While interest rate increases have reignited interest in financials stocks, Guy de Blonay, manager of the Jupiter Financial Opportunities and Jupiter
International Financials funds suggests the recovery story has become more complex given the challenge financial technology companies are posing to the sector.
In recent weeks, the US Federal Reserve (Fed) has outlined plans to reduce the size of its balance sheet, and increased the Fed funds rate by 0.25%, the second such move in six months with more expected. A tightening labour market has led to a more hawkish stance from Chair Janet Yellen. Combined with the Trump effect, policy normalisation at the Fed has led to a rush towards cyclical financials – namely, banks. To some extent this has come at the expense of specialist global payments and financial technology businesses.
Banking stocks have rallied for good reason. Interest rate increases translate into improvements in net interest margin. However, I question the rotation out of Fintech that has been the flipside to the reflation story. In my view, a more balanced approach is required. Cyclical growth in one doesn’t necessarily negate structural growth in the other.
Too big to change?
Where the financial crisis raised questions about whether behemoth banks were “too big to fail”, fintech is asking if they are “too big to change”. For decades large banks have enjoyed a natural moat in the form of customer inertia. This has been due to poor transparency and the convenience of product bundles, which have allowed them to act as a one-stop shop for financial services. However, technological developments, new regulations to improve transparency and the rise of digital savvy millennials, who already use non-traditional payments providers like Apple, Google, PayPal and Facebook, suggest the era of inertia banking could be coming to an end.
Regulators in a number of jurisdictions have introduced policy to encourage greater competition. For example, the Open Banking initiative, which has been introduced by the Competition and Markets Authority in the UK, is expected to significantly change the way customers interact with banks. This initiative will make it easier for data to be shared and will allow greater freedom for customers to tailor banking services. The widespread practice of bundling products will most likely no longer be as effective for banks, which will have an impact on the current practice of using high margin products to subsidise low.
Meteoric growth in Fintech investment
Large banks tend to be complex organisations and many of these have severely underinvested in IT. According to analysis produced by Redburn banks in North America, Europe, APAC and LatAm spent US$241bn on IT infrastructure last year, but only a quarter of this was spent on innovation. Three quarters of this paid for maintenance.
The daunting challenge traditional banks face comes across in the statistic that JP Morgan, the world’s largest bank by market capitalisation, spent some $3bn last year on IT, while Google and Amazon spent $14bn and $16bn respectively on R&D – not exactly like-for-like, but symbolic nevertheless. Notably, investment growth in financial technology has ballooned from $5.5bn in 2005 to over $100bn today.
The most exciting developments in Fintech are occurring in China, where tech giants Alibaba (ecommerce), Tencent (messenger) and Baidu (search engine) have major digital payment operations. Their scale is extraordinary: Alipay, for example, has a customer base in the region of 400 million. The story in China is something of a wakeup call for western banks where cultural factors are a key hurdle to innovation.
The key impediments to innovation in western banks
Source: Redburn, There Will be Blood: Technology Eroding Financial Services, May 2017
Like all innovation, Fintech is not immune to periods of overcrowding when it comes to investment or frothiness in terms of stock market expectations. Nevertheless, there remain, in my view, a broad range of reasonably priced businesses that offer exposure to the fast growing area. Jupiter’s financials funds have exposure to this theme through companies like Temenos, which is a global leader in banking solutions, and digital payments businesses like PayPal and Global Payments, as well as traditional credit card companies Visa and MasterCard. These companies offer exposure to much-needed IT investment by banks, as well as the broader structural shift to a cashless society.
This does not mean we are avoiding the current cyclical drivers. The financials funds I manage have roughly 40% invested in bank shares. This exposure is selective and I remain cautious about trying to second guess the path of interest rate policy and President Trump’s stimulus agenda. The funds hold a mix of financials stocks, for example defensive banks, including well capitalised institutions with solid dividends from the Nordics, Switzerland and the US. Through these holdings, the funds also have exposure to potential rate rises in the US and an economic lift in Europe. Importantly, the dividend yields of these holdings offer a potential hedge against the risk of economic disappointment in the US or Europe.
While the direction of interest rates is important, it is helpful to remember that the global financial sector offers opportunities to invest in a cross-section of economic and structural growth themes. The focus on a cyclical recovery might drive activity in the near term, but I believe it is unwise to ignore the opportunities presented by the structural changes occurring in the sector.