Canadian financial services companies will continue to thrive in 2007. Despite an expected slowdown in the U.S. and Canada, economic fundamentals — low and stable interest rates, low inflation, low unemployment and strong equity markets at home and abroad — remain strong.

“It’s tough to be negative on financials,” says Dom Grestoni, managing partner and head of North American equities at I.G. Investment Management Inc. in Winnipeg.

Although U.S. domestic demand is slowing, many other economies, particularly those of China and India, show strong growth. And that will help support the Canadian economy, says Grestoni: “While lower growth in the U.S. may worry some people, I’m not going to lose sleep over it.”

Rachel Volynsky, vice president of TD Asset Management Inc. in Toronto and lead manager of TD Canadian Value Fund, agrees. If interest rates stay stable as expected — they are projected to move sideways or drop a bit in 2007 — Canada’s financial services sector will be set to do well, she says. And if the economy suffers a major slowdown, financial services firms will suffer less than others, she adds.

Fund managers don’t expect consolidation to be a major theme in 2007, although some small fish could be swallowed by the big players. “Most of the consolidation in Canadian financial services has already happened,” says Bernard Gauthier, vice president of equities at CIBC Asset Management Inc. in Montreal.

Most managers are overweighted in banks, at market weight in big insurance companies and underweighted in property and casualty insurers, investment dealers and mutual fund and investment-management firms.

> Banks. “All the banks have given us good guidance for 2007, and banks are usually pretty conservative in their guidance. Their earnings projections are good, between 5% and 12% earnings per share growth in 2007,” says Gauthier.

Although Gauthier and others expect a slight to modest deterioration in credit quality, they note the market has long been expecting this. The damage will be limited as long as interest rates and unemployment rates don’t move up.

“Banks have been reducing risk and securing more of their lending with residential real estate,” says Tim Johal, a financial services analyst with I.G. Investment Management.

Some money managers are concerned that Canadian banks are trading at higher price/earnings multiples than many global banks. “Canadian banks are not overvalued, but they are fully valued,” says Chris Lowe, senior vice president and portfolio manager at Burlington, Ont.-based AIC Ltd. He does not hold any of the Big Six Canadian banks in his global funds, arguing foreign banks with lower valuations and strong growth potential are more appealing.

Others contend that Canada’s strong economic fundamentals and domestic banks’ profitability records justify the higher multiples. Grestoni, for one, believes Canadian banks are “worth those valuations.”

For his Canadian portfolio, Lowe likes TD Bank Financial Group and Royal Bank of Canada. He says both have strong, vigorously defended domestic franchises.

Royal Bank is a case study in consistency, performing well in every business line, says Lowe. Even its U.S. operation, after initial problems, is starting to bloom. Grestoni agrees: “Royal Bank is the largest holding in many funds, and we think it’s a well-justified position.”

TD has also performed remarkably well, more than doubling its profit in the fiscal year ended Oct. 31, 2006, from a year earlier, mostly on the back of its strong domestic line. Its Portland, Me.-based subsidiary, TD Banknorth, has had poor results. TD has installed a new CEO at Banknorth and is taking it private.

Bank of Nova Scotia draws about one-third of its profit from its international businesses, mainly in the Caribbean and Latin America. Some investment managers believe this gives Scotiabank greater growth potential and insulates it from a downturn in the domestic market. “Its international growth has been overwhelming,” Volynsky says.

Bank of Montreal suffered this year from a lagging retail division, losing share to rivals. Frank Techar, former head of BMO’s Chicago-based subsidiary, Harris Bankcorp Inc. , has been given the job of righting the bank’s domestic retail ship. “I think he’s going to do it, but it’s going to take more than a year,” Grestoni says.

CIBC did a good job of repairing its balance sheet in its first fiscal year after absorbing a $2.4-billion Enron Corp.-related body blow in 2005. The bank cut costs, reduced risk and tended to its core retail business. CIBC was rewarded with a turnaround year. “CIBC is doing all the right things,” Lowe says.

@page_break@Montreal-based National Bank of Canada posted good numbers for 2006. “Its wealth-management arm has allowed it to push out its frontiers,” Lowe says. But some analysts fear the bank’s reliance on the Quebec retail market makes it vulnerable to an economic downturn.

