Financial Services: Asset Managers Are Forced to Adapt

• We assess the global financial-services sector as fairly valued. It has recently traded at a market-cap-weighted price/fair value estimate ratio of 1.04--a 4% premium to what our analysts believe the sector is worth.
• The near- to medium-term earnings growth of many financials will be based on how much additional income financial companies generate from higher interest rates compared with increases in funding costs.
• For asset managers and life insurance companies, regulation and competition is leading to business model changes and mergers.
• Natural catastrophes have recently led to high claims levels at insurers. We are skeptical that incurred losses are large enough to lead to an exit of capital from the reinsurance space and a significant rise in prices.

The global financial services sector appears to be fairly valued. The overall sector trades at a price/fair value ratio of 1.04, which suggests bargains are limited. The cheapest subsectors are Global Banks and Regional European Banks with an equal-weighted by company average, price/ fair value ratio of approximately 0.97 and 0.95, respectively.

Americas Financials Update By Brett Horn, Eric Compton, Greggory Warren, Jim Sinegal, and Michael Wong

U.S. Asset and Wealth Management Firms: When we came into 2017, we noted that six different issues would probably affect the U.S.-based asset managers in the near to medium term: 1) a weaker regulatory environment for financial services firms; 2) distribution channel disruption on the retail-advised side of the business; 3) continuation of the ongoing shift from active to passive products; 4) greater focus on relative fund investment performance and fees; 5) the inevitability of industry consolidation; and 6) U.S. corporate tax reform.

On the consolidation front, our general take has been that consolidation is inevitable for the industry, with active asset managers, and even some passive managers, needing to add scale to offset a lower fee and profitability environment as the United States and other developed markets are forced to address the ongoing movement of investors into low-cost options.

We expect to see fund companies that cater to retail customers consolidate their funds not only internally to increase scale and eliminate underperforming offerings, but externally as well, with midsize to large asset managers pursuing deals that increase the scale and/or product breadth of their operations.

We expect most of the U.S. firms in our coverage to consolidate internally where it makes sense, increasing the scale of individual funds under the direction of solid active managers that are more likely to provide them with the best chance to keep fee cuts to a minimum while still gaining access to third-party platforms. This can be a double-edged sword, though, as funds tend to underperform the larger they get in size, so managing that differential will be critical to long-term success.

As for external consolidation, we view most of our U.S.-based asset manager coverage as being buyers rather than sellers. However, unlike past rounds of consolidation that involved buying up managers to either fill in product sets or expand distribution reach, we expect future deals to be done more for scale than anything else.

In these type of deals, we envision midtier asset managers (those with $250 billion-$750 billion in AUM) acquiring small to midsize firms (those with $25 billion-$250 billion in AUM), understanding that they could lose assets as they consolidate the acquired company's funds into their own. Although there are plenty of firms out there that fall well below the threshold of a small firm, we don't expect to see much buying activity of these types of firms for scale. If anything, we could see deals of that size done to fill product holes or as product-enhancement moves.

Given that we're in the earlier innings of this consolidation wave, though, the deals we've seen to date have been far more selective than they are likely to be once we get further down the path.

For example, the merger between U.S.-based Janus Capital Group and U.K.-based Henderson Group (announced in October 2016) not only increased the global scale and distribution outreach of the two companies, which is expected to offset some of the pricing pressure and higher costs that we expect to see in the industry longer term, but filled in some product holes and opened some potential avenues for growth. Our thought at the time was that Janus and Henderson preferred to start the dance early, finding a more desirable partner that could fill in portfolio and distribution gaps, rather than waiting around for the latter inning of the game when consolidation starts to take place just for consolidation's sake.

The large wealth management firms that we cover should be fine regardless of whatever changes occur in the Department of Labor's fiduciary rule for financial advisors to retirement assets. The definition of who is a fiduciary to retirement assets and the impartial conduct standards went into effect in June 2017 and remain in effect.

