Financials: What Will Really Drive Interest Rates?

• The financial services sector appears close to fairly valued, trading at just a 3% discount to our fair value estimates.
• Investors' attentions are often focused on Fed actions, missing the larger picture.
• We think the underlying factors producing low interest rates--advances in technology, demographic trends, and the state of the global leverage cycle--will result in a gradual normalization rather than a quick return to historical norms.

U.S. Banking Outlook - Jim Sinegal The interest rate environment is likely to remain a key focus for financial stock investors in 2017. In the weeks following the U.S. presidential election, the yield on U.S. 10-year Treasuries rose by approximately 50 basis points as investors reassessed their outlook for the country's economic prospects. The Federal Reserve also raised its target for the Federal funds rate for the second time since the financial crisis (by 25 basis points to 0.50%-0.75%), and the members of the Federal Open Market Committee took a slightly more hawkish stance toward future actions.

However, a deeper look at current conditions produces a little more cause for caution. Investors' attentions are often focused on Fed actions, missing the larger picture. The Fed sets short-term rate targets in the near term, but its actions are effectively responses to changes in an unobservable real interest rate. If the Fed's policies are too loose relative to the true equilibrium rate, inflation results. If the Fed is too conservative, unemployment rises. Only in the short run can the Fed change the rate environment--bigger macroeconomic factors are at play in the long run.

It's also important to note that rates themselves are made up of building blocks. The first block is the real interest rate--the true economic return after inflation. On top of that, inflation expectations are added. Finally, a term premium--the extra return needed to hold long duration securities--typically results in an upward-sloping yield curve. Of these building blocks, we believe the market is currently focused on inflation. Five-year forward inflation expectations have jumped by nearly 20 basis points since the election. With this volatility came a 30-basis-point increase in the New York Fed's term premium estimates.

We think the change in inflation expectations may be a result of three factors. First is the likelihood of increased infrastructure spending--a plan favored by both parties. Second is an increasingly protectionist attitude toward trade. The U.S. has been importing deflation from low-cost countries, a trend likely to reverse over time. Third may be the prospects for tax cuts and the potential impact of a higher resulting debt burden.

Increased spending on roads and bridges should both stimulate growth and create high-paying jobs for an important segment of the population--a relative lack of construction jobs has been somewhat problematic since the housing bust. Thus, some upward wage pressure could result. As products are increasingly required or encouraged to be produced domestically, consumer prices could rise considerably. A "Made in the U.S.A." label is typically accompanied by higher labor costs. Higher levels of debt resulting from a looser fiscal policy--taxes are likely to be cut under the new administration, while spending cuts could be slower to materialize--are also inflationary. That said, inflation remains below the central bank's 2% target, supporting our view that current policy is closer to neutral than many suspect.

Of equal importance is the evolution of the real equilibrium rate, and on this front we see little reason for enthusiasm. The Federal Reserve seems to agree that the real equilibrium interest rate is still quite low by historical standards. We think the underlying factors producing low interest rates--advances in technology, demographic trends, and the state of the global leverage cycle--will result in a gradual normalization rather than a quick return to historical norms.

We hypothesize that these factors will determine the future course of interest rates:

First, the "new economy" characterized by globalization and technological advancement (automation) will have long-lasting effects on the balance of savings and investment and will continue to exert an effect on the demand for capital and labor for years to come. Thus, a lower rate is needed to ensure full employment and robust capital investment and inflation pressures will be reduced.

Second, demographic changes--primarily an aging and longer-lived global population--will eventually reduce the savings glut produced by rapid growth of the working-age population in recent decades and result in higher healthcare spending by older generations, offset by potentially lower consumption in other areas. The rise of the millennial generation in the U.S. will also contribute to economic growth. As millennials--the largest generation in U.S. history--begin to enter their 30s, we expect household formation and home purchase activity to accelerate dramatically. A healthy labor market should only add fuel to the fire.

Finally, the state of the credit cycle will weigh on consumer and corporate behavior, as well. The U.S. population is beginning to borrow again--though credit growth is likely to be subdued relative to the expansion that occurred from World War II to 2008. Furthermore, other major economies--Western Europe and China, for instance--are unlikely to experience a near-term rebound in credit demand.

On balance, these trends should result in slow upward movements in rates, but we expect a multi-year normalization process. Our fair value estimates incorporate a partial normalization by 2020 and reflect a Federal funds rate of 2.25% and a 3.5% 10-year Treasury yield. Our long-term assumptions reflect a nominal risk-free rate of 4.5% as a full mean reversion is much more likely. We value companies based on cash flows into perpetuity, and we don't expect that the global technological, demographic, and leverage considerations impacting our five-year outlook to persist indefinitely.

