Slow growth ahead for financial firms

This year, Canadian banks and insurers will search for revenue in the context of the overindebted Canadian consumer sector and the uncertain global economic outlook. Despite these negative headwinds, fund portfolio managers believe the Canadian economy will grow by 2%-2.5% this year, with some chance of besting that range if U.S. economic growth is stronger than expected, which would increase Canadian sales south of the border. “The U.S. might surprise,” says Dom Grestoni, senior vice president and portfolio manager with I.G. Investment Management Ltd. in Winnipeg, who points to recent improving, albeit still weak U.S. employment figures.

Fund portfolio managers think interest rates will remain at their historically low levels throughout 2012. Says Jennifer Radman, vice president and portfolio manager with Toronto-based Caldwell Investment Management Ltd.: “I think it’s pretty safe to say that central banks are going to keep the economy as accommodating as possible.”

Continued low rates are likely to be a drag on the earnings of the banks, which are seeking increased net interest margins and higher returns on investments, as well as on the earnings of the life insurers, whose product liabilities increase when rates are low.

In general, fund portfolio managers are market-weighted in banks and underweighted in insurance companies and asset-management firms in their funds for the year ahead. Here is a closer look:

> Banks. Fund portfolio managers don’t see a lot of upside this year for banks, as potential growth will be constrained by several headwinds. “You can look through all their business segments,” Radman says, “and you can see that it’s going to be hard for the banks to come by growth.”

The most prominent challenge is the likely slowdown in loan growth. “We’ve had close to double-digit loan growth every year, and that’s not sustainable,” says Richard Nield, a portfolio manager with Invesco Canada Ltd. in Austin, Tex. “I think loan growth rates will slow in 2012, perhaps to mid-single digits.”

A significant correction in the Canadian housing market, which has experienced several consecutive years of remarkable growth, is another potential pitfall. Any pullback would lead to Canadian consumers reining in borrowing and spending, and this would have negative knock-on effects on bank revenue, Nield says.

Despite the negative signals, fund portfolio managers are relatively positive on the Canadian banks, which have — time and again — shown the ability to adapt to changing economic and regulatory realities and grow earnings.

“Historically, the Canadian banks have done a tremendous job at being able to generate revenue,” Radman says, “and [the most recent] quarter is an example of how they have been able to come through and exceed what the Street was expecting.”

Fund portfolio managers expect the banks to increase their dividends next year — but only modestly, as all firms have to build up their capital reserves to meet the new international regulatory requirements under Basel III starting in 2013. “You might see every bank raise dividends once in 2012,” Jones says. “But I don’t think you’re going to see two hikes from any one bank.”

Banks are expected to be very careful about making acquisitions, preferring smaller deals that make sense strategically. “The acquisitions are going to have to be exactly the right fit,” Jones continues, “in exactly the right region and in exactly the right business line. These guys aren’t just going to go out and buy anything.”

Of the Big Six, portfolio managers appear to prefer Toronto-Dominion Bank, which, they say, has one of the strongest franchises — particularly in the retail side of the business. “Both in the short- and medium-term basis, it probably stands out looking the best,” Nield says. “What we’ve noticed is that when the markets sell off, TD tends to fare better.”

Portfolio managers also like Royal Bank of Canada but express some concern over both the bank’s capital markets business, which is vulnerable to any global economic slowdown, and its exposure to Europe.

> Insurance. Beset by low interest rates and bearish equities markets, Canada’s insurance companies had a difficult 2011, with share values down by 20%-40%. But even at these lower prices, portfolio managers aren’t bullish on the subsector for 2012. “We think they’re fair value,” Nield says. “But it’s tough to go out on a limb and say you need to own [shares of Canadian insurers].”

Portfolio managers say there are very few encouraging signs for the insurers in the short term. Earnings won’t move up until interest rates do. Canadian lifecos are required to update their product liabilities continuously, based on the assumption that current interest rates will not continue throughout the life of products, many of which have long durations. Thus, in periods of low interest rates, product liabilities rise, which reduces net income. When rates increase, the decline in product liabilities will enhance earnings.

In addition, changes in the value of financial assets, including equities, are also included in lifecos’ income statements under the international financial reporting standards adopted in Canada, effective for fiscal years starting in 2011. With stock markets so volatile, changes due to the IFRS can also dampen lifecos’ earnings.

Some insurers are making changes to their business models in order to adapt to the new economic realities facing their industry. Sun Life Financial Inc., for example, announced in December 2011 that it would be leaving the variable annuity and individual life products lines of business in the U.S. and laying off 800 employees.

Investing in the insurers today, fund portfolio managers say, really is making a longer-term bet on economic recovery and the eventual rise of interest rates. “If you have a stake in insurers, you don’t want to dump it; but you don’t add to it,” Jones says. “When you get an idea that interest rates will start to rise, then you step in.”

Among the major insurers, Winnipeg-based Great-West Lifeco Inc. is considered the strongest. GWL has a sound book of business, Nield says.

Among the property and casualty insurance firms, fund portfolio managers are impressed with Intact Financial Corp.’s management, lauding it for its recent record of acquisitions in particular. The chief concern is the firm’s market valuation, which some managers feel is a little high.

> Asset Managers. Portfolio managers have mixed feelings regarding the asset-management firms. On the one hand, they consider firms in this subsector as being generally well run and enjoying some competitive advantages. “We like the asset-management business,” Grestoni says. “It’s not capital-constrained, and it’s not overly regulated.”

Other portfolio managers worry that spooked Canadian investors may choose to sit on the sidelines in 2012 with their cash instead of making it available for investment and reducing these firms’ assets under management.

As with the insurers, portfolio managers see the asset-management firms as a play on a possible stronger than expected economic recovery. “If you think we’re oversold in the markets,” Radman says, “I’d pick up one of the asset managers.”

> Stock Exchanges. Most portfolio managers are steering clear of adding to any existing position in TMX Group Inc. until there is some resolution in the regulators’ response to the proposed acquisition of TMX by Maple Group Acquisition Corp., a consortium of Canadian financial services companies.

“Right now, [TMX is] not trading on fundamentals,” Nield says. “It’s trading on whether the takeover will be allowed.”

> Holding Companies. Fund managers continue to be positive in general about Power Corp. of Canada, saying that both its insurance subsidiary, GWL, and its wealth-management arm, Investors Group Inc., are strong, well-run franchises.  IE