Carolyn Bigda: From Janus Henderson Investors, this is Research in Action. A podcast series that gives investors a behind-the-scenes look at the research and analysis used to shape our understanding of markets and inform investment decisions.

Rising interest rates have taken their toll on many areas of the stock market, but if there’s one group that has benefited, it’s financial services. Bank loans once made at rock-bottom rates now earn healthy yields, while market volatility has increased trading activity and the related fees that banks can charge.

Of course, when you get into the weeds, the landscape is a little more complicated, as John Jordan points out. He’s a Portfolio Manager and Lead Analyst on the Financials Sector Research Team.

John Jordan: It’s my view that the market is likely over-focused on near-term credit losses and missing both substantial potential benefits from higher net interest income, as well as the potential longevity of that net interest income.

Bigda: What does that mean for the outlook for bank stocks?

I’m Carolyn Bigda.

Matt Peron: And I’m Matt Peron, Director of Research.

Bigda: That’s today on Research in Action.

John, welcome to the podcast.

Jordan: Thank you.

Bigda: In January, big banks delivered their fourth-quarter earnings, with many reporting strong profits. In fact, one CEO for a large U.S. bank said 2022 was one of the best years ever for the bank. What drove the sector’s positive results, in your opinion, John?

Jordan: Thanks, Carolyn. One of the biggest factors driving improved profitability at banks over the last year has been higher U.S. interest rates. Higher U.S. interest rates translate into higher yields on loans and some floating-rate securities that banks have as assets. Meanwhile, banks have not had to pass along the full amount of rate increases to their deposit holders. This has driven higher net interest income (NII), which has been a key driver of bank profitability this year.

Bigda: And this is remarkable because it’s been a long time since we’ve seen rising interest rates, is that the idea?

Jordan: That’s right. I think [the] Fed Funds [Rate] averaged about 83 basis points over the period from 2010 to 2019, and more recently we’ve seen that number in the fours [4%]. So, that’s been quite a remarkable change relative to the time period post the Global Financial Crisis (GFC).

Bigda: That’s the positive side. But at the same time, many banks report that they’re actually adding to rainy-day funds in anticipation of an economic slowdown in 2023 and rising loan losses. Are we seeing any evidence of higher defaults yet?

Jordan: Surprisingly, during the period of the pandemic, we saw an initial increase in loan loss reserves and fears of high credit losses. For the most part, those credit losses did not come to pass. And in fact, during 2021, we had some of the lowest credit losses at many banks for many years. Part of the reason for that good credit quality was government stimulus and increased savings, part of it was a fairly robust job market, and part of it was the recovery from a number of industries being slower related to the pandemic in 2020.

As we moved into 2022, we have seen some credit metrics begin to normalize; so, for example, delinquency rates returned to levels that we might have seen in the 2018-2019 period before the pandemic. But in most cases, we are not still back to those, what we might call more normalized levels for a relatively good economy. So, what we’ve seen in 2022 is credit metrics getting incrementally worse but starting from such a good base that they are still well better than they were in the years preceding the pandemic.

Peron: John, to put a finer point on these two cross-currents that you talked about, typically the rates and the NII story is quite strong and really drives bank profitability, but then I guess the market is offsetting that with the prospect of higher capital charges and loan losses, etc. Where do you think the market is on that?

Jordan: Thanks, Matt. It’s a great question. I would say that the credit losses will be in part dependent on how the economic environment plays out; whether we have a recession, and how deep that recession is. So, I acknowledge that there is meaningful uncertainty around that. What I would say is that at many banks, the benefits from the higher net interest income associated with higher interest rates is likely to be significantly higher than the credit provisions they’re likely to face. Obviously, in a very bad recession that might be different, but the net interest income benefits are quite significant, and the starting point for the credit situation is relatively strong, so I see the former likely outweighing the latter.

Peron: I mean the capital buffers that they’ve built up over the past decade are quite impressive, but yet, it seemed that the market didn’t give them as much credit for that.

Jordan: I agree, Matt. If you look back over the last decade or so, bank relative to performance – so, how banks have traded relative to the market – has tended to be highly correlated with 10-year [Treasury] yields. In part, because the market, I think, acknowledged that higher interest rates were very beneficial for banks and lower interest rates presented profit headwinds. We saw that begin to break down during 2022. It really started in the first quarter, and I think that is fears about an economic downturn, which obviously do impact banks through credit losses, that’s one way. They can also impact banks in other ways. If, for example, equity markets go down, on their wealth management business they may earn less. So, there are a variety of factors there. But it’s my view that the market is likely over-focused on near-term credit losses and missing both substantial potential benefits from higher net interest income, as well as the potential longevity of that net interest income. Obviously, there’s some macro uncertainty around that as well. If the Fed [Federal Reserve] were to reduce interest rates back to 0% or close to it, then that would be an incremental headwind for net interest income. But absent that, I think there’s significant opportunity for banks.

Peron: John, you and your team cover a broad array of sectors, not just banks. So, we get it, that the setup for banks looks pretty good. Let’s talk about maybe the next group, wealth management, and the trends there.

