Investors tend to shy away from financial stocks when the interest rate cycle reaches its peak, but Guy de Blonay says low rates could yet provide a further boost to the bourgeoning financial innovation sector.
Central banks have turned increasingly dovish this year against a backdrop of slowing global economic growth. The Fed is expected to cut rates and negative yields are becoming a worrying feature of Europe’s government debt market. While the rate backdrop doesn’t bode well for bank profitability, the global financial sector is a broach church which continues to offer some compelling opportunities – not just despite, but because of the outlook for interest rates.
It’s important to realise that the global financial investment universe extends far beyond the banking sector – it also encompasses a wide range of additional sub-sectors including exchanges and payment processing, as well as companies that support the financial services industry such as cybersecurity and data analytics. These sub-sectors often respond differently to differing economic conditions, and therefore generally have a low correlation to one another.
A diamond in the rough
In stark contrast to the banking sector in Europe, which faces persistent economic headwinds, banks in the US are in good shape. Unveiled on 27 June, the Fed’s stress tests comfortably surpassed expectations, paving the way for $136bn worth of share buybacks and dividends – c.10% of their combined market capitalisation. These tests included 12 domestic banks and six subsidiaries of overseas banks.
JPMorgan and Citigroup have pledged dividend increases and share buybacks since the Fed’s announcement. JPM is looking to increase its dividend yield by 12% and to buy back $29bn worth of shares by June next year. Citigroup’s dividend, meanwhile, will rise by c.11% and the company plans to repurchase $21.5bn in shares, representing c.10% of its market capitalisation (as of 30 June 2019).
There is little doubt that an interest rate cut will dampen profitability, and subdued valuations this year already reflect the expected squeeze on net interest margins. However, there are other reasons to be relatively optimistic about US banks.
That these organisations can return so much capital to investors reflects the underlying strength of their capital positions. Common equity tier one capital ratios have more than doubled in the past 10 years since the credit crisis and now comfortably exceed the Fed’s estimates for the minimum ratios required to withstand a “severely adverse scenario”. By implication these banks are well placed to continue rewarding shareholders even in a tougher economic environment.
Moreover, the key drag on net interest margins is the flattening of the yield curve, rather than low rates, per se. As was recently noted, a rate cut at the front end of the curve combined with a positive resolution to the US-China trade war could help to normalise the curve to the benefit of the banking sector.
We, therefore, believe it prudent to retain exposure to JPMorgan and Citigroup, although not only for their improved capital positions. They are also embracing the profound structural changes that are occurring in the financial sector.
Opportunities to innovate
The surprising beneficiaries of the low rate environment are likely to be innovators: financial institutions seeking to cut the bottom line and embrace change, and those disruptors and enablers at the forefront of that change, operating in areas as diverse as electronic payments and cybersecurity. Low interest rates therefore have the potential to hasten the long-term structural growth trend seen in the global financial services industry over the past few years.
While financial technology companies can pose some threat to traditional financial institutions, they can also bring many growth opportunities. Investment in innovation is allowing financial institutions to deliver more efficient solutions and provide tailored services and products, which not only attracts new customers such as tech savvy millennials and the upcoming Generation Z, but also improves customer satisfaction and therefore retention rates.
Fintech consolidation the next phase in long-term growth story
The extraordinarily large volume and value of M&A deals this year among financial innovation stocks speaks to just how important they have become for the global financial sector. In March, Fidelity National Information Services announced its acquisition of Worldpay; the combination of stock and cash values Worldpay at $43bn, making it the largest ever deal in the payment sector. Earlier in the year Fiserv also announced its acquisition of First Data, in a $22bn all- stock transaction. Other significant deals year-to- date include Global Payments’ acquisition of TSYS for $21.5bn, and Canadian company Nuvei’s purchase of Israeli-based company SafeCharge for $889m.
A recent report from Boston Consulting Group and Swift predicts that global revenue from payments companies will reach as much as $2.42tn by 2027. We expect to see further consolidation in the sector, particularly in Europe, where fragmentation is still relatively high. There are two key groups that could benefit from this: companies that have been spun out from banks, where the cost synergies from M&A joint ventures are likely to be the source of upside; and technology start-ups, which can offer attractive organic growth potential.
It’s widely recognised that take-rate margins – revenues as a percentage of total payments volume – have been compressed over time due to increased competition. This highlights the need for companies to differentiate themselves from competition through ‘value-added’ services, such as data analytics and integrated payments, which we believe will drive the upside.
Financial innovation remains a key theme in Jupiter’s Global Financials strategy, with a particular focus on four key areas: digitalisation, payment processing, data analytics and cybersecurity. We look to identify the financial institutions leading the way in financial innovation (the ‘adopters’ of technology), as well as the fintech companies that are enabling this innovation through a wide range of innovative services and solutions (the ‘enablers’). We believe that technological change will continue to drive growth in the global financial sector for many years to come.