Earlier this month, a survey of UK financial companies by the Confederation of British Industry (CBI) and PricewaterhouseCoopers found that for the first time in 18 months, firms were pessimistic about the state of the market. About 40% blamed a slowdown in sales during the fourth quarter of 2004. Rising interest rates and fears of falling house prices were the main reasons not to be cheerful, and the CBI warned that this was not just a temporary moan.In the US, financials are negatively affected by general uncertainty over the health of the US economy. Consumer spending has not been as buoyant as expected, and worries persist over job stability and stagnant wage inflation. Certainly, the memory of the more substantial shocks of the last few years seem to be receding, if only gradually. The sector has been subjected to events such as the $50bn (£28bn) loss to the global insurance industry after 9/11, multi-billion dollar payouts from US investment banks to compensate for financial scandals, and, in the UK, the decimation of the life assurance industry because of equity-related losses. Regulators everywhere have worked overtime on the broader project of “restoring confidence” in financial services, whether in relation to Enron, conflicts of interest within banks, or the collapse of the mutual insurer Equitable Life. With all that in the distance, global financials have outperformed the global equity market over the first three quarters of 2004, providing returns of 2.9% compared with 1.9% for the wider market, according to Thomson Financial Datastream. But concerns still linger over the prospects for many key groups in the sector. Some of Mthese are short-term, while others are perhaps more substantial. One illustration of this climate of uncertainty is the way that some managers of general equity funds in the UK are rotating their financial stocks in the context of these concerns. Tineke Frikkee, manager of the Newton Higher Income fund, is increasingly sceptical of the UK banking sector: “Banks tend to do better in times of healthy economic growth. A look at the environment today tells you that consumers are spending more than their wages, and that costs are rising everywhere, from council tax to public transport. Banks are well managed, but they are likely to bear the brunt of these trends in terms of declining business.” However, financials are still well represented in the fund: “Financials make up around 29% of market capitalisation in the UK. We are only slightly underweight at 28%, but the composition of our financials has changed.” In terms of equity performance across markets, there has certainly been a reversal of fortunes during the recent recovery period. Guy de Blonay, manager of New Star’s Global Financials fund, suggests: “The general rule is that the losers of the two years before March 2003 are the winners now. These are the institutions that needed to restructure their balance sheets and reorganise debt, but found it difficult because of the tough market conditions for raising capital. With the recovery, they regained hope that their debt could be tackled in a better environment. “At the same time, the companies that were leveraged, but had underlying quality – in particular the investment banks – benefited from rising markets. The losers have been the dull, defensive firms that did not suffer as much during the bear market – in particular, the domestic savings banks.” It is perhaps the banking sector that is attracting the most scrutiny at present. In terms of their economic clout and profitability, domestic retail banks – which on both sides of the Atlantic have delivered yearly equity returns of up to 20% over the past decade – have been at the centre of the financial services sector. Yet it is recognised that a new, more troublesome era beckons. >From the early 1990s, retail banks emerged as the main beneficiaries of a rising culture of consumer credit, and their loan businesses experienced rapid growth. At the same time, their earnings stabilised more because of securitisation, hedging and general risk management initiatives. Consolidation between banks proved to be an effective vehicle for cost-cutting, allowing UK banks to cut back branches by half from an original number of 20,000. Loan growth, cost-cutting and mergers meant that banks could withstand intensifying competition, which was tending to erode margins. However, according to Deutsche Asset Management banking analyst Jonathan Morris, the “fat profitability” that has characterised Anglo-Saxon banking is not going to last. The main culprit is interest-rate rises. They tend to increase credit risk and bad debt, while at the same time slowing down new loan business – although the precise impact on the banking sector is hotly debated. For Morris, the longer-term perspective is that with loan growth less profitable than it was, banks are looking to generate returns elsewhere. Some buy back shares, others try to diversify through product or industry, while others still – such as Barclays in its attempts to enter the South African market, or Royal Bank of Scotland with its acquisitions in the US – diversify by geography. “The trouble is that the return on capital through this diversification is typically lower than commercial banking,” says Morris. “Surplus capital is not as productive as it once was. It is basically the case that nothing is as profitable as domestic commercial banking.” More generally, there are worries that the aspiration among some banks to build up financial supermarkets through M&A or to diversify into unrelated areas, such as insurance – a feature of the 1990s – may be misguided and a sign of “irrational exuberance”. The banking issue is probably the one that most concerns US and UK fund managers in general. “The retail banks have had a fantastic performance since the recession of the early 1990s,” says Richard Dunbar, manager of the Scottish Widows Investment Partnership Financial fund. “Looking ahead, however, you have two viewpoints. The first is that the consumer has borrowed too much, and with rising interest rates, you are going to see slow lending growth and an increase in bad debt. The second, to which we tend to subscribe, is that we will not see the growth and profitability of the last decade, but there will still be a strong appetite for loans, leading to further growth.” Another significant area of uncertainty is the insurance sector. The old joke is that insurance executives are more likely than others to be found on the golf course. Today, they may be more likely to be found at their therapists. One reason is that UK insurance firms are still recovering from lost equity investments. At the height of the bull market in early 2000, firms made a record £12.5bn worth of equity investment, only to make sales of £7.1bn in the two years that followed as the market plummeted. As the Financial Times’ chief economics commentator Martin Wolf has argued, this unprecedented institutional selling of equity was an important factor behind the collapse of the whole UK market. As is well known, life assurers have suffered the most. Consumer confidence in life assurance products, in particular with-profits equity funds, continues to decline given that entities in the life assurance sector are still reneging on “guaranteed” bonus payments. Abbey, for instance, announced in March 2004 that it would not pay bonuses to its 850,000 with-profits customers for the second consecutive year. More generally, the global insurance and reinsurance industry has been reeling from its largest-ever single loss of $50bn because of 9/11. However, 2003 saw signs of a recovery. Global reinsurer Swiss Re reported earlier this year that premiums in the global property and casualty industry grew by 8% during 2003. Global life assurance fared less well, however, with only 0.8% growth. The interim results of Allianz, Europe’s biggest insurer, reflect this situation. The company reported a strong profit in the first half of 2004, which it linked to strong non-life business, but life business continued to disappoint. In the UK, however, life assurers have tried to adapt by focusing on higher-margin business, such as group pensions and with-profits bonds. In the UK, big firms like Aviva, Prudential and Legal & General have squeezed out smaller competitors through econo-mies of scale. Legal & General reported a 9% increase in operating profit before tax for 2003 because of sales of higher-margin annuity products. Cutting costs has been integral to the recovery of firms – the Prudential alone has slashed its workforce from about 17,000 to 6,000 in recent years, for example. Fund managers of financial funds continue to be ambivalent about insurance, at least in