Higher Asset Yields and Favorable Currency Outlook Will Manage to Offset Headwinds for Japanese Banks - Mari Kumagai Since the U.S. election, Japanese bank shares have advanced about 29%, more than doubling the 13% gain recorded for Topix, reflecting a market expectation for higher inflation, higher asset yields, and lower asset volatility. Low valuations among the global banks and the prospect for additional capital returns following the year-end release of final capital regulation argue well for additional equity investment in Japanese banks, which has attracted the second-largest net inflows after U.S. banks during the quarter.

At the current valuation level, with about 30% discount to the tangible net book value, we still see some value in underappreciated global names such as

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During the quarter, the transition from monetary to fiscal policy has gained traction globally, starting with the Bank of Japan abandoning its money supply target in favor of a yield curve target, which we view positively as the banks are positioned to gain from a small term premium emerging, particularly for longer duration beyond 10 years. In late October, the Bank of Japan bluntly acknowledged an increasing side effect of negative interest rate policy since January 2016, and we do not foresee the central bank reversing the course given most regional banks have suffered significantly from net operating deficits due to systemic inability to pass on the cost increases to their depositors.

More expansionary fiscal policy under the next U.S. administration, with wage inflation already accelerating, would justify multiple rate hikes and higher inflation expectation in the U.S. Japanese banks are also set to benefit from an improved operating environment globally with their controlled non-domestic risk taking away from riskier emerging markets. The Japanese government's continued fiscal stimulus, together with recent yen weakening tied to wider yield spreads between major countries, should support a slightly better economic outlook, with the IMF forecasting Japan's real GDP growth improving to 0.9%, above the trend growth rate of 0.7%. On growth, Japan's low inflation outlook remains the immediate, yet manageable, concern in our view, with the latest 0.5% headline inflation still tracking below the 2% policy target imposed for the past three and half years.

A major policy shift away from negative interest policy to yield curve controls also means a better operating environment for banks. Investors should be aware that large excess liquidity, which is unique to Japanese banks, indicates higher sensitivity to market factors on a systemic basis.

Australian Banking Outlook - John Likos and David Ellis Anticipated below-trend GDP growth in Australia will provide challenging operating conditions for the banking sector in 2017. While major bank earnings are forecast to grow an average of 3%, generous dividend payouts are expected to remain flat. Meanwhile, return on equity is anticipated to improve marginally to an average of 14%. Amidst this backdrop, we do not expect any change in the Reserve Bank of Australia's historically low 1.5% cash rate, with risk to the downside.

Despite the risks, a low interest rate environment with capacity for further cuts, a lower Australian dollar compared with previous years, a stable inflation environment, healthy population growth, and strong employment will provide support to the domestic economy in the event of any negative surprises. We expect the 10-year Australian Government bond yield to maintain its long-time correlation with the U.S. 10-year bond yield and trend upward toward 3.25% during the year. Domestic issuer credit profiles should remain resilient, although funding costs are expected to increase, providing a headwind that hasn't existed in several years. We prefer exposure to issuers with economic moats as a way of offsetting these risks. We expect corporate spreads to widen as credit conditions become less favorable relative to recent years. The Australian iTraxx Index, currently trading at about 105 basis points, is likely to end the year higher.

We expect building approvals, wage growth, and credit growth to soften as economic risks are increasing. If the economy enters a sustained recession, bad debts will rise, profits will fall, and dividends will be cut. But this is not our base case, as we expect the economy to "muddle through" with 2.8% GDP growth likely, with momentum likely building as the year progresses. Widespread competitive, funding, and regulatory pressures continue to squeeze net interest margins, or NIMs, but recent loan repricing partially offsets. Further loan repricing is likely if margin pressure intensifies despite increased political scrutiny. Loan losses are expected to continue rising, with our loan loss ratio forecast to increase to a still-below long-term trend level of 0.22%, up from 0.21% in fiscal 2016.

Despite the likely modest slowdown in credit growth, we expect good volume growth and a solid performance in cost management to support our forecast average 2.6% EPS growth for the major banks. We expect residential lending to slow from current levels of 6.4% to about 5.5% and business credit growth to slow from 4.4% to approximately 3.5%. The urgency to raise large amounts of additional capital is abating; however, the Australian Prudential Regulation Authority is expected to announce tougher regulatory rules to ensure the major banks are "unquestionably strong." Balance sheets are expected to remain well capitalized with key metrics in the top quartile of global peers. We expect any further capital requirements to be satisfied organically and from dividend reinvestment plans.

