are upward of $800 billion of plan assets that are using advice and could be subject to the rule.
• In regards to product and service offering, we continue to see the acceleration of three key wealth management trends--a move to fee-based from commission-based accounts, increased usage of digital advice offerings, and a shift to more passive investment products from actively managed.

We're Scrutinizing European Bank Moats and Near-Term Forecasts in Light of Brexit

The Brexit vote will have wide-reaching implications for our European financials coverage universe. We plan to lower the fair value estimates for several U.K. banks such as

We do expect the U.K. system and the broader European Union to experience substantial uncertainty and volatility going forward, as the U.K. seeks to renegotiate trade agreements with other countries, unwind other legal agreements with the EU over the next several years, and deal with the political aftermath of Prime Minister David Cameron's resignation. We also now see the strong possibility of Scotland seeking independence, causing further turmoil to the overall system, particularly the Edinburgh-based banks Lloyds and Royal Bank of Scotland, which may need to re-domicile. Although the impact of Brexit is far reaching, we do see an undervalued opportunity with

There are several fairly immediate considerations for banks. We would expect to see higher funding costs for U.K. banks, sharply lower loan growth (as we expect anywhere between a 3%-6% impact to U.K. GDP), and a significant drop-off (potentially 40%-50%) in investment banking fees. Asset management and trading operations will be impacted by the stock, bond, and currency volatility, and we expect trading losses as well as lower asset management fees.

Foreign banks, such as

Our impression on Brexit for U.S.-based capital market-related companies is that their earnings may be more affected by the knock-on macro effects of Brexit than the future operational disruption. Based on our current understanding, a relatively simple response to Brexit is for institutions to open a subsidiary in the EU to continue enjoying trade privileges similar to the ones in the United Kingdom. Some additional capital may be locked up for regulatory requirements, and duplicative expenses will be incurred, but overall we don't expect it to be material.

More material to near- to intermediate-term earnings will be Brexit effects on macro factors. Global uncertainty shifts central bank policy to a more accommodative stance. Firms leveraged to rate hikes, such as retail brokerages, may have to wait longer to receive earnings boosts. Companies with material earnings denominated in European currencies will have EPS-depressing translation effects--25% of

Wealth and asset management firms that bill based on client asset levels will also have their fortunes affected by any decrease in asset prices and assets denominated in foreign currencies. Volatility will increase trading volumes, definitely helping trading platforms such as the financial exchanges, while having a somewhat mixed effect on brokerages that will have higher trading volumes potentially offset by valuation marks on their trading inventories. Continued capital market volatility will also dampen underwriting and advisory revenues.

In regards to the Deutsche Boerse and the

), unless the merger is restructured, we think it is less likely to go through, and we are dropping our assumed chance of the deal happening to 25% from 50%. While management teams from both companies have said they are moving ahead with the deal and presumably had considered the Brexit possibility in behind-the-scenes negotiations, we think it will be more difficult to obtain regulatory approval for the deal from Germany and the European Union. We also think increased uncertainty tends to decrease shareholder enthusiasm, and the latest turn of events is likely to be no exception.

The U.S.-based asset managers we cover are not quite as exposed as firms based in the U.K. or Europe. That said, most of the asset managers we cover have exposure to the region by virtue of investing in the stocks and bonds of European-based firms, while a handful also have exposure by way of clients being domiciled in the region--namely,

We expect all of these firms to be caught in the undertow of declining global markets in the near term. Although there is likely to be a fair amount of market and currency turmoil, primarily because most market participants were caught flat footed by the vote (having believed the British people would vote to remain in the EU), we're not anticipating making wholesale changes to the fair value estimates of the companies we cover.

Over the longer term, we also see largely negative impacts for U.K. financials. We would expect a lower level of normalized GDP growth for the U.K., as it has been one of the strongest beneficiaries of GDP growth in the EU since it was formed. We also believe the reorganizations that will take place at many U.K. banks will lower the overall importance of London as a key financial center, making it harder for banks to compete for talent and the relationships that drive fee income and help retain deposits.

There are also renewed concerns regarding several countries in the European Union, such as Italy, France, and Spain, where citizens have expressed strong interest in holding their own referendums and seeking to leave the European Union. Again, the impact for the banks we cover within those systems, such as

),

), and

), would likely result in higher costs and slower growth, which combined with weak capital levels would be quite concerning.

However, if more countries split off the European Union, we believe that brokerages, exchanges, and financial information providers stand to benefit. More countries with their own currencies and monetary authorities with disparate interest rate policies would lead to higher currency and rates trading volumes. Information providers collecting and disseminating these new data points will also be more valuable.