However, the best-interest contract, which was the primary enforcement mechanism of the rule via the potential for class-action lawsuits, has had its implementation delayed to July 1, 2019. Although the specific best-interest contract enforcement mechanism has been delayed, there are still multiple ways that advisers to retirement assets can be held liable for violating impartial conduct standards, so it makes sense that firms continue to change their business models.

U.S. Auto Insurers: A flurry of natural catastrophes and associated flooding has led to unusually high claims levels for personal auto insurers. However, looking at the underlying results, we're still seeing a significant deviation in growth and profitability for the major U.S. players, as the industry continues to adjust to a more general rise in claims.

While progress is uneven, there are strong signs of mean reversion in underlying underwriting results, as price increases take hold. Further, policy in force growth shows that the direct response channel continues to take share from captive agents, which supports our view that

U.S. Banks: We think the Federal Reserve's cautious approach to raising interest rates is the correct one given the state of the economy. In our view, the Federal Reserve is walking a fine line as it attempts to normalize rates. Returning to a "normal" interest rate environment would give the central bank more ability to fight a recession, and the combination of low unemployment rates and solid economic growth arguably shows the economy is ready for higher rates. However, tightening too quickly--before inflation data proves the need for higher rates--could cut short a long and fragile recovery. We continue to expect a slow and steady normalization--in line with the Fed's commentary.

Many of the banks are confident that relatively low repricing of deposits, or deposit betas, will continue to hold for the immediate future, but we've already started to see repricing in accounts for more interest rate sensitive customers, such as commercial clients and high net worth individuals. We believe that low betas cannot stay forever. Eventually, competition will have to pick up. As a result, we forecast that betas will begin materially increasing in 2018, and net interest margin expansion will begin to slow somewhat but will still occur amid slow but steady rate increases over the next several years.

Asian Financials Update By Iris Tan, Mari Kumagai, and Michael Wu

China Banks: H-share Chinese banks under our coverage are trading at 0.95 P/FV after a strong rally in 2017 on better investor sentiment given the market's lifted expectation for lower financial risks and a stabilizing economy. However, we think the improved macro fundamentals have been largely factored in, and we have a less optimistic long-term view for China's macroeconomy than the market.

) is currently the only 4-star stock in our coverage. The stock is undervalued, trading at a 0.6 times 2018 price/book ratio and 5.2% dividend yield. This level is the lowest among other big four banks that are trading at 0.7 to 0.8 times 2018 book value. Having the largest overseas banking exposure with gross profit contribution over 35%, Bank of China benefits from rising interest rates and growing offshore loan demand, helped by a recovery in exports and fast overseas expansion of Chinese enterprises. Additionally, the bank is less impacted by ongoing tightened financial regulations given its more diversified geographic mix.

After a nearly 70-basis-point contraction in net interest margin since Bank of China's interest rate cuts in late 2014, Chinese banks' net interest margins finally bottomed out and slowly recovered in the past two quarters thanks to rising interbank interest rates and average loan pricing. However, recovery in net interest income is still weak, as banks are scaling back their corporate lending on credit quality concerns.

Large banks with a strong deposit franchise outperformed, as their cheap funding costs enable them to be the largest beneficiaries in the rising rate environment. Meanwhile, smaller banks with heavy reliance on interbank funding and large exposure to shadow bank credits are still suffering due to a rise in interbank rates and tighter restriction to high-leveraged interbank investments. Looking forward, we expect the regulatory stance will remain tough in 2018 as the regulator emphasizes removing implicit guarantees in China's asset management business. Interest rates are likely to remain at a high level, and banks will face increasing deposit competition pressure.

Fee income growth is more divergent as some banks with large exposure to the asset management business (bank WMPs and agent sales of other financial products including insurance, mutual funds, and trust products) are seeing a sharp contraction as a result of regulatory tightening in the asset management market. Banks with a large fee income contribution from payment also saw rising threats from fintech competitors in the payment field. Fee income from bank card and investment bank-related services saw resilient growth.

