Six themes to watch for financial equity investors 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.

1. Blockchain
   Blockchain or distributed ledger technology will finds its first real and recognized user cases, but at the same time bitcoin will become ever more volatile. With increasing regulation and growing critique of its very poor carbon footprint, other (regulated) crypto-currencies which require no mining become more popular.
   
   
2. Volatility
   As (long-term) interest rates increase with growing inflation, volatility will also rise. This will lead to much more interest in life insurers, exchanges and investment banks, but whether overall markets will end higher in 2018 depends on how measured these increases will be.
   
   
3. Consolidation
   Consolidation in payments continues with high activity in the US, Europe, cross Atlantic and increasingly the Far East. Tech platforms will become more important globally, in terms of direct influence with more and more partnerships but also as a model for the future financial services landscape in the rest of the world.
   
   
4. Geopolitics
   The places to be in 2018 are China and India. These two 1 billion+ population countries are obviously growing in importance, but the US and Europe remain very important for market sentiment. How will the changes in tax law affect the US and the rest of the world? What will president Trump and his administration do in 2018?
   
   
5. Tech investments
   After years of underinvestment and the need to make investments on the regulatory side and in KYC (know your client), banks, insurers and asset managers will devote substantial resources to getting their core technology platforms up to speed. Some companies will try to hide this for their shareholders by capitalizing these investments on the balance sheet, but no matter how the investments are made, they are necessary!
   
   
6. Regulation
   As the regulatory pendulum swings back from more and more regulation and rules to less regulatory pressure, one should not be surprised by the occasional unexpected new and tougher regulation, as there are still enough politicians and regulators out there with little love for the financial sector. On top of that China is doing some regulatory maintenance after years of laissez-faire. Finally, around the world there is a need for better rules on Initial Coin Offerings, crypto-currencies and more generally fintech innovation.