Jordan: Thanks, Matt. We do see significant opportunities from a secular growth perspective in wealth management. We certainly see significant growth in overall wealth, as well as in demand for advice and how to manage that wealth. In terms of more recent trends, as we think about wealth management companies, the decline in asset markets, including equity markets, during 2022 was a headwind for revenues. But many wealth management firms also take as deposits or take in in other ways cash of their clients. So, as interest rates have risen, we’ve seen the earnings associated with those cash balances of clients rise significantly. So, that’s been a significant offset, or even more significant than the declines in markets. We think the volatility of the pandemic is likely to maintain or even increase the overall growth in the demand for advice and, therefore, be a tailwind to select wealth management firms.

Peron: And I think it’s fair to say the wealth group is generally had above-average revenue trends with more stability. So, it’s a pretty attractive area, so long as that continues, which I think is your base case for a number of years because of the trends you mentioned around the need for advice, etc. That backdrop, I think, is set to continue?

Jordan: Absolutely, Matt, I’d say certainly there’s tailwinds from the growth in overall wealth – demand for not only advice but incremental advice – and then we think that there are select firms that are taking market share. Some of them are doing that, in part, because of their brand; in part, because of the quality of their advisors. Others may be doing it, in part, because of their technology investments and the technology capabilities that they bring to advisors and/or to the end client.

Peron: So, let’s come to one other secular favorite for your team, which is payments. Talk us through how you’re thinking about payments, again, from a long-term perspective, as well as the sort of ebbs and flows given what we just went through with COVID.

Jordan: Well payments, I’d highlight a few things about payments. First, I think it’s one of the most dynamic areas of financial services. We continue to see significant innovation and growth. And we continue to see a variety of players competing in offering services across the payments landscape. One of the things that I’d highlight about payments is that we still think the secular growth opportunity is large. Still, one of the largest parts of that is the move away from cash and check towards electronic payments, whether those are on a credit or debit card or another form of electronic payment. We also see significant value that payments companies are providing to their end clients; for example, around safety and security, protecting against cyber or fraud risk; for example, around data and helping companies have more data to manage their business and attract more customers. There were cyclical headwinds to certain payments businesses associated with the pandemic. For example, we saw sales and transactions at physical stores and restaurants decline significantly. We also saw a sharp fall in both corporate and consumer travel, including a very sharp fall in cross-border travel. And over the last couple of years, we have seen a meaningful recovery across many of those categories. Everything from face-to-face at restaurants to cross-border travel, and that has been an incremental tailwind beyond the secular benefits that we talked about to a number of payments firms.

Peron: Presumably, during that rebound, they’re maintaining their increased [market] share that they earned, which has given them leverage.

Jordan: That’s right. If we talk about consumer payments, as an example, consumer payments has steadily taken share from cash and check in the United States, but also in most countries around the world. The pandemic, if we look, say, from the beginning of the pandemic to a couple of years afterwards, those market share gains relative to cash and check were either maintained or in many cases accelerated.

Peron: Okay, so we like banks, the setup for banks. We like payments. We like wealth. Those are three rather oligopolistic groups. So, they basically, there are players in each one, and you like those secular trends as groups. But fintech is a very different story; a lot of dispersion there. Is that fair to say that fintech is very different from the other groups that we’ve said, it’s very stock-specific, if you will?

Bigda: Maybe you can explain what the difference is between fintech and payments, too. Is there overlap ever in that category, or how are they different?

Jordan: Those are great questions. I think the term fintech probably means different things to different people. Sometimes, fintech is associated with newer entrants into a range of financial services where tech is a meaningful part of their business model or value proposition. That can be from just them being an online or predominantly an online-oriented business to other aspects of their business model. Many or most companies within payments would say that technology is important, and they would say that payments is a financial services business. So, in that sense, they could be called fintech companies. But some of these companies have been around for decades: Mastercard and Visa were originally started by banks and owned by the banks, and both of those go back quite a number of decades each. So, under the definition of fintech as a new entrant, they would not be a fintech; but under a financial services company where technology is important to their business, they would be.

Peron: Oftentimes, a fintech is trying to disrupt a traditional payments processor. So, they’re trying to bring the tech piece to bear in that endeavor.

Jordan: Yes, I think we have seen a tremendous amount of price volatility and valuation changes across the fintech sector. Many of those companies are private, some are public. Certainly, some of the public companies saw very significant price increases in 2021, followed by very significant price declines in 2022.

Bigda: And that contrasts with the more traditional, what we might think of as the financials sector, is that correct?

Jordan: I would say that, generally, the volatility of the price moves in fintech, both the up moves in 2021 and the down moves in 2022, were much more pronounced in fintech than they were in traditional financial services.

I’d like to talk about a couple of things that I think our team works on and debates regularly. The first is the business model. We’re very focused on understanding what a company’s business model is, which clients they’re trying to serve, and how they compete against others in the marketplace. And we don’t have labels or categories that say a traditional financial services company can’t have good technology or is necessarily disadvantaged. But on the other hand, we also don’t think that an incumbent, whether through a tech-driven strategy or some other strategy, can’t take market share. So, we spend a lot of time looking at business models.