The improvement in operating efficiency was suspended in 2016 as a result of revenue contraction. But the improving trend resumed in some banks that saw recovering top-line growth. The rapid pace of banking digitalization and network upgrade/repositioning, together with recovering top-line growth in the following quarter should translate to near-term operating efficiency improvement for banks that are well positioned to take advantage of such trends.

Credit quality has been showing signs of stabilization, while banks are keeping credit costs at a high level. Credit quality pressure also diverges among banks, with large banks with prudent operations and credit exposure to lower risk sectors (government-led infrastructure, retail, and private sectors) seeing less risks as financial deleveraging and supply side reform are showing some progress.

Hong Kong Banks: We continue to see the Hong Kong banks as overvalued and believe the benefit from an increase in U.S. interest rates and stronger loan growth is factored in to current share prices. Interbank rates picked up in the recent months in anticipation of another U.S. interest rate increase in December. However, the impact on net interest margin for fiscal 2017 is limited with one month left before year-end.

As noted at the first-half results, we expected net interest margins in the second half to be pressured as interbank rates have compressed throughout the year from highs early in the year. Our expectation was for net interest margins to be largely steady for the full year.

Positively, stronger interbank rates do provide support for an increase in net interest margin in the medium term. However, competition in mortgages and a focus on lending to quality corporates should see net interest margin increase at a moderate pace.

Although the level of liquidity in the system is still strong and the majority of local banks under our coverage derive their funding from low-cost deposits, the increase in interbank rates have translated into an increase in the composite interest rate, or the weighted funding costs, for banks in the system. The composite interest rate surged to 50 basis points in October from 3 basis points in the previous month and a level not seen since mid-2014.

We expect the two narrow-moat rated

) and

(HKG:

) to fare better given their sizable deposit market share and a large proportion of their deposit base consisting of lower-cost current and savings deposits.

Loan growth continues to be strong up to the month of September, supported by a recovery in the Chinese economy in late 2016 and early 2017. System loan growth is tracking at 13% year to September, driven by both loans inside and outside Hong Kong and across all sectors. There is strong demand for offshore investments by Chinese corporates, and we expect loan growth of high midsingle digits in fiscal 2018.

Japan Banks: A strong rally during the quarter managed to offset weak performance earlier in the year, and Japanese banks are now trading closer to our fair value estimate.

Major banks are looking internally to cost reductions from digital banking initiatives and externally for margin expansion from non-domestic banking. We are cautiously optimistic about most names as available policy options are likely to be limited until April 2018 when the Bank of Japan will announce the new governor after Haruhiko Kuroda. Investors seem to have higher confidence in Japanese banks' sensitivity to rate increases, while we are less optimistic on the pace of actual margin improvement. Our top pick remains

), a leader in universal banking with a growing international franchise.

Little movement on domestic interest rates does not mean Governor Kuroda has failed to deliver his political mandate to achieve the 2% inflation target for the past four years and until 2019. Signs are emerging that Japan's CPI is edging up to 0.7% year on year, although key drivers remain volatile food and energy prices that tend to offset each other. Short-term interest rates started to react with TIBOR finally turning positive, although the low absolute level, tracking below 7 basis points, does not materially impact any of the banks' earnings. We do not expect a notable change in market liquidity provision, although the Bank of Japan is trimming the scale of its asset repurchase program.

Many headwinds remain in the world's fastest-aging economy with less capital investment needs for the future. Wage growth is likely to be subdued with aging employees despite some tailwinds from predictable job growth. Altogether, we expect banks are likely to see similar performance metrics in the coming quarters. Although more precautionary saving from low risk appetite is likely to elevate deposit growth unsustainably high around 5.8% year on year, better corporate earnings are likely to support systemic loan growth tracking around mid-3% for the time being. We remain concerned that low asset efficiency will trend lower with the average return on assets tracking below 1% as investment opportunities for banks are limited with 10-year JGB rates being trapped under 5 basis points.

Singapore Banks: We believe the Singapore banks are generally fairly valued. Interbank rates in Singapore have improved moderately in fiscal 2017, and this has translated into higher asset yields for the banks. We see further improvements in the medium term and similar to the Hong Kong banks, competitive pressure on margins remain. We note that the contribution of the Singapore business is 60% given the banks' exposure to the region. Interest rates for the rest of the region, with the exception in Hong Kong, are still tracking lower and will offset the improving net interest margins in Singapore and Hong Kong.

