If there’s one sector that is being transformed completely, it’s the financial sector. Blockchain, fintech, and all sorts of other developments will continue to change the financial world as we know it. We have distilled six themes investors need to watch in 2018.
At the start of 2018, we are in a market with slowly increasing volatility from very low levels, with a very flat yield curve. Interest rates are historically low and credit spreads have also narrowed substantially. US banks and many European banks are expensive. Financials with a high dividend yield or the fantasy of higher dividends or buybacks have seen valuations climb, as investors are searching for yield. However, there are still quite a few attractively priced financials. These often have lower dividend yields, are more growth-oriented, or investors do not believe in their cash-flow generating and future dividend-paying capacity. Financial tech stocks are mostly valued at higher levels but also have the earnings growth to justify these valuations.
So what will happen in 2018? As long as economic growth remains good around the globe and recession is still far away we see no justification for such a flat yield curve. Lower tax rates in the US and many other countries will surely help boost economic growth further and lower unemployment, which at some point will have to result in higher inflation. We therefore expect both short and long rates in the US to rise, while elsewhere long rates will rise as Quantitative Easing around the planet is reduced or even unwound. Credit spreads are probably too tight, but as long as credit quality remains strong, credit spreads should widen only gradually.
In a world with high valuations for the overall equity market we are happy to be focused on the financial sector, where many undervalued investment opportunities remain. With very low volatility, very low interest rates and a very flat yield curve, but at the same time very low unemployment and solid economic growth, we think it’s just a matter of time before central banks stop creating such a big imbalance in all asset markets. When that happens, volatility, interest rates and the yield spread should increase significantly. Hopefully, the increase will be gradual and measured so that it does not impact global economic growth, credit quality and equity markets too much. Undervalued investments in life insurers and global exchanges would surely benefit.
Digital finance stocks have solid long-term (earnings) growth potential but needs to beat expectations in order to deliver further stock performance. In emerging finance there are still many attractively priced financials with good growth potential, although their performance is very much country dependent. We like most of Asia - especially China and India - Africa, Russia and certain parts of Latin America, particularly Argentina.
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