I’m not sure I could identify one that is particularly well situated or one that is not. But I would go back to is just the business model and how meaningful the competitive moat is or could be. So, as an example, we’ve seen a number of fintech business models that have focused on lending. Many of these firms have argued that they had better technology to do better underwriting or are able to access better data. Our experience is that the lending business is a very competitive business. And to generate large competitive moats is quite challenging. So, that would be an area where we felt like such claims deserved incremental scrutiny. I would contrast that with niches where you had a relatively underserved market where a technology company was coming in and providing data or infrastructure that was not being provided by another player. So, entering basically perhaps a very small market but a brand new market and trying to get advantages from, for example, being the first there, or having proprietary data, or a better user interface.

Peron: I think this gets back to the point I was making earlier, which is to say, that space is so highly idiosyncratic; you really have to do your research on what technology they have, what market they’re addressing, are they trying to be a better technology? And I think that’s where, as a contrast to the other groups where you identify secular trends, say, in wealth management, you can more or less ride that. But in this space, it’s really a stock pickers market.

Jordan: I think in hindsight there was a lot of, there was a broad amount of enthusiasm for new challengers for parts of fintech, for disruptors, for example, during 2021. And so, navigating that euphoria, and then followed by – some might say more realism, others might say more despair or pessimism – I think is challenging. There are some lending companies that may ultimately survive, but historically, lending businesses have been treated as fairly commodity-like, fairly cyclical, and therefore, been given quite low valuations. And there was a time when some of these companies were treated as tech companies that deserved to trade on multiples of revenue. And then, when you actually unpacked what they were doing, they were originating loans and they were selling them that day, or fairly immediately onto others. So, we’ve had businesses – some of which claim to have technology advantages – throughout different cycles of financial services, and the earnings of those businesses are incredibly volatile. And they look great when times are good, and then they turn over.

Bigda: We’ve centered a lot of this discussion around the U.S. banking sector. What about outside of the U.S.?

Jordan: We are finding significant opportunities outside the U.S.; perhaps I can highlight two examples. First, in Europe, after a very long period of close-to-zero interest rates, we’ve seen meaningful rate increases in the eurozone and also in the United Kingdom. As with U.S. banks, those higher interest rates are translating into higher net interest income and therefore improving profitability for the sector. Europe has also, similar to the U.S., gone through a lengthy period of heightened regulation and capital requirements post the GFC. In some respects, the European regulatory cycle and recovery from the GFC was longer than the U.S. But I think we’re now entering a period where many banks in Europe are set up not only to earn higher returns but also to increase the amount of capital that they can return to shareholders through dividends and/or through buybacks.

Peron: So, John, 10 years ago or so, there was a lot of skepticism that U.S. banks would ever achieve returns on equity of, say, more than 10%. Yet, as we sit today, they’re at 17%-plus; they’ve really done an amazing job of getting the returns up. Is it possible that the European banks are going to follow that playbook and get their returns into a competitive range?

Jordan: I think that’s a good analogy, Matt. We do think that the European banks are likely to follow their U.S. peers. The actual returns in any given bank will vary, but we see the prospect for meaningfully higher returns at a number of European banks.

Bigda: So, those are European banks. Are you seeing opportunities anywhere else in the world?

Jordan: Yes, across selected emerging market countries. These banks are benefiting from relatively low current usage of financial services products; so, as the economies grow, both consumers and businesses tend to consume more financial services products and, therefore, give them the opportunity for significant growth over time. In addition, we are seeing supply chains globally beginning to realign, and that can be an additional tailwind to bank loan demand, to bank deposits, and to demand for other bank products.

Bigda: The financial sector did outperform the broader equity market in 2022. But given the economic backdrop that we talked about, do you expect financials to have a repeat year?

Jordan: I am optimistic on the outlook for many areas of financial services in terms of profit growth and share price appreciation over the medium term. I think the performance in 2023 will be dependent in meaningful part on whether we have a recession and how deep that recession is. But I think there are many opportunities that we’re finding where we’re very confident in their ability to withstand even a severe recession and we think grow their businesses and their profits substantially over the medium term.

Bigda: I guess one thing we can say about the outlook for 2023, if we do go into a recession, this time around it’s not going to be driven by the financials sector. The sector itself is in a much better position capital-wise, just business-wise, in general.

Jordan: I think that’s right, Carolyn. The financial services sector and particularly the banking sector has improved a great deal since the Global Financial Crisis. A significant part of that has been driven by regulation, including increased liquidity requirements, including increased capital requirements, including annual stress testing for many banks. But it’s also driven by the firms choosing to streamline their businesses, focus on businesses where they had a competitive advantage or higher returns; in some cases, exiting businesses. And they’ve had opportunities to learn from the mistakes and the things that went wrong in the Global Financial Crisis.

Bigda: So that’s at least one argument for the financials sector this year. John, thanks so much for joining us today. We really appreciate your expertise.

Next month, we’ll be joined by the Global Property Equities Team to talk about where they see opportunities after a tough year for the real estate sector. We hope you’ll join.

Until then, I’m Carolyn Bigda.

Peron: I’m Matt Peron.

Bigda: You’ve been listening to Research in Action.