There is no change in our view that

) will be the largest beneficiary of the rising interest rates environment given its large deposit base, a larger proportion of lower-cost current and savings deposits, and a greater exposure to both Singapore and Hong Kong.

Oil and gas non-performing assets remain an issue, but all oil and gas exposures have been previously identified. The non-performing assets recognized in recent quarters were previously flagged by the banks. Collateral values backing the non-performing assets are still declining, and this has contributed to the higher level of non-performing assets. Charterers are being pressured by oil majors as the latter is assuming $50 oil price for new projects and the number of projects remain limited. We do not expect the oil and gas loans to be resolved in the near term, and we see it as an opportunity to accumulate shares in the three narrow-moat banks if concerns over non-performing assets arise. This is in line with our thesis when the banks' share prices declined in 2015, as we argued the three banks are well provisioned and adequately capitalized. We remain positive on the long-term prospects of the Singapore banks and their greater reach around the region to capture inter-regional trades.

Fee income growth was a highlight in the third-quarter results, with recent acquisitions supporting fee income growth for both DBS Group and OCBC. The wealth management segment for both banks has strengthened, and scale for the two private wealth operations are comparable to the larger Swiss/U.S. banks in the region. We expect wealth management income to be supportive of non-interest income growth, providing a more diversified income base for the banks. We also note that wealth management income is more stable relative to other income such as trading and investment banking.

Australian Financials Update By David Ellis The Australian government announced a Royal Commission into the financial services sector in late November. Despite the surprise in the government's policy backflip, we like the way the four major banks surprisingly pre-empted and headed off the potential for a more dangerous and far-ranging parliamentary inquiry.

The Commission will go some way to ending political attacks on the banking sector, a sector underpinning Australia's market economy. The Commission will cover banks, big and small, wealth managers, superannuation providers, and insurance companies. Importantly, the Commission is not examining the four major banks in isolation.

Longer term, the Commission will enable the banks to rebuild reputations, consumer confidence, and trust, three key requirements necessary for Australia's world-class financial system. We like the Commission's narrow focus on misconduct, governance, and regulation rather than examining the stability and competitive structure of the financial system. We are not expecting major surprises in the final report, but there is always the risk of unintended consequences.

Although it should come as no surprise the four wide-moat major Australian banks are in strong positions to satisfy higher regulatory capital requirements, there are still a few challenges on the horizon that investors should be aware of. Once the "unquestionably strong" capital benchmark is achieved, we expect the Australian Prudential Regulation Authority, or APRA, to turn its attention to strengthening the total loss absorbing capital, or TLAC, capacity of the major banks--another hurdle we expect the banks to clear comfortably. The feared major bank capital deficit is quickly turning into a surplus, with capital returns likely in fiscal 2018.

The major banks will comfortably satisfy APRA's "unquestionably strong" minimum capital benchmark requirement by the Jan. 1, 2020, deadline. This will likely be achieved in an orderly fashion, leveraging strong internal capital generation capacity and asset sales rather than capital raisings.

) is best placed due to announced and future asset sales with its pro forma common equity Tier 1 ratio comfortably exceeding the new benchmark.

) is in a strong position following the announced sale of its life businesses and discounted dividend reinvestment plan, or DRP.

) strong organic capital generation and DRP boosted capital to just above APRA's 10.5% benchmark. On an international comparable basis, current major bank common equity Tier 1 capital ratios range between 14.5% and 16.2%.

We remain confident the major banks' strong credit quality profiles will hold with an expected slowdown in the housing market not expected to cause drastic increases in loan impairments. Concerns around the vulnerability of Australia to a downturn in China are overdone. As long as there is a reasonable level of credit growth, a relatively benign credit environment and sufficient capital, banks remain reasonable investments. We are concerned about the lack of business credit growth, but infrastructure opportunities are increasing at a rapid rate with the Australian government and state governments playing a key role. Fintech is slowly evolving, but it's not necessarily a significant threat to the Australian major banks at this stage.

