Financials’ recovery to continue

Canadian banks, insurers, asset managers and other financial services firms should do well despite only modest Canadian economic growth – forecast at 2%-2.5%, buoyed in part by a stronger U.S. economy, which is predicted to grow by 2.5%-3%.

“We’re not saying it’s going to be a rip-roaring [Canadian] economy in 2014,” says Shane Jones, chief investment officer with Toronto-based ScotiaMcLeod Inc. “But we don’t think it is headed anywhere near recession, either.”

Portfolio managers say there’s little likelihood of a “hard landing” in the Canadian real estate sector, projecting housing prices to stay stable or drift modestly lower. Even if these prices drop further, that is unlikely to have much of an impact on the earnings of Canadian banks and other financial firms.

“The loan-to-value ratios [of mortgages] at Canadian banks,” says Jones, “are in very good shape.”

Short-term interest rates in Canada are likely to remain low or edge upward only slightly in 2014, says Richard Nield, portfolio manager with Invesco Canada Ltd. in Austin, Tex.: “I think the Bank of Canada would like to keep rates low, just because there have been pockets of weakness in the Canadian economy.”

However, most portfolio managers agree that longer-term rates are likely to continue to drift higher. That will provide relief to insurers, whose long-term liabilities are calculated by assuming that rates remain at current levels.

In general, portfolio managers’ funds are market-weighted in bank stocks and life insurers but underweighted in other financials.

Here’s a look at what is expected in Canadian financial services, by subsector:

– banks. Fund portfolio managers believe that Canadian banks will remain solid investments in 2014.

“We see the banks having a decent year, with earnings growth in the 7%-8% range,” Jones says. “And if you combine that with dividends, and you get additional dividend growth, that could easily translate to 10%-12% total return.”

Dividends are expected to rise in line with the banks’ earnings. However, most of the banks are close to the upper limit of their target payout ratios, so these increases are not expected to be dramatic.

There are potential headwinds, particularly in domestic retail banking – the core business for Canadian banks. Projected Canadian economic growth will not be strong enough to produce big returns, particularly as loan-loss provisions are at low levels and widely expected to rise, given the high debt loads of Canadian consumers.

“Loan growth is still doing well, as it has for a long time, and that really has been led by the mortgage market,” says Jennifer Radman, vice president and portfolio manager at Caldwell Investment Management Ltd. in Toronto. “I think there’s an expectation on the Street that loan growth is going to slow down a little bit.”

However, a decrease in loan growth may be muted by less deterioration in net interest margins, says Kedwell: “Net interest margin is not yet going to expand, but the pace of the decline is really starting to level out for some banks. So, while you have less forecasted loan growth, you also have less pressure from declining net interest margins.”

Portfolio managers are looking to the banks’ wealth-management and non-domestic businesses, such as U.S. or international retail banking and global capital markets, as segments in which opportunity and growth will be found.

“Wealth management was the strong area for the banks [in 2013],” Radman says. “As long as markets continue to do well, that should do well, too.”

There is a possibility of banks making acquisitions to diversify their businesses away from domestic banking. “Each bank is generating excess capital,” Kedwell says, “and that excess capital is going to be put to work.”

Among the big banks, portfolio managers prefer Royal Bank of Canada for its dominant position in domestic retail and for its wealth-management business, as well as Toronto-Dominion Bank for its U.S. retail business. Bank of Nova Scotia also has strong long-term potential in this line of business, despite facing some recent headwinds in its international business due to weakness in emerging markets.

Next: Insurance
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– insurance. The share prices of the major life insurers had a significant run-up in 2013. Investors flooded back into these names as long-term interest rates began to inch upward.

For insurers to have another strong year in 2014, long-term rates must continue to rise and economic conditions in Canada and elsewhere must continue to improve.

“The major life insurance companies still have a little bit of upside,” Jones says.

Certainly, higher long-term rates have been a boon for the insurers, which had struggled in recent years because of record-low rates.

“With rates moving higher, the insurers now have more pricing power,” Nield says. “They can come out with insurance products that are more attractive for the customer on a yield basis, whereas that was difficult before.”

The big insurance names also have been helped greatly by the strong year in the equities markets.

“People underestimate how important the wealth-management pieces of the business are for companies such as Manulife Financial Corp. and Sun Life Financial Inc.,” Nield says. “Those businesses not only are growing quickly, they are gaining assets under management rapidly.”

Among the big life insurers, portfolio managers like Manulife, which should be able to continue to find more efficiencies. Says Jones: “I think that’s going to help boost earnings.”

Portfolio managers also like Great-West Lifeco Inc. (GWL) – particularly its recent purchase of Irish Life Assurance PLC, which was made at a favourable price.

Among the property and casualty insurance firms, portfolio managers like Intact Financial Corp., describing it as a conservative, high-quality P&C franchise.

– asset managers. Firms in this subsector have seen their prospects improve as investors have shifted their money into rising equities markets.

“We started seeing that earlier in the RRSP season,” Nield says, “so it’s benefiting asset managers.”

Portfolio managers like Brookfield Asset Management Inc., which has established a track record of delivering strong earnings and has positioned itself well for future growth.

“[Brookfield’s] fund performance is very good,” Nield says. “So, it’s continually able to go out and start new funds and to raise money from either sovereign countries or large institutions. We’ll continue to see its assets under management increase.”

Among the major distributors, both Canaccord Genuity Corp. and GMP Capital Inc. have struggled due to the pullback in the commodities sector, although portfolio managers feel that Canaccord has done more to diversify away from its dependence on resources.

– stock exchanges. Portfolio managers generally are steering clear of TMX Group Ltd. Says Kedwell: “It’s a high-return business that seems fair-to-full value. Nothing really against the name, but we think there’s better opportunity elsewhere.”

– holding companies. Some portfolio managers prefer getting exposure to GWL through Power Financial Corp., which owns 67% of GWL’s shares.

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