Financial Services: A Positive Outlook for U.S. Banks, More Consolidation to Come for Asset Managers

• We assess the global financial-services sector as approximately fairly valued. It has recently traded at a market-cap-weighted price/fair value estimate ratio of 0.94--a 6% discount to what our analysts believe the sector is worth.
• While the economy remains relatively strong, increased competition among banks shown in rising funding costs are slowing net interest margin growth, and uncertainty regarding credit costs is increasing.
• There is a general easing of financial regulation in the United States, but some tightening in China and Europe.

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

U.S. Asset and Wealth Management Firms: Scrutiny of the Securities and Exchange Commission's package of best interest regulations is moving to the forefront with firms focused on wealth management, as the U.S. Department of Justice chose to not appeal the vacating of the U.S. Department of Labor's fiduciary rule to the U.S. Supreme Court during the second quarter. We envision the trend toward increased fiduciary duties continuing in the United States, with both the SEC and multiple states expected to roll out their own fiduciary rules in the near to medium term. As such, we expect many of the changes that advisors, broker/dealers, and asset managers have made to their business models the past several years to persist.

Looking more closely at the U.S.-based asset managers, we see the following five issues impacting the industry in the near to medium term:

1) A weaker regulatory environment for financial-services firms. 2) Ongoing disruption of the retail-advised distribution channels. 3) Continuation of the shift from active funds to passive products. 4) A greater focus on relative fund investment performance and fees. 5) Industry consolidation

On the consolidation front, our general take has been that consolidation is inevitable for the industry. Active asset managers, and even some passive managers, have a need to add scale to offset a lower fee and profitability environment as the U.S. and other developed markets are forced to address the ongoing movement of investors into lower-cost options--primarily index funds and ETFs. We expect fund companies that cater to retail customers to 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 we cover 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, 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 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 mid-size firms (those with $25 billion-$250 billion in AUM), understanding that they could lose a fair amount of AUM 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 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.

At this point, we're still in the early innings of the expected consolidation wave, with the deals that have been done so far--such as the merger between U.S.-based

U.S. Insurers: The property and casualty insurance industry was buffeted by a flurry of natural catastrophes in 2017, with multiple hurricanes and wildfires hitting companies' bottom lines. Typically, industry pricing firms up after large catastrophes, and the early indication is that this will be the case again. However, the increases look to be modest, and lower than what we've seen in the past, as the industry remains well-capitalized. In our view, this adds up to an underwriting environment where moaty firms should still be able to use their competitive advantage to generate modest excess returns. Looking across the main areas of P&C insurance, we see some divergence. Personal lines, particularly auto, are currently enjoying strong pricing increases, which in most cases is more than offsetting a recent rise in claims and leading to strong profitability. The outlook in commercial lines is much more mixed, and it is questionable if pricing increases are keeping pace with claims increases. We remain most concerned about reinsurance lines, however, as we see catastrophe bonds as a growing source of capital, and believe structural overcapacity could leave pricing inadequate even if prices rise modestly in 2018.

U.S. Banks: With tax cuts being signed into law, good reasons to expect more economic growth, regulatory relief already playing out, and a normalizing rate environment, the near-term outlook for bank performance is positive. Overall, bank stock market values today are much higher than they were a year ago. We think this is warranted to some degree, as we now believe returns for banking will continue to improve and will end up roughly in between precrisis return levels and the returns seen in the past 10 years since the crisis. However, this also means that bargains within the U.S. regional banks are few and far between.

For U.S. banking in general, we believe four key themes will play out in 2018. First, we see higher loan growth in 2018 as uncertainty surrounding tax reform abates and companies are incentivized to invest given increased capital expenditure deductibility during the next five years. Second, we see more room for expense savings as banks continue to automate more functionality, embrace more technological change, and decrease or better optimize branch footprints. Over time, we think this trend favors the largest banks, which have the most scale and the most money to spend on new technology. Scale and technology should only increase in importance, and this should be a major factor in determining the winners and losers within banking over the next decade. Third, we believe regulatory spending likely peaked in 2017, and we expect the explicit regulatory spending burden to be flat to down in 2018, and the burden from holding excess capital on the balance sheet should only decline over the medium term. Finally, we see continued but measured federal-funds rate hikes in 2018. We also see increasing deposit betas offsetting the benefits of higher asset yields, as banks are forced to begin giving back more of each rate hike to their clients.

