Carolyn Bigda: Welcome to this special series of Research in Action, where we talk about the outlook for the major economic sectors and related investment opportunities in 2024.

Today, we’re joined by Research Analyst and Portfolio Manager John Jordan. He heads up the Financial Sector Team here, and I think it’s fair to say, John, that 2023 has been a pretty busy year for you, would you agree?

John Jordan: Yes, it has. Definitely a busy and interesting year, with a lot of opportunity for our team on the research front.

Bigda: Okay, so the reason for that is, primarily, it started at least with the regional bank crisis, kicked off by Silicon Valley Bank in early 2023, and that spread to other banks of that size.

So, welcome to the podcast, and let’s get right into it. Give us an update on the health of regional banks: Do you think these institutions have better prospects in 2024?

Jordan: Yes, great question. Look, there are many different regional banks, and so, I’ll speak about them broadly. I’d say from a safety and soundness perspective, they really appear to be in quite good shape, from my perspective. Not particularly worried about the failures that we saw in the spring happening again in the regional bank sector.

Bigda: Could you just, maybe, describe when you say safe, what does that mean, exactly?

Jordan: That means that I expect those institutions to still be around a year from now, the vast majority of them. Again, it’s a broad sector, but I certainly still expect them to be in business a year from now.

What I would say we are seeing, though, is pressure on profitability and pressure on returns. I think some of those issues have gotten worse as 2023 has gone on. I do think 2024 could be a better year, but I think some of that will depend on the economy.

And so, just to identify what a couple of those headwinds were: Certainly, we’ve seen rising pressures on deposits, both the amount of deposits, which grew very rapidly during the pandemic but have more recently been shrinking for the system, as a whole, as well as the cost of deposits. Many depositors expect a higher return. And so, that has pressured banks’ net-interest revenues, so the difference therein between what they earn on their assets and what they have to pay on their liabilities, primarily deposits. I think for many banks, we’re getting to the later stages of that, but I do expect that to continue to be a pressure as we go into early 2024.

I think one of the big unknowns is, really, the credit macro picture. So, if we have a meaningful recession, then I think we could see meaningful credit losses. I think that will vary quite a lot by bank, but that’s definitely something that the market is thinking about and that we’re spending meaningful time on.

And then, look, there are definitely macro scenarios. If we talked about interest rates going to 10%, then I would be worried about more systemic stresses across the system, or very large changes in interest rates or other macro variables. But I think the recession is probably the biggest macro uncertainty. We know that there’s some distressed areas. I think they’re relatively small for most banks. Again, it depends on the bank. Parts of commercial real estate, particularly office, I think is definitely going to experience increased losses. I think there are other areas that could if we see a recession but might be relatively good without that.

Bigda: Given what you said, would you say valuations for these banks reflect a justifiable risk- reward benefit at this point, or is this an area that investors have to tread very carefully right now?

Jordan: I think I would say it’s very bank specific. I do think valuations have come down a lot. Now, earnings have come down a lot as well, or expectations for earnings have come down significantly in a lot of firms. I would say there are pockets of opportunity, but you need to be selective, from my perspective.

One of the things that I didn’t talk about, just one other headwind out there, is some of the regulatory changes. And again, that’s something where we have some insight into what’s likely to happen, and I think it’ll be manageable for most institutions, but we won’t have full clarity of that until well into 2024.

Matt Peron: So, are you getting paid for that risk, versus large banks? Is that spread interesting to you?

Jordan: I would say some of the largest banks, we still find, have very attractive franchises. Relative to the regional banks, they tend to have a relatively larger percentage of their deposits in consumer deposits. We’ve seen some of the least pressures particularly on checking accounts, on both rates paid, as well as [checking] balance outflows. I think that’s a positive for the franchises of some of the largest banks.

And then they tend to be more diversified, whether that’s capital markets or wealth management, so a little less dependent on net interest income, and that tends to lead to a more stable earnings stream over time, just that diversification.

If we went back a number of years, regional banks, generally, traded at premiums, say, relative to forward earnings versus the larger banks. We’ve actually seen that largely reverse. Again, some of it depends on what you think the estimates are going to be next year or whether their earnings will actually come in next year. I’d say, maybe, regional is relatively more attractive, but we still are attracted to some of the really strong franchises at some of the largest banks.

Bigda: And that’s because of the diversification and the less sensitivity to interest rate moves, generally speaking?

Jordan: I’d say that, certainly, diversification is one part of that, and I’d say just the quality of the franchise, and some of those are retail deposit franchises I talked about, I think are important.

