Money managers remain bullish on the long-term prospects of Canadian financial services firms, praising their stability and strength relative to their global peers. However, most money managers believe that in the near term, financials may have reached a plateau. The sector might even see a slight correction and otherwise will grow only modestly this year, in line with the moderate economic recovery expected both in Canada and globally.

“The Canadian financial services sector has really proven itself to be world-class,” says Norman Raschkowan, chief investment officer at Mackenzie Financial Corp. in Toronto.

Money managers praise Canada’s financial services firms, particularly the big banks, as being generally well run, well regulated and well positioned for long-term growth. Most money managers are projecting the stock prices of these firms to rise by 5%-7% this year.

Few think the sector will provide investors with an encore of its strong performance of 2009, when the S&P/TSX financial subindex closed 94% above it’s February low.

“The easy gains are over,” says Richard Nield, portfolio manager with Toronto-based Invesco Trimark Ltd. in Austin, Texas. Nield feels the big banks are generally more expensive than the insurance companies, from a valuation perspective. But, he says, the insurers are likely to face more headwinds from the low-interest environment, which lowers the future value of their assets; those asset values are tied to the firms’ long-term liabilities.

Money managers are predicting that the economy will continue to recover gradually but remain sluggish, with unemployment stubbornly remaining around current levels. Interest rates should stay flat until the summer, when money managers expect that the Bank of Canada, as well as other central banks globally, will start raising them, although not significantly. In general, money managers don’t believe that either deflation or inflation is a significant risk in 2010.

“If rates rise by 25 to 50 basis points, it won’t make much of a difference to the performance of financials,” says Shane Jones, managing director and head of Canadian equities with Scotia Asset Management LP. “In fact, a modest rise in rates might be good for banks and insurers, as credit spreads will widen.”

A major concern for market observers are those banks, insurers and other financial services companies that have exposure to the U.S. commercial real estate market and U.S. lending, areas in which defaults over the next few years are expected to be high. Manulife Financial Corp. has particularly high exposure to the U.S. market. Royal Bank of Canada, Toronto-Dominion Bank and Bank of Montreal all have U.S. platforms and some exposure to the U.S. commercial market as well. “Weakness in U.S. commercial real estate is material enough,” Raschkowan says, “to slow down growth significantly for those firms affected.”

A key risk for the entire Canadian financial services sector is the uncertainty around changes arising from international efforts to change how banks are regulated globally. (See story below.) Although Canadian banks and insurers are considered models of good governance and stability in comparison to their global counterparts, any changes made internationally will undoubtedly affect domestic banks. As a result, senior executives at Canadian banks and insurers are cautious about deploying any of the significant amounts of capital they’ve raised in the past year.

Possible regulatory changes requiring banks and insurers to hold greater levels of capital may limit domestic and global banks from posting the type of standout gains they’ve made in the recent past. Says Raschkowan: “The rate of earnings growth from financial services firms will not look like [that of] the past 10 years.”

In general, money managers’ portfolios are slightly underweighted in banks, which they feel may have overperformed — at least, in the short term; are also slightly overweighted in insurers, which many feel are slightly undervalued; and are at market weight in the other financial services categories.

> Banks. Despite booking significant loan losses, Canadian banks were able to post decent earnings in 2009, thanks mostly to robust domestic books of business and surging trading revenue. None of the Big Six had to cut its dividend — something many industry observers feared might happen in 2009.

“Over the long term, Canadian banks have always shown an uncanny ability to recover,” says Dom Grestoni, senior vice president and portfolio manager with I.G. Investment Management Ltd. in Winnipeg.

@page_break@Domestically, Canadian banks have been able to profit from the fact that many foreign lenders have left the Canadian lending space, allowing the Big Six to fill the void.

Most money managers are predicting that loan losses will stabilize in 2010, although there may be a creeping up in losses over the first half of the year, particularly in the banks’ credit card businesses. But some money managers doubt the banks’ capital-market divisions will be able to maintain the high levels of trading revenue generated in 2009 and thus won’t be able to offset still-high levels of loan losses.

Money managers believe the banks will maintain their historically high capital levels, but are divided on whether the banks will deploy any of that capital. Some think the banks could increase dividends, while others predict they won’t. “The banks still feel it’s too risky,” Jones says.

Royal Bank and TD are still favoured for their dominant positions, but some money managers believe those banks’ stocks are too expensive. Many money managers also believe Bank of Nova Scotia is selling at a premium and may face headwinds from its international exposure — which, nevertheless, some feel is one of the bank’s unique strengths over the long term.