Strategic and Financial Effects of the Department of Labor Fiduciary Rule Are Substantial

During the quarter, the U.S. Department of Labor released its finalized conflict-of-interest, or fiduciary standard, rule for financial advisors, and we believe it will disrupt many business models in the industry. We've already seen the exit of several foreign banks (Barclays,

We agree that the Department of Labor's finalized rule is in many ways more lenient than the initial proposal, especially in terms of the operational feasibility of the best-interest contract exemption. That said, a couple of areas of the rule were made even more restrictive, and the rule still has teeth through the best-interest contract as a litigation-based enforcement mechanism. In fact, we foresee that compliance with some of the rule's provisions may not only cause changes in how financial advisors service retirement accounts, but also how they serve taxable accounts.

In terms of advised retirement assets, we initially estimated that the rule primarily affected $3 trillion of advised, commission-based IRA assets. In addition to that, we further estimate that advice services are being offered to approximately $4 trillion of private, defined-contribution-plan-participant assets and that there are upward of $800 billion of plan assets that are using advice and could be subject to the rule. Advice providers to private defined-contribution plan participants need to double-check that how they formerly advised or managed assets on behalf of retirement plan participants remains in line with the Department of Labor's updated rules. More than $200 billion of annual IRA rollovers are also receiving professional advice that fall under the rule. Advisors, including fee-based RIAs, will have to document why a rollover will be in the best interest of an individual.

In regards to product and service offering, we continue to see the acceleration of three key wealth management trends--a move to fee-based from commission-based accounts, increased usage of digital advice offerings, and a shift to more passive investment products from actively managed. The proportion of fee-based assets increased 1- to 3-percentage points at several of the large wealth management firms in 2015. Digital advice assets continue to ramp up and more than doubled at the leading players in 2015. Since the beginning of 2016, we've already seen major partnerships being inked--such as by BlackRock's FutureAdvisor--between digital advice solution providers and traditional wealth management firms. We continue to see the potential total market opportunity for passive investment products from the fiduciary rule as $1 trillion with a reasonable prospect of a $140 billion increase in broker-dealer advisor use of just the ETF portion of the passive investment market.

We believe that the beneficiaries from the Department of Labor fiduciary rule will be discount brokerages, financial technology companies including robo-advisors, and providers of passively managed products (primarily index funds and exchange-traded products like ETFs). There will be a mixed effect on active asset managers and full-service wealth management firms, while certain alternative asset managers and life insurance companies will be challenged. Overall, the rule will spur changes in wealth management firm operations, market share shifts among financial products, creation of new financial service offerings, and greater need for substantiation of financial advisors' adherence to their clients' best interest and value that they provide.

Top Picks

Synchrony Financial

SYF

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $40

Fair Value Uncertainty: High

Consider Buying: $24.00

We believe Synchrony is deeply undervalued and poised to outperform as consumer spending on private label continues to thrive. The indiscriminate recent selling off of bank stocks following the Federal Reserve's heightened reluctance to increase interest rates in 2016 offers a compelling opportunity to purchase this unique private-label card franchise at a significant discount. Investor misunderstanding of Synchrony centers on the attractive nature of the firm's closed-loop model, particularly its retail sharing agreements, funding picture, and growth prospects. Retail sharing agreements with Synchrony offer more detailed information on consumer behavior and lower interchange fees. For cardholders, Synchrony offers unique discounts and rewards on future purchases. Given this attractive proposition, Synchrony's receivables growth has been double that of general purpose cards over the past few years, and we expect these growth trends and market share gains to continue. Credit losses in the 4%–5% range are easily offset by significantly higher net interest margins, and we believe the market overestimates future credit risk.

Citigroup

C

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $68

Fair Value Uncertainty: High

Consider Buying: $40.80

Over the past five years, management has reduced compensation expense by 11%, occupancy expense by 14%, and boosted common equity by $42 billion. Yet Citigroup's stock is now trading at 2011 levels. We think Citigroup will benefit from an improved U.S. housing market over the next three years--expenses related to crisis-era mortgage lending still account for about 10% of the total. In the meantime, risks related to emerging-markets and energy exposures are manageable, representing 150% and 33% of common equity Tier 1 capital, respectively. Over the next three years, we expect the company's stock price will reflect significantly higher earnings per share and dividend payouts.

Commerzbank

(

)

Star Rating: 5 Stars

Economic Moat: None

Fair Value Estimate: EUR 10

Fair Value Uncertainty: High

Consider Buying: EUR 6

Commerzbank reported a difficult first quarter in a volatile market environment and indicated that its 2016 goals will be challenging to reach. The bank faced several headwinds during the quarter. The first is market volatility, which contributed to a sizable decline in capital markets profits to EUR 70 million from EUR 250 million last year. Second, within its Mittelstandsbank division, low loan demand, negative interest rates that pressured deposit margins, and intense competition for market share caused profits to decline to EUR 209 million from EUR 364 million. The bank is attempting to convince clients to move excess deposits elsewhere and is already charging certain large corporate clients to keep deposits on hand. However, the bank has made substantial progress in terms of wrapping up its noncore assets, and we think investors have sold off many European banks indiscriminately in 2016, providing undervalued opportunities.

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