Both Montreal-based Laurentian Bank of Canada and Edmonton-based Canadian Western Bank are considered good growth stories outside of the Big Six, although fund managers don’t consider them the bargains they once were.

> Life And Health Insurers. Like the banks, the big Canadian insurers continue to reward investors with strong earnings. They also offer shareholders a safe harbour in an economic slump. “If the economy begins to slow, and people are looking to stay in the markets, the lifecos will pick up some of that money,” says Greg Placidi, vice president and portfolio manager at AIC.

“The insurers are less exposed to loan losses and credit quality than the banks. On the other hand, their profitability is lower compared with the banks,” adds Gauthier.

Management is also strong in the subsector. “The Canadian life insurance industry has been almost a model for the insurance industry globally,” says Placidi.

In his opinion, the strongest management team belongs to Toronto-based Manulife Financial Corp. , the “premier” life insurer in the country. Manulife does almost two-thirds of its business outside Canada, focused in the U.S. and Asia. Manulife’s acquisition and integration of Boston-based John Hancock Financial Services Inc. has been a success, he says, and Manulife’s Asian business will probably be strong in 2007.

Winnipeg-based Great-West Lifeco Inc. has a strong Canadian presence, with effective distribution through its in-house sales force. Domestic prospects are good, but growth is tied to the company’s international performance — particularly in the U.S., where it has recently seen some success. Its Britain-based European franchise has had good earnings growth.

Sun Life Financial Inc. has a strong franchise in Canada but has had problems with its Boston-based asset management business, MFS Investment Management, and with its U.S. variable annuity business. The company is looking to grow its operations in India, where it has taken a significant position.

Quebec City-based Industrial Alliance Insurance & Financial Services Inc. does all its business in Canada. It has been on the acquisition trail the past several years, picking up small brokerages and mutual fund firm Clarington Funds Inc. in an attempt to spread out from its Quebec base and broaden its platform. “The management team has executed very well,” Volynsky says.

> Property & Casualty. The P&C segment is expected to come off its historically high profits of the past few years. “We’re going to see premium growth continue to slow,” Placidi says. “But that’s not necessarily a bad thing. It shows a company knows how to underwrite its operations and walk away from unprofitable business.”

ING Canada Inc. is the strongest player, in Placidi’s view: “Its long-term results and combined ratio [operating expenses and losses as a percentage of net premiums earned] are testimony to that.”

Volynsky has a position in Kingsway Financial Services Inc. because its valuation is so low that it discounts most of the risk involved with owning the stock. “There’s a lot of cushion for error,” she says.

> Mutual Fund And Investment Managers. Money managers each have their favourites among Canada’s mutual fund and investment-management companies. CIBC’s Gauthier holds a position in IGM Financial Inc. because of its captive distribution model as well as its attractive valuation.

CI Financial Income Fund also benefits from multiple distribution channels, including subsidiary Assante Corp. and a captive distribution arrangement with Sun Life. In addition, Grestoni says, the income trust tax changes are “neutral to positive” for the firm. “CI will benefit from lower taxes until 2011, and then it can convert back [from an income trust] with no tax consequences for unitholders,” he says.

Volynsky prefers Toronto-based AGF Management Ltd. for its lower valuation and fund-management expertise. “Growth has accelerated again. AGF is looking good for the RRSP season,” she says.

Fund managers prefer U.S. brokerages to Canadian ones because of their size, global reach and lower valuations. Canadian brokerages that have caught their attention include GMP Capital Trust and Rockwater Capital Corp. GMP has posted phenomenal earnings as an investment dealer for commodity issues and has made efforts to diversify through private-equity arms and by pursuing global opportunities, says Grestoni. He believes Rockwater has long-term potential as a play on the company’s management team, which has a track record of success.

Most managers are shying away from holding big — or, in some cases, any — positions in TSX Group Inc. , which they consider expensive, even though it is relatively cheap compared with global exchanges. There is concern about the shifting global exchange landscape and TSX’s position in it.

Most managers get exposure to Power Financial Corp. and its subsidiaries, Great West and IGM, through parent Power Corp. , which they consider a well-run firm with solid long-term prospects. IE