The outlook for Canada’s financial services industry is uneasy as the new year gets underway. Although the underlying economic fundamentals are reasonably supportive, the risks to the outlook are significant and escalating.
Economic growth remains relatively solid, both globally and in Canada, yet the pace of that growth appears to be slowing. Interest rates are on the rise, which could exacerbate a downturn, particularly given the high levels of household debt and increasing corporate leverage. (See Interest rates point to bleak outlook.) Debt has long been a concern for policy-makers in Canada, but it’s also a growing worry globally. In mid-December 2018, the International Monetary Fund announced that global debt now is a record US$184 trillion.
Combine these economic factors with an expanding list of geopolitical risks that could rattle financial markets’ confidence – from uncertainty regarding Brexit to deteriorating U.S./China relations and rising trade tensions – and the financial services industry could find itself exposed to negative macroeconomic forces, downward pressure on asset prices and further financial market turmoil.
The final weeks of 2018 foreshadowed the forces that are likely to buffet the industry in the year ahead. Amid continued strong economic growth and robust job markets, the U.S. Federal Reserve Board raised its key policy rate for the fourth time for the year in late December, which – along with worries about global debt levels and intensifying geopolitical risks – helped drag markets downward dramatically.
As a result, equities markets finished the year on the downside for the first time since the global financial crisis of 2008-09. U.S. equities declined by about 8% for the year, and Canadian equities fared even worse, declining by 13%. The declines for some markets look even more precipitous when compared with the record highs they hit earlier in 2018.
The increasingly tumultuous outlook has Canadian banking regulators girding for tougher times ahead. In mid-December, the Office of the Superintendent of Financial Institutions (OSFI) ruled that the Big Six banks should build up their capital buffers a bit, given the growing risks. One major risk is the prospect of rising interest rates that would lead to higher credit losses for the banks as the economy slows and debt service costs rise.
Of course, the banks also will benefit from rising rates, as that provides them with wider net interest margins, which boosts earnings even as loan losses accumulate. Other, more market- sensitive elements of the financial services industry may be less pleased with the prospect of interest rates returning to more normal historical levels. Although rising rates may boost investment income, they often also are accompanied by declines in asset prices, which have a negative impact on financial services firms’ balance sheets and curb trading activity.
That said, central banks are not blind to these perils. Although the long-term trajectory of rates certainly is higher, both the Bank of Canada and the Fed have tempered expectations for interest rate hikes in the year ahead amid the growing headwinds facing the global economy. This suggests that unanticipated sharp moves higher in rates – which could really shake markets and financials – are not in the cards for the year ahead.
Alongside the macroeconomic and financial market forces that will underpin the industry’s fortunes in 2019, the regulatory environment is another key driver. Here, too, the overarching theme for 2019 is uncertainty – for both the regulators and the policies they’re pursuing.
The securities regulatory framework in Canada remains in flux heading into 2019. The long-delayed effort to build a new co-operative, federal/provincial authority has gained momentum, yet it remains a work in progress. Indeed, the prospect of a new national regulator launching this year remains unlikely. Without a politically powerful champion that is capable of bringing together a wide array of moving parts, this effort may never bear fruit.
The regulatory policy landscape also is murkier than ever this year, thanks in large part to the Ontario Progressive Conservative government elected last year, which has proven willing to intervene on key policy initiatives such as securities regulators’ plans to reform mutual fund fee structures.
The Ontario government’s propensity for political meddling and its anti- regulation ideology have thrown securities regulators’ long-running efforts to enhance investor protection into doubt. As a result, the quality of regulation ultimately may suffer, which could affect investor confidence negatively. (See A disruptive force.)
In the short term, though, the industry is unlikely to face any onerous new regulatory obligations in the coming year. Instead, the industry may see regulatory rollbacks in certain areas.
The most immediate challenges for the industry in the year ahead probably won’t be regulatory. Instead, they’re more likely to come from the macroenvironment and the industry’s internal competitive dynamics. Even if regulators aren’t able to proceed with reforms designed to improve investor outcomes by stoking price competition and encouraging the use of cheaper, more cost-effective investment products, these trends already are underway.
Globally, the investment industry is undergoing a significant shift from active investment strategies to passive strategies, which is pressuring fees and revenue for traditional asset-management companies. At the same time, the ongoing emergence of relatively cheap, simple online advisory businesses (a.k.a. robo-advisors) is posing a challenge to traditional distribution models.
The investment industry is going to have to continue grappling with these forces, most likely through a variety of strategic responses, in the year ahead. Some firms will see further consolidation as their best option for staying competitive, allowing them to build scale and reduce their costs. (See Consolidation on the horizon.)
Others will turn to innovation. On the advisory side, partnering with fintech firms or implementing robo-advisor technology in an effort to meet clients’ expectations for a more tech-savvy client/financial advisor relationship are other options. Advisors also may take advantage of some of the advances that robo-advisors enjoy in streamlining the client-onboarding process and rationalizing other back-office functions.
Innovation may be particularly popular in the asset-management business this year, thanks to new rules taking effect this month that are designed to enhance investor access to so-called “liquid alternative” mutual funds. (See Will clients embrace alternatives.)
Asset managers that are seeing their traditional active-management business under threat may be increasingly capable of combating this challenge by offering alternative investing strategies that can command a premium from investors.
The outlook for the financial services industry in 2019 is one of cautious optimism, with solid underlying economic prospects but growing downside risks. Regulatory pressure on the industry appears modest, but internal competition and the demand for innovation are ramping up relentlessly.