European Financials Update By Derya Guzel and Henry Heathfield

European Banks:

The Bank of England published its 2017 stress test results for the U.K. banks in November. The Bank of England started testing banks' capital positions in 2014, and this is the first time since then that no bank has needed to strengthen its capital, which came as a relief for some banks. This is especially the case for

In this year's stress testing, the Bank of England used an economic scenario that was more severe than the global financial crisis. The test used a GDP decline of 4.7%, interest rate of 4%, and a 33% fall in house prices. The test results under this scenario showed that even under this severe downturn, U.K. banks would be able to continue lending and indicated that they are three times stronger than they were 10 years ago.

All in all, no bank would need extra capital injections as a result. U.K. banks' common equity/bank risk-weighted assets stood at 13.4% in 2016 versus 4.5% in 2008, and following the stress test scenario, the capital ratio would fall to 8.3%, which is above the minimum standard. In the 2016 stress test, while

),

) met the minimum capital requirement level, which is the hurdle level and systemic reference point (the higher standard for bigger banks),

As we pointed out in our previous quarterly update, higher levels of collaboration between fintech companies and retail banks are here and happening with more news and activity between fintech and the banking space continuing during the quarter.

We attended the European Retail Banking conference held in Amsterdam, which was themed around fintech and banking collaborations. Several fintech firms that presented at the conference were, in our view, seeking potential buyers to make the most of funds available from banks.

Most banks have now set up fintech funds enabling them to increase this activity. For example,

Although on a smaller scale, other Dutch banks

) and Rabobank also have fintech funds of around EUR 10 million and EUR 40 million, respectively. We expect similar fund activities to increase within European banks in coming quarters as banks seek to catch up with technology and innovation, and increase their digitization exposure in the hope of reducing cost.

European Insurance: European insurers are still broadly overvalued with our coverage trading at 1.05 times P/FV. We continue to believe the main theme within the European insurance sector is the increasing importance of asset management divisions within these businesses.

European insurance companies, or European life insurance companies more specifically, have been repositioning their asset management businesses and offerings to something more in line with the unit-linked business that is generally becoming much more prominent versus traditional business that carries capital and interest guarantees. As we noted in the last update, there has been significant activity within this space, in tie-ups with larger asset management businesses. We believe this is largely the result of companies looking to protect their businesses against the other side of industry competition and build scale necessary to compete.

In line with incoming regulations, we believe a renewed focus on distribution is also occurring. The combination of an efficient distribution strategy and a well-positioned and -performing asset management business unit can provide a life insurer, in particular, with a competitive edge. For example, we saw

Specifically, this is also providing an opportunity in conjunction with the incoming regulations for businesses to reposition and do something similar. We have seen

) has also said that its asset management unit will remain independent and that it is no longer pursuing a tie up with Natixis (PAR:

). And we stand firm that in order to compete more successfully with its peers, it needs to significantly improve the performance of AXA Investment Managers.

More specifically, in line with the incoming regulations and these shifts we have mentioned, our top pick in the life insurance space is

(BIT: G), with a P/FV of 0.86. In line with the incoming regulations, the business is repositioning its asset management offering and utilizing technology to greater effect. The business is revamping its asset management unit and growing into real asset and multiasset funds, which will be used to offer an alternative to more traditional business in terms of limiting volatility, providing something similar to capital guarantees, and increasing the businesses fee income. Likewise, the business is deploying greater use of platform technology to scale up adviser assets, and we think capture a greater share of flows into proprietary unit-linked.

In the reinsurance space, the big news has been the three hurricanes that hit the East Coast of the United States, Irma, Maria, and Harvey, as well as the earthquakes in Mexico. Although we believe this has been one of the largest natural catastrophe years in recent history, we are skeptical this has been a big enough event to lead to an exit of capital from the market and a significant rise in prices.

