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After quite a volatile 2015 and a significant sell-off in December, we are rather optimistic on the outlook for financial equities in 2016, even seeing potential for double digit returns.
Our basis macro-economic scenario for 2016 is one of moderate global growth and low inflation. We don’t expect very high growth numbers in neither developed nor emerging markets. US economic growth will be reasonable, with the Fed gradually hiking interest rates and long-term rates showing perhaps an even more modest increase. Most euro zone economies will be okay, with Ireland as a clear positive outlier.
We expect interest rate hikes in the US, Canada, Australia and the Nordics, but these have already been priced in. Loan growth will not be very large. Many banks, such as US bank Wells Fargo, are already resorting to buying loan portfolios in order to grow.
We are very cautious about banks. Most of the uncertainty about regulations is over now, which is a clear positive. However, much of this has already priced in and with the upcoming presidential elections in the US, there is a lot of rhetoric about banks. We are underweight banks in developed markets. We do have Bank of Ireland, which is a leading bank in a country whose economy is clearly recovering. In Japan, we have a position in Suruga Bank, which offers mortgages, a product that is hard to find elsewhere in Japan.
We have several emerging market banks in the portfolio. These are the higher-quality banks with a valuation discount, located in growing emerging countries.
This brings us to the first trend in our portfolio: Emerging Finance. The Emerging Finance trend focuses on the growth of the global middle class. In emerging markets the middle class is growing fastest while financial penetration is still very low.
We expect this trend to have a relatively difficult time in 2016. The beginning of this year was a clear illustration of the current volatility in emerging markets. On balance, though, we expect a plus this year, mainly because of the very low valuations of the stocks in this trend.
The portfolio has 30% exposure to the Emerging Finance trend, of which around 16% is invested directly in emerging markets.
The second trend in the portfolio, Aging Finance, is about the need for financial lifecycle planning. An important part is how to build enough savings to retire comfortably. Many of our investments are pension or life insurance related. 35% of the portfolio is invested in stocks related to the Aging Finance trend.
Aging Finance stocks had a difficult time in 2015, mainly because of the problems life insurers were facing. Interest rates were supposed to rise, but didn’t, which negatively affected insurers. In addition, European insurers faced uncertainty about Solvency II. Both negative factors will turn positive in 2016, as interest rates are likely to rise (somewhat at least) and Solvency II will be introduced, putting a stop to the uncertainty surrounding this new regulation. An additional positive factor is the very low valuation of insurance stocks.
Three consequences of Solvency II
As for Solvency II, we foresee three main consequences of this new standard. First of all, the number of mergers & acquisitions in insurance will rise. Insurers will have a fresh look at their portfolio and swap parts of their operations that will not be profitable anymore for other, more attractive businesses. Second, there will be certainty about the dividend companies can pay out. We do not expect many insurers will be required to do a capital raising. Third, there will be an increasing focus on capital-light models in the next ten or so years. There still isn’t a good offering for the ‘mid-income’ category (EUR 50-500k), which has too little money for private banking and too much to be contented with ETFs or robo-advisors. The mid-income category is a growing market, presenting huge opportunities. St. James is a good example of a company that meets this growing need. Fintech companies can also play an important part here.
For asset managers the climate will be challenging. The level of assets will be under pressure, especially in fixed income investments. Assets under management are likely to either stay the same or decline, depressing earnings. Valuations are also quite lofty. On a positive note, the long-term asset base is growing as there will be an increasing need for Defined Contribution solutions. This segment will be serviced by asset managers, insurers and banks, with the help of Fintech solutions. We are invested in asset managers that can bring in new money, such as KKR, and turnaround stories.
Digital Finance was hot in 2015 and it will remain so in 2016. It was the best performing trend in the portfolio last year. This year, growth will remain strong while consolidation is heating up. Although at first this will happen in the US, we would not be surprised if a global deal would be struck in 2016. Will banks be completely replaced by Apple, Google and Amazon? Will all bank branches disappear? No, but we do see significant changes coming to the financial industry which will look very different ten years from now. There will be stronger differences between winners and losers.
The investment community is becoming increasingly aware of the possibilities of digital payment, security solutions and blockchain. Whereas Fintech was last year’s buzz word, this year it will be blockchain. A blockchain is a carefully cryptographically protected, public ledger. It is like a super-advanced, cloud-based spreadsheet, which is maintained by its users. By far the most famous implementation of blockchain is in the transaction procedures for cryptocurrencies like bitcoin.
The blockchain technology is widely expected to reduce the need for intermediaries like banks. Currently, there is only one user case, i.e. a business model that actually works on blockchain technology: the NASDAQ blockchain user case for managing shares of private companies called Linq. In 2016 we expect to see more user cases. One of the most likely leading groups for blockchain development is R3 CEV, which connects 51 global banks but also regulators, central banks and ministries of finance.
Don’t fear Fintech, embrace it to grow
We do not think blockchain and other Fintech technologies will be disruptive, but rather expect existing parties to cooperate with Fintech companies to make their operations more efficient or client-friendly. Platforms like MasterCard and Visa are here to stay. It is important to be selective, though. We like companies that embrace the Digital Revolution, for example by downsizing their back offices and introducing blockchain processes.
35% of our portfolio is invested in Digital Finance, of which 21.5% is in non-financials or Fintech. The latter percentage includes more traditional investments such as Visa, MasterCard and Alliance Data Systems, which have been in the portfolio since 2008. We also invest in the suppliers of technology, such as Temenos, a Swiss supplier of banking software systems, and Earthport, which provides white-label cross-border payments services to banks and other financial institutions.
With the first Fed rate hike behind us and 1-3 further hikes expected, a lot is already priced into especially US bank stocks. Other developed markets banks such as in Canada, Australia, the Nordics and even Japan look fully valued. As there is relatively little loan growth, higher rates offer the main hope for further performance. A steeper yield curve would also benefit life insurers across the globe and valuations there are a lot more reasonable. Most of our Financials continue to trade on very attractive valuations. The sell-off in December has now created what we believe is a double digit upside potential.
If long-term interest rates were to rise gradually the upside for the sector would increase. Very interesting investment areas are life insurance and certain diversified financials. Our investments in the Fintech space, such as electronic/ mobile payments and financial services IT, have been steadily growing.
Robeco New World Financial Equities is a long-term investment, which is interesting for investors who believe in the strength of the Emerging, Aging and Digital Finance trends. Taking an even longer term horizon, we expect regulations, low valuations and digitization to turn the financial sector into one of the most important sectors in 10 or 20 years’ time.