Australia's political landscape has changed for the worse, and we are increasingly cautious of the risks to the profitable banking oligopoly. The concerns stem from increased public and political scrutiny of the lenders and tougher regulatory oversight. Nevertheless, we believe the major banks' pricing power will ensure return on equity is maintained above the cost of equity with recent loan repricing evidence that the negative impact to NIMs can be managed. Inflation is likely to remain weak during 2017, expected to average about 2.0%, with downward pressure continuing to come from anemic wage price inflation that will likely remain below trend under 2.0%. Unemployment is likely to range between 5.5% and 6.0% as the domestic economy continues to transition away from the mining economy. We expect the participation rate to remain under pressure and the trend toward higher levels of part-time employment to persist.

The Australian dollar is likely to continue to weaken against the U.S. dollar, particularly as the U.S. reprices benchmark rate expectations upward. We expect the Australian dollar/U.S. dollar to trade between 0.70 to 0.75 for most of 2017, with the risk to the downside. This risk becomes more pronounced in the event Australia loses its AAA sovereign credit rating. The transition away from the mining to the nonmining economy will continue, though a slowdown in the construction cycle could present a material risk to employment and spending. The risk of a sharp correction in housing is increasingly skewed toward apartments in Melbourne and Brisbane, though should this scenario eventuate, we would anticipate spillover to other cities and types of housing.

Top Picks

Affiliated Managers Group

AMG

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $185.00

Fair Value Uncertainty: Medium

Five-Star Price: $129.50

AMG continues to trade below our fair value estimate, despite most of the rest of the U.S.-based asset managers rallying off of the market lows after the Brexit vote in late June. While some discount in the shares is warranted because of the company's greater exposure to emerging and developing markets as well as the United Kingdom and Europe, which does increase its risk profile in the near term, we think that the fundamentals of AMG's business model, with a projected future organic growth profile that is on par with some of the better flow generators in the group, remains intact and that the current discount to the rest of the group presents a decent buying opportunity for long-term investors.

Visa

V

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $104.00

Fair Value Uncertainty: Medium

Five-Star Price: $72.80

We believe that the potential effects of mobile applications are balanced on Visa's moat. It may be marginally easier for cardholders to switch among payment methods using mobile technology, but advances in technology should accelerate growth in the market for electronic payments. Another potential threat is the bypassing of traditional banks and payment methods altogether, as Alipay has done to a large extent in China. However, the regulatory environment in developed markets presents a formidable obstacle to similar upstarts. Nonbanks do not typically have the ability to hold customer deposits, providing a huge advantage for banks and their preferred payment technologies.

In fact, we see the competitive environment as more stable than only a few years ago. Visa and

Even cutting-edge technologies like Blockchain appear limited by the difficulty of establishing a large network. Visa is experimenting with ledger technology for international business-to-business payments, and banks are using Blockchain for other fairly centralized applications like derivatives and trade clearing. However, transaction processing for millions of parties around the world via such a system seems very far off, in our view.

Oaktree

OAK

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $50.00

Fair Value Uncertainty: High

Five-Star Price: $30.00

We see Oaktree as mispriced due to investors' not understanding Oaktree's business very well. The accounting can be complex and off-putting, competitive advantages can be unclear, and results can be volatile depending on market activity and performance fee levels. Further, Oaktree has yet to replace its very profitable crisis-era fund with new investing opportunities as performance fees have dwindled. We expect as new opportunities emerge within the credit space over the next few years, Oaktree will able to put capital to work and return to more normalized earnings levels.

More Quarter-End Insights

Market Outlook: New Expectations Set the Tone for 2017

Economic Outlook: More of the Same Anemic Growth

Credit Insights: Global Rates on the Rise

Basic Materials: China-Led Rally of 2016 Rests on a Shaky Foundation

Consumer Cyclical: Poised (and Priced) for a Strong 2017

Consumer Defensive: Cooking Up a Bit More Value

Energy: OPEC Adds a Plot Twist, but Ending in Unchanged

Healthcare: What Does a Trump Administration Mean for Healthcare Stocks?

Industrials: Baking In Too Much Optimism

Real Estate: Through the Noise, Opportunities Exist

Technology: This Firm Is the Newest Software Empire

Utilities: Still High Even After Bonds' Withdrawal