Top Picks

American International Group

AIG

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $76.00

Fair Value Uncertainty: Medium

Consider Buying: $53.20

We believe previous management's focus on growth and lack of discipline is the root cause of AIG's poor historical performance, and now the company has set a course in the opposite direction. When AIG announced that it would be taking a $5.6 billion reserve development charge in the fourth quarter of 2016, the market's confidence in management dimmed and the stock now trades at a significant discount to book value. CEO Peter Hancock departed in light of this disappointment.

We see Brian Duperreault as a strong choice to replace Hancock, as his extensive background in commercial property-casualty lines contrasts with Hancock's lack of experience on the underwriting side and inspires confidence that Duperreault can solve the one issue that Hancock failed to make progress on.

Given the potential for improvement, we think the market valuation is overly skeptical and this creates an opportunity, especially as the recent reinsurance deal with

We think a valuation close to book value is appropriate, as our view is that AIG will improve returns to a level on par with our estimate of the cost of equity within the next two years. In essence, we assume AIG is able to bring results in line with other no-moat insurers, a fairly low bar to clear.

Bank Of China

(Shanghai:

)

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: HKD 4.70

Fair Value Uncertainty: High

5-Star Price: HKD 2.82

We think that the one-off sales gain of Nanyang Commercial Bank in the second half of last year led to weaker-than-peer 2017 earnings growth for Bank of China and a buying opportunity. The Hong Kong shares of the stock are undervalued, trading at a 0.6 times 2018 price/book ratio and 5.2% dividend yield. This level is the lowest among other big-four banks that are trading at 0.7 to 0.8 times 2018 book value. As the bank with the largest overseas banking exposure with gross profit contribution over 35%, Bank of China benefits from rising interest rates and growing offshore loan demand, helped by recovery in exports and fast overseas expansion of Chinese enterprises. Additionally, the bank is less impacted by ongoing tightened financial regulations given its more diversified geographic mix.

Swedbank AB

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: SEK 236.00

Fair Value Uncertainty: Medium

Consider Buying: SEK 165.20

We like Swedbank's consistent profitability and its commitment to cost management, which have resulted in a stellar cost/income ratio (38% versus 47% for Swedish peers) and higher return on equity, or ROE, than that of peers. We do not expect its superior cost/income position to change, as Swedbank intends to continue its investments in the areas of saving, lending, and digital banking.

Under our base case, although we expect a lower interest-rate environment to persist for the foreseeable future, we forecast its net interest margin to follow a stable trend, as it has for the past eight years, enabling the bank to post ROE of close to 15% during 2017-21, above peer averages.

Although we acknowledge the risks on the overheated Swedish housing market, where Swedbank is a leader, we believe the Swedish FSA has taken the necessary steps to cool mortgage-lending via introducing a cap, raising the risk weights, and introducing an amortization requirement; hence, in the event of a downturn, the financial system should sustain itself.

We find Swedbank’s valuation metrics, namely a 2018 P/B of 1.9 times and a 2018 P/E of 11.2 times, to be attractive. We have a narrow moat and stable moat trend rating, along with our fair value estimate of SEK 236 per share, offering 15% upside potential at current levels.

Quarter-End Insights

Stock Market Outlook: A Dearth of Opportunity Amid the Rally Credit Market Insights: Flattening Yield Curve Impacts Performance Basic Materials: The Most Overvalued Sector We Cover Energy: A False Sense of Security for Oil Markets Communication Services: A Deal Eludes Sprint and T-Mobile Consumer Cyclical: E-Commerce a Key Threat for Some, But Not All Consumer Defensive: Hungering for Top-Line Gains Healthcare: Pick Carefully as Valuations Head Higher Industrials: Pockets of Uncertainty Present a Few Opportunities Real Estate: Slow but Steady Climb Continues Technology: Most Bellwethers Are Overvalued Utilities: A Weak December Could Foreshadow a Tough 2018 Venture Capital Outlook: Dry Powder for Late-Stage Deals Private Equity Outlook: Eyewatering Acquisition Multiples Crypto Asset Outlook: Installation Phase