Financials accounts for around 25% of the world's equity markets, making it the largest sector and a...
Financials accounts for around 25% of the world's equity markets, making it the largest sector and a critical one to get right. Not all of the constituent parts behave uniformly of course and neither does investor behaviour, but that is what creates investment opportunities.
The current economic climate has generally been good for financials: steady growth, low interest rates and low inflation. The credit cycle for banks and the underwriting cycle for insurance have also been positive in 2004. One area which has suffered is the more mainstream part of the fund management sector, where both flat markets and increased competitive pressure have depressed fees.
In the banking world the best region to invest in has been Japan, where signs of a sustainable economic recovery have encouraged investors to believe that the ailing banking system may finally be putting its problems behind it.
In the US, there has been a sharp contrast in the performance of the large wholesale banks, whose shares have lagged, and the domestically-focused regional banks. The latter have performed well, benefiting from the recovering US economy and a pick-up in consolidation activity.
In Europe, the performance of banking shares has been mixed, with those operating in the faster growing economies tending to do better than those in less healthy economies such as Germany or Italy.
In the Far East, a more volatile region in any event, bank share prices have not kept up with the improvement in the regional economy. Worries about rising US interest rates and a slowing Chinese economy clearly caused some concern.
In the insurance industry, investors have been worried that the strong underwriting cycle was turning down and have been unnerved by the recent storms to have hit the industry in the form of hurricanes, typhoons and Eliot Spitzer. It has, however, been possible to make money by investing in companies with strong balance sheets, good management and proven underwriting skills. Many of these are to be found in the US, amid smaller and mid-sized insurance companies.
Looking forward to 2005, the performance of banking shares is likely once again to be driven by the performance of the economies in which they operate, as well as restructuring and consolidation. The strongest economic growth is expected to come from emerging markets and Asia. We expect the reflation story there to provide good returns for bank stock investors. Consolidation is bound to continue in the US but at a slower pace than 2004. Investors there should probably focus for the time being on banks operating in the faster growing parts of America. There are a number of reasonably-valued, good quality banks in Europe to choose from, but stock picking will be crucial and we remain nervous of certain European economies.
The impact of Spitzer on insurance is likely to lead to a more open, transparent industry and, as such, will be beneficial in the long term. Fears of declining premium rates are overdone. While they are coming down in some lines, in many cases the decline is from unsustainable high levels and the business is still profitable. In other lines, rates, terms and conditions remain firm and there is nothing like four hurricanes going through Florida in six weeks to remind underwriters and those they insure of the importance of having insurance and charging the right price for it. While interest rates remain low the hard market will persist.
On the subject of interest rates it is important to note that financials, particularly banks, tend to pay good dividends which in this world of low returns should add to their attraction as an investment in the future.
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