Some money managers consider Canadian Imperial Bank of Commerce a better play, from a valuation point of view — particularly if it continues to avoid the type of major problems that it seemed to encounter with regularity in the past. As well, CIBC’s focus on domestic banking will allow it to avoid the types of challenges faced by its counterparts with significant U.S. and international businesses.

BMO is also believed to be a good buy, from a valuation standpoint.

“These two banks have arguably had a more difficult time,” Raschkowan says, “but they potentially offer more upside.”

Most money managers believe bank share prices may have overshot and could flatline or dip early in the year. “It’ll be a transitional year for banks in 2010,” says Dale Harrison, portfolio manager and co-head of the Canadian equities research team with RBC Phillips Hager & North Investment Coun-sel Inc., who believes significant loan losses will continue to be a drag on bank earnings this year. But, he says, “In 2011, we’re back to the races.”

> Insurers. In general, money managers think Canada’s big insurance companies will struggle with low interest rates and that their investment exposure to equities will leave them vulnerable if markets turn lower in 2010.

“The road ahead for the insurers is still murky,” Jones says.

Canadian insurance companies experienced greater turbulence in 2009 compared with the banks. Most notably, Manulife was forced to cut its dividend and issue equity, events that spooked investors and led them to sell off shares of the other major insurers as well. However, the insurers, like the banks, saw their share prices rebound sharply last year, starting in early March, as investors picked up what they considered to be more affordable — but high-quality — companies with long-term potential.

Manulife’s significant exposure to the U.S. market remains a key risk. Sun Life Financial (Canada) Inc. and Great-West Life Assurance Co. also hold positions in U.S. commercial real estate, but to a lesser degree.

Industrial Alliance Insurance & Financial Services Inc. , Canada’s fourth-largest insurer and a dominant player in Quebec, is considered to be a strong niche player.

Some money managers believe the market’s negative sentiment toward Canada’s big insurers presents good opportunities. “The insurers could have a dramatic run, if sentiment improves,” says Harrison, who is overweighting the insurers.

Grestoni also is bullish. “Despite their difficulties, there is still a need for insurance products, both complex and simple,” he says. “It’s their natural strength and sweet spot. They are in good shape, in the greater scheme of things.”

One concern among money managers is the difficulty in getting strong assessments of risks. “Life companies are far more complex than banks,” Jones says, “and it’s harder to get a read of what they’re holding.”

Possible regulatory changes at the provincial level, especially in auto insurance, may help property and casualty insurers, but there’s also a lot of uncertainty in this segment of the market. The big banks are trying to expand their insurance powers and, over the longer haul, that might be a challenge for this segment of the insurance business.

P&C insurer Fairfax Financial Holdings Ltd. of Toronto has done well in the past two years, thanks to savvy investments — specifically, large purchases of credit swaps that resulted in large gains.

> Asset Managers. Money managers regard the asset-management companies as a play on the equities markets, and tend to prefer the bigger, established players in that segment. “[Asset management] is still an attractive business because it requires little capital,” Grestoni says. “You’re only managing the assets, not assuming the risk. I think it will continue to be a high-growth industry.”

Raschkowan agrees: “In general, consumers are rebuilding savings right now, and that’s good for the asset managers and the financial services industry in general.”

One of the major, long-term issues facing this segment is competition from the banks. But money managers feel that those asset managers that can carve out niches and find ways to stand out will thrive.

> Distributors. The major distribution shops, such as Toronto-based GMP Capital Inc. and Vancouver-based Canaccord Financial Inc., are considered cyclical plays on the equities markets.

GMP merged its wealth-management subsidiary, GMP Private Client LP, with Richardson Partners Financial Ltd., also of Toronto, in late November. The combined entity manages more than $11.5 billion on behalf of high-net worth clients.

Canaccord has endured a turbulent couple of years, but the firm seems to be moving in a positive direction. “It’s a bull-market stock,” Harrison says. “We think it might have a lot more to run.”

> Stock Exchange. Managers appear to be avoiding TMX Group Inc. while they wait for its competitive landscape to become easier to read. In the past several years, new entrants have shaken up the business. “We’ve seen how quickly alternative exchanges can be set up and take share,” Grestoni says.

> Holding Companies. Money managers continue to be fans of Montreal-based Power Financial Corp. as a play on its subsidiaries, IGM Financial Inc. and Great-West Lifeco Inc., both of Winnipeg. Says Nield: “Power has had a tremendous long-term track record of enhancing shareholder value.” IE