At best, the stocks of Canadian financial services companies will match the overall stock markets in 2011 — but they may well lag, as they did last year.

Although these companies are well past the tumult of the global financial crisis, banks, insurers and other financial services firms are still contending with the headwinds of lingering global and domestic economic uncertainty, consumer indebtedness and narrow interest rate margins.

“You’re not going to get 20%-30% returns anymore from Canadian financials,” says Shane Jones, managing director and head of Canadian equities with Scotia Asset Management LP in Toronto. “I think we’re going into an era of 7%-10% returns.”

Portfolio managers are assuming moderate gross domestic product growth of around 3% in Canada and 2%-3% in the U.S., so interest rate increases, on either side of the border, will be minimal and occur later in the year — or not at all.

Some portfolio managers believe that the share prices of banks and insurers already reflect these modest economic growth expectations. But if equities markets enjoy a stronger than expected 2011, or if interest rates rise slowly and steadily, thereby improving margins, banks and insurers could surprise investors with growth levels higher than widely predicted.

“If I had to lean one way or the other at this juncture, maybe financials will do a little bit better than what the consensus thinks,” says Stuart Kedwell, vice president, senior portfolio manager of Canadian equities and co-head of the Canadian equities committee with RBC Global Asset Management in Toronto.

Although the Basel III global banking rules have not been finalized, most portfolio managers believe that the threat of overly stringent regulations, which had hung over Canadian banks last year, has now largely passed and the big banks should be able to meet any new capital requirements. However, possible regulatory reform in the insurance industry still hangs over that subsector, representing a possible negative to future earnings.

Within the overall financial services sector, portfolio managers are generally “market weighting” the banks for 2011, slightly underweighting the insurers and slightly overweighting the asset-management firms. Here’s a closer look at the subsectors:

> Banks. Portfolio managers believe that the big Canadian banks will be hard pressed to outperform the market in 2011. Explains Richard Nield, portfolio manager in Austin, Tex., with Toronto-based Inves-co Trimark Ltd.: “There are just not a lot of lines of bank business that you can count on for double-digit earnings growth in 2011.”

Loan growth is expected to slow this year, as Canadian consumers deal with paying down record levels of debt. The federal government is also signalling that it might step in if consumer indebtedness continues to grow. In fact, there’s some speculation that the mortgage-lending regulations could be tightened.

The banks’ commercial and international lending growth is expected to offset the slowdown in domestic retail lending somewhat. However, there’s risk in their capital markets businesses. Says Jones: “The biggest risk to any banking system in the world, including Canada’s, is a real meltdown in Europe in 2011.”

Most portfolio managers believe inves-tors can expect dividend increases or share buybacks from the Big Five in 2011, but they expect these to be modest. Banks’ boards of directors have to walk a fine line — maintaining high core capital ratios while making acquisitions, investing in growth and returning capital to shareholders.

Canadian banks are likely to be on the acquisition trail in 2011, although strictly on an opportunistic basis. Indeed, there has already been action on this front, with Bank of Nova Scotia in the process of acquiring the rest of DundeeWealth Inc. it did not already own; Bank of Montreal announcing that it was purchasing Milwaukee-based bank Marshall & Ilsley Corp.; and Toronto-Dominion Bankdeciding to purchase Farmington Hills, Mich.-based Chrysler Financial Corp.@page_break@> Insurance. This subsector struggled in 2010, beset by low interest rates and continued weakness in global equities markets, forcing insurers to book reserves against future liabilities as required under Canadian accounting rules, which resulted in quarterly losses.

In fact, the life insurers still have a long road ahead of them, Jones says: “They’re in a period of slow growth.”

Manulife Financial Corp., which saw its share price drop the most in 2010 among the four major Canadian insurers, had delved heavily into the variable annuity and long-term care businesses during the boom years and is now being forced to book massive reserves against these products as markets and interest rates remain unfavourable.

Nield doesn’t believe that Manulife has reserved enough for these long-term liabilities: “[The company has] done a little bit, but I think there should probably be some [further] goodwill impairments, and I think reserves probably need to go higher.”

Portfolio managers generally consider Great-West Lifeco Inc. to be the best bet among Canadian insurers. GWL was the most conservative before the financial crisis in terms of what products it sold and how it hedged its positions. Says Nield: “It’s more of a traditional life insurer.”

However, despite the headwinds the insurance industry currently faces, portfolio managers like the long-term prospects for the insurers, particularly if interest rates begin to rise and equities markets appreciate. Specifically, they like the significant business lines that Manulife and Toronto-based Sun Life Financial Inc. have built abroad. “There’s little growth in North America for the insurers,” Jones says. “Most of the growth is going to come from Asia.”

Adds Dom Grestoni, senior vice president and portfolio manager with I.G. Investment Management Ltd. in Winnipeg: “If you buy insurance companies now, you’re not going to be unhappy in a couple of years.”

Of the property and casualty insurers, portfolio managers suggest that Intact Financial Corp. is well positioned as the dominant player in its sector. Consumers may choose to forgo buying life insurance in a period during which they are worried about paying down debt, but they can’t do the same with home and auto insurance.

> Asset Managers. Portfolio managers generally like the outlook for these firms. They were hit hard by the equities market fallout during the downturn but are performing better now that equities prices are slowly moving upward. These companies had cut costs during the recession; they don’t have the same capital requirements that burden the banks and insurers; and they are potential takeover targets for the banks and insurers who want to beef up their wealth-management divisions.

Kedwell finds asset managers quite attractive: “If equities markets surge by another 8%-10%, [asset managers are] going to do quite well, because all that [revenue] flows through to the bottom line.”

> Stock Exchanges. Most portfolio managers are not bullish on TMX Group Inc. , noting that the firm faces pricing pressure and other competitive headwinds. But, they say, it could be a takeover target for a foreign firm, given its dominant position in its market. Says Jones: “There’s a possibility [TMX will] either strike a partnership or another exchange may try to acquire it.”

> Holding Companies. Portfolio managers prefer Power Corp. of Canada as a way to invest in subsidiaries Investors Group Inc. and GWL. The parent, unlike subsidiary Power Financial Corp., also gives investors exposure to assets in Asia and to other private investment businesses. IE