Financials: Strong Fundamentals, but Volatility Clouds Outlook

Key Points:

Banks maintain strong fundamentals that, combined with Fed interest rate increases, should support revenues going forward.
In the wider financial industry, rising rates and inflation are potentially more challenging, particularly for asset managers and mortgage REITs.
Insurers are almost uniformly upbeat, buoyed by favorable pricing conditions.
ESG continues to be a key part of financial sector conversations, particularly following the formation of the Glasgow Financial Alliance for Net Zero.

At RBC Capital Markets Global Financial Institutions Conference, corporates and investors convened to discuss the year ahead amidst a turbulent macro environment. The global economy is in a state of near-term uncertainty that’s unlike any experienced before. As we emerge from the global pandemic, we already faced the risk of inflation, cost-of-living concerns linked to energy prices and supply chain disruptions. The Russian/Ukraine conflict adds a new volatile element to this that is difficult to predict.

But despite this backdrop, the fundamentals for the financial industry remain strong. In the short term, the rising rate environment should generate significant tailwinds at a time when loan growth outlook remains positive. However, in the longer term, the impact of inflationary pressures on the economy could be negative, particularly if current geopolitical tensions don’t resolve soon.

The outlook for banks

The regional banks are likely to continue outperforming the money center, custody, and investment banks due to expected wider net interest margins and less exposure to weaker investment banking business and market volatility. Companies exposed to the capital markets and residential mortgage banking businesses will have greater revenue and earnings challenges in the near term. Overall, the core banking industry outlook remains robust, driven by 2–3% expected real GDP growth, higher short-term interest rates, and an expected pick-up in loan demand. Additionally, valuations are attractive due to the recent pullback in stock prices, offering investors an opportunity to purchase the bank stocks.

For SMID-caps and consumer finance, core commercial and industrial loan growth is pulling through in the first quarter and the outlook remains positive. Margins and net interest income are aligned to benefit from the recent and future rate hikes, and expense pressures appear manageable despite some headwinds from inflation and compensation. Asset quality also remains solid with low levels of NCOs and NPAs, adding to a healthy near-term environment.

Canadian banks specifically have no direct exposure to Russia or Ukraine, and reserves and capital levels are still very high, making the Canadian banks relatively defensive during this period of significant market volatility and uncertainty.

Rates and inflation in the wider financial industry

For other companies in the financial industry, including business development companies (BDCs) and mortgage-backed securities (MBS) firms, rising rates and inflation are concerning, but most see minimal credit implications in the near term. On Mortgage REITs, even though mortgage spreads have widened to attractive levels and the quality of earnings and predictability of cash flows from mortgage bonds are positives, the geopolitical uncertainty could keep mortgage REIT investment postures relatively defensive.

Inflation is having a significant impact on portfolio companies, although larger firms are better-positioned to pass through costs. The software and business services sectors, which have seen relatively more BDC investments recently, are less susceptible to commodity cost inflation, though they have more exposure to wage inflation.

If rates rise, that shouldn’t impact credit performance in the near-term, given where rates are and rate floors, but there could be some uncertainty if rates rise meaningfully. On the other hand, rising rates should drive net interest income benefit, given equity capital funding and liability side funding that has fixed-rate unsecured debt.

Insurers were almost uniformly upbeat on their outlook. P&C insurers continue to benefit from favorable pricing conditions and manageable loss trends. Life insurers have begun to respond to an improving interest rate outlook amid growing optimism that Covid-19-driven mortality impacts could fade significantly. P&C brokers likewise continue to benefit from favorable pricing conditions, strong organic growth, and a robust M&A environment. Mortgage insurers remain upbeat about their earnings prospects in 2022 and expect to see active insurance policy growth despite a slowing housing market. They also continue to see favorable reserve development and capital return.

Tech and ESG support

There’s ample runway for growth in information services supporting the financial industry moving forward. The industry is still in the midst of its transformation, catalyzed by cloud, artificial intelligence and machine learning trends that have increased the demand for data. These secular trends are catalyzing key revenue opportunities and accelerating new product pipelines and go-to-market.

There’s also a strong demand for ESG data and solutions, as investors focus on ESG and climate factors. Financial institutions increasingly need independent scoring tools to help them build models, manage climate attribution and navigate the energy transition.

Banking on ESG

Business ethics as part of operational risk and financial inclusion are both big ESG trends for the banking industry, while the physical impacts of climate change are, as always, of significant importance for the insurance sector.

The asset management panelists highlighted several ESG-related offerings, including specialized funds, that have increased interest. But they also emphasized that ESG initiatives were still in the early innings. ESG products in the investment world are still more prevalent in Europe than in the US.

We estimate that AUM in dedicated sustainable equity funds now stands at $1.3 trillion as of the end of February, following strong AUM growth in 2020 and 2021. Net inflows into sustainable funds have been stable (in positive territory) in recent months, though they are tracking below their early-2021 highs.

Global, US, and European actively managed sustainable funds tend to be underweight in the financials sector, with underweights being most pronounced among global and US-focused funds. However, ESG momentum, taken from shifts in ESG risk scores, controversy assessments, and ESG sentiment scores, has been high for financials relative to other sectors, which could lead to more constructive ESG fund positioning trends.

This content is based on sessions and analysis from RBC Capital Markets’ Global Financial Institutions Conference, which was held on March 8-9, 2022. For more information about the conference, please contact your RBC representative.

Disclosures and Disclaimers