There are other things, for example, technology investments, that I think are part of that retail franchise but also impact other parts of the business where we still think there are share opportunities for the largest banks.

Bigda: European banks: We had you on the show about a year ago, and at that time you said many banks in Europe could be set up to earn higher returns and increase the amount of capital returned to shareholders through dividends and/or through buybacks. Did that come to pass? And what’s the outlook for European banks in 2024?

Jordan: Yes, so, I’d say it did at most of the banks. We saw both higher returns and higher capital returns. I think the European banks are also facing some of the headwinds that we have talked about relative to the U.S. regionals, for example, some of the deposit pricing continues to rise. Again, very idiosyncratic bank by bank. That might be a modest headwind versus a more significant headwind. But I’d say, overall, assuming a relatively stable macro environment in Europe, we still find the European banks quite interesting, both for the starting evaluation, the better returns, the quite large capital return, both currently and going forward. We still see a lot of opportunity there.

Bigda: Just remind us again, what’s put them in this position to return so much capital to shareholders and be in a position of strength?

Jordan: It’s been a long road. I think, really, a lot of those institutions were healing in multiple ways, all the way going back to the GFC [Global Financial Crisis]. Some of that was regulatory driven. Some of that was business-model driven, but that was exiting businesses, getting out of less risky lending and building capital for a really long time, in some cases, well over a decade.

And so, I think they finally got to a point where they have cleaner businesses, less risk. They probably pruned some of the parts of their franchise where they didn’t have much competitive advantage and focused on areas where they did have more.

And then, certainly, while higher interest rates do bring some challenges, in aggregate, it is a positive for the total profit pool of banks because when the interest rates are zero, the ability to have a deposit that you pay zero on isn’t particularly valuable. It’s much more valuable when rates, depending on what part of Europe we’re talking about, it could be 3%, 4%, 5% kind of range.

Bigda: Got it.

Peron: Right, shall we switch gears from the old to the new?

Bigda: Yes, let’s do that.

Peron: Payments: You were very constructive in that sector for a number of years, secular growth. Can you update us on where that thesis is, what inning are we in now?

Jordan: Yes, I’d say we still see a lot of opportunities for secular growth. We certainly saw that this year, in terms of the revenue growth of a number of those businesses. But I think, similar to some of the other areas we talked about, it matters a lot, the specific companies and the specific business models.

There are parts of payments that have relatively more competition, and sometimes there’s competitive cycles, go-win [?] cycles, and they wax and wane at times. And so, I think, frankly, 2023, we’ve seen meaningful debate in the market around a number of firms that I think still have attractive revenue growth opportunities but where the degree of competition and the duration of that growth has become more of a debate.

We actively do research in the area. I think we have generally focused on those areas of payments that have some of the least competition and, we think, more of the competitive moats around that. But it continues to be a very interesting area and an area I think research makes a big difference.

Peron: In addition, the debate has led to a dispersion in stocks, so it’s actually an interesting fertile ground for stock pickers.

Jordan: Absolutely, absolutely. There are, certainly, payment stocks that have done as well or better than the market this year and there are some that have very substantial underperformed.

Bigda: If you had to sum it up, what is the case for owning financials in 2024?

Jordan: I guess I’d answer that in a few ways. I think it’s definitely important in financials to be research driven and to pick your spots because I think it’s hard to make a call on financials in aggregate in 2024, given some of the uncertainties about the macro, as an example.

I think depending on the part of financials that we might talk about, maybe I’d hit a couple of things. So, first of all, on the secular growth side, certainly in payments, certainly in wealth management, certainly in digitally enabled businesses, whether that’s in traditional financials or other areas, we still see significant secular growth. And so, we’re excited to invest behind those names and watch them compound their earnings and revenue over time.

I think some of the other areas, the cycle and the valuation matters. And so, we do see – we talked about European banks – opportunities there. Some of that’s structural, but some of that is also driven by valuation. And really, company-specific improvement there that we’re excited about.

We haven’t talked about property casualty insurance, but that’s another area where we have seen positive pricing trends, which generally helps returns across that industry. And where some of the, I guess, dislocations that have driven that pricing has really opened up opportunities for the best firms to take market share and grow. And so, we’re certainly excited about that area, as well.

Bigda: All right, well, here’s wishing you an easier 2024. Thank you so much for joining us.

Jordan: Thank you, my pleasure.

The discount rate is the interest rate used to determine the present value of future cash flows in a discounted cash flow analysis.

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