We think the U.S. 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.

In June, the Federal Open Market Committee raised its target for the federal-funds rate to 1.75%-2%. We think the advantages of a sticky retail deposit base are likely to shine through as rates rise.

Asian Financials Update By Iris Tan, Jay Lee, and Michael Wu

China Banks:

Chinese banks' H-shares under our coverage are trading at a price/fair value of about 0.77. Current valuation level implies 0.5-0.8 times 2018 price/book value for the Chinese banks we cover with

As for Chinese banks, there are five industry trends worthy of attention in 2018. First, bank lending rates will continue to climb as a result of tighter credit availability and rising interbank rates. Average lending rate has increased 57 basis points to 6.01% by the end of March 2018 from the trough in end-2016. Second, deposit costs face greater pressures in 2018 as competition further heats up given M2 growth slowed to 8.2% in 2017 from the average of 13% during 2011-16. This was also exacerbated by mounting threats from deposit substitutes including money market funds and savings-type insurance products, while banks' wealth management products become less attractive as they no longer carry implicit guarantees by banks and yield lower returns as their investment in shadow credits are banned.

Third, bank loans will maintain its steady growth at around 13% in 2018 as credit demands are still strong. This also helps partially make up for the unfilled financing gap left by ongoing shadow banking curbs. Contrary to market belief, we do not expect the banks are able to shift a majority of their off-balance-sheet shadow banking exposure into their books, given stringent regulations including requirements on capital, provisioning and loan quota. Fourth, there is a higher level of credit costs uncertainty in 2018. This is attributable to stricter rules in bad debt recognition in 2018, despite the gradually declining bad debt formation ratio since mid-2016. Besides, the banks are likely to increase provisions given climbing credit quality risks amid ongoing bond defaults as shadow bank borrowers are now facing refinancing pressure.

Finally, fee income growth will temporarily be dragged lower by ongoing regulations in wealth management products. We have seen wealth management business slow pending the upcoming release of detailed regulations by the regulator. We expect wealth management products will shrink in scale as both supply and demand for shadow bank credits are subject to strict controls.

We believe the larger Chinese banks will steer through such challenges better than peers given their very limited shadow bank exposure and prudent operations.

Hong Kong Banks:

There is no change to our view that the Hong Kong banks are overvalued, and the key focus is on net interest margin improvements and the prospect of further loan growth in 2018 as regional economies continue to improve. There is no change to our view that net interest margins will rise steadily in the medium term as stronger economic conditions underpin the normalization of interest rates globally. The Hong Kong Interbank Offer Rates, or Hibor, continue to edge higher in the second quarter as liquidity exited Hong Kong. The latter saw the Hong Kong Monetary Authority intervening in the foreign currency market to maintain the Hong Kong dollar peg. The higher Hibor should underpin rising net interest margins but get offset by competition. As noted previously, the Hong Kong banks continue to see pressure on lending spreads for both corporate and commercial loans. In our view, competition could ease as rising interbank rates increase funding costs across the industry, particularly banks without a large deposit franchise. We believe narrow-moat

The strong system loan growth continued in the first quarter and remains a key positive. Year to April system loan growth of 7.4% should see overall loan growth in line with last year. The strong increase last year was across both corporate loans and loans to individuals. Demand for offshore loans also saw strong growth on higher demand for investments in mainland China and elsewhere in the region. With the Chinese economy continuing to moderate at a controlled pace and global economic conditions strengthening, we expect the strong loan growth to be sustained for the remainder of fiscal 2018.

Japan Banks:

We maintain our preference for

Credit cost was benign for the Japanese banks in the fourth quarter, in line with banks in the region. We are forecasting higher provisioning thereafter as Mitsubishi has a larger exposure to international loans, which we deem slightly riskier. However, we believe the risk is priced into the current share price.

We do not expect a significant increase in non-performing assets in the medium term and credit cost should remain low for the remainder of 2018. Interest rates are expected to remain low in Japan as inflation growth remains weak. While the low interest rate should result in a lower level of credit cost, net interest margin will continue to be pressured. This is further compounded by weak loan demand domestically and we expect net interest income to remain largely steady.

Finally, Sumitomo announced a long-awaited share buyback plan, which was expected after clarification from regulators on Basel 3.5 at the end of 2017. It announced buybacks of up to 1.3% of outstanding shares, which was greater than expectations. We view this as a positive step to allow Sumitomo to rightsize its balance sheet for higher returns, while still maintaining healthy cushions in regulatory capital.

Singapore Banks:

The Singapore banks' share prices softened in line with the wider market in the second quarter. While

All three banks reported solid first-quarter results, reflecting the favorable operating environment as global economic activities ramps up. Higher net interest income was driven by both improving net interest margins and stronger loan growth, while favorable capital markets saw rising demand for investment products and wealth management, underpinning increases in fee and commission income. Credit costs were extraordinarily low, which also benefited from the write-down of their oil and gas non-performing assets last year. With global economic conditions maintaining its upward trajectory, we expect the above trends to continue for the remainder of the year.

Australian Financials Update By David Ellis

The otherwise solid earnings outlook for Australian major banks has been completely overshadowed by very damaging revelations and accusations raised to date at the Royal Commission into misconduct in the banking, superannuation and, financial-services industry. Despite the potential for damaging industry consequences, the Australian banks continue to be supported by solid economic fundamentals as global and domestic economic conditions improve. Australian GDP growth for the March quarter came in at a respectable 3.1% year on year, with strong employment growth, continued positive net immigration, solid credit growth of around 5% and record high infrastructure investment. House prices are easing, and we expect further modest house prices weakness in the year ahead.

At current prices,

Political and regulatory risk is increasing, with a range of issues unfolding. Commonwealth Bank recently agreed to settle civil proceedings raised by the Australian government's anti-money laundering agency, Australian Transaction Reports and Analysis Centre, or Austrac. Under the agreement, the bank will be fined with a civil penalty of AUD 700 million, a record settlement made by an Australian bank. We are treating the AUD 700 million Austrac provision as a significant item and excluding it from our unchanged fiscal 2018 cash profit forecast of AUD 9.9 billion. The financial impact of the provision is immaterial to our valuation or to the AUD 123 billion market capitalisation. Longer term, the high-quality franchise, strong market positions and reinvigorated senior management will support Commonwealth Bank's earnings and dividend sustainability.

Despite the political and regulatory risks, we expect improved productivity and benign credit quality to support future fully franked dividends delivering attractive dividend yields in the 6%-7% range. We forecast average annual dividend growth of just 1.3% to fiscal 2022, with average payouts forecast to decline to 73% in fiscal 2022 from 76% in fiscal 2017. Major bank forward price/earnings ratios have contracted to an average around 11 times from 13 times eight months ago and are now below longer-term averages around 12 times. Returns on equity are expected to average above 14% during the next five years, with Commonwealth Bank to stand out at around 16%. Political uncertainty is not helping business confidence, while weak wages growth is a drag on consumption and the Reserve Bank of Australia inflation target. The most damaging negative risk to bank earnings is the potential for an exogenous shock triggering a global downturn that drags the Australian economy into recession, but this is not our base case.

European Financials Update By Johann Scholtz and Henry Heathfield

European Banks:

For many parts of Europe, the themes for 2018 have hardly changed compared with 2017. For 2018, U.K. banks within our coverage are hopeful on the U.K. economy despite the ongoing Brexit. The consensus view is that GDP growth will be at similar levels to that in 2017, which in our view should be supportive of banking assets and balance sheet growth.

As of the start of 2018, IFRS 9 is now in full operation for European banks. In July 2017, EBA guided that common equity Tier 1 ratios are expected to decrease by up to 45 basis points on average, driven by an increase in the impairment charges. While banks have been emphasizing that the impact on capital ratios will somehow be lower than that guided by EBA, they have been reiterating their guidance on the topic with their full-year results. Management of

Finally, at

European Insurance: European insurers are slightly undervalued with our coverage trading at 0.95 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 and also increased attention on disciplined underwriting.

European insurance companies have been repositioning their asset management businesses and offerings to something more in line with the unit-linked business that is generally becoming more prominent. A significant part of the attraction for life insurance and pension products is the savings element they carry. And we have seen non-life insurers establish strong third-party asset management businesses.

The acquisition of XL by

There has not been news out regarding the breakup of

While distribution is the means of collection, ultimately in mature markets, advisers and consumers will gravitate to the best product. And those will be proven, as with Prudential, time over time.

Top Picks

American International Group

AIG

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $76

Fair Value Uncertainty: Medium

5-Star Price: $53.20

We believe previous management's focus on growth and lack of discipline are the root causes 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 still 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.

The company's first-quarter results were poor overall, but contained some positive glimmers, and we think Duperreault deserves some patience. To that end, we are encouraged by his goal to generate an underwriting profit in P&C lines by the fourth quarter. In our view, if the company is able to achieve this on a sustainable basis, it should be in position to generate an acceptable overall return.

Capital One

COF

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $123

Fair Value Uncertainty: Medium

5-Star Price: $86.10

Capital One is beginning to realize the sizable benefits from lower credit losses that we believe will result in earnings per share growth of more than 30% in 2018. Capital One's improving earnings will likely enable the company to increase share repurchases and its dividend. Furthermore, we believe the company's improving results and brightened prospects for increasing capital returns could serve as a catalyst for the company's shares. If Capital One were to maintain its recent dividend payout ratio of around 20%, the company would be able to increase its annualized dividend by about 25% resulting in a dividend yield of more than 2% based on today's share price. Currently, Capital One trades at a more-than 25% discount to our fair value estimate of $123 per share.

For months, we've been monitoring monthly credit card delinquencies, anticipating that moderating, but still healthy, growth will result in substantial improvements in consumer credit quality. As we correctly anticipated, decreases in credit card delinquencies began earlier this year. We believe Capital One's increasing credit losses the past few years represented an overhang in the company's shares. Given this uncertainty appears to be going away, we believe investors in Capital One will be rewarded.

Although a majority of Capital One's results are driven by its credit card business, auto loans also play a role in the company's fortunes. Used car prices continue to outperform our expectations, though we believe Capital One is seeing greater competition within auto lending. Eventually, this competition should pressure Capital One's growth and possibly lower margins on new loans. For now, it appears that Capital One will benefit from minimal charge-offs as used-car prices remain high. However, in recent months, Capital One has seen a deceleration in auto loan originations. In our view, we believe this is a minor offset to Capital One's improving results within domestic credit cards.

Invesco

IVZ

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $40

Fair Value Uncertainty: Medium

5-Star Price: $28

While there are several U.S.-based asset managers trading at steep discounts to our fair value estimates, narrow-moat Invesco remains our top pick among the group. The company continues to transform itself into a much tighter organization capable of generating profitability and cash flows on par with the higher-quality names in our asset manager overage and overcoming any hurdles that might be thrown in its way.

The company closed out May with $977.3 billion in managed assets, up 13.8% year over year. Excluding the impact of the Source and Guggenheim acquisitions, total AUM was up 6.3% when compared with May 2017, which is still respectable given the volatility in the markets since the start of the year.

While Invesco's organic growth did weaken during the first quarter of 2018, we believe that the firm's three- and five-year investment performance should be good enough to spur 1%-2% annual organic growth during our forecast period. Assuming Invesco hits our end-of-year AUM target of between $900 billion and $1.1 trillion, we expect the firm to generate mid-single-digit revenue growth during 2018, with adjusted GAAP operating margins of 24%-26%.

The market tends to reward both organic growth and operating profits in the U.S.-based asset managers, which explains why

That said, Invesco has generally traded at a slight discount to the group, which we've always believed was warranted as its operating margins averaged 24.2% annually during 2013-17. At today's prices, though, the stock is trading at a 25% discount to the group multiple (based on 2018 consensus earnings estimates) and a 35% discount to our $40 per share fair value estimate. A valuation that implies that the firm has as much as 25% less in managed assets than it is currently reporting.

Communication Services: Undervalued With a Case of Merger Fever U.S. telecom consolidation is in the works with a T-Mobile-Sprint merger.

Basic Materials: Overpriced, With Significant Downside Ahead for Commodities Few basic materials stocks currently offer risk-adjusted return potential amid our negative outlook for commodity prices.

Technology: Data Security and Privacy Remain on the Forefront Overall, we view the Tech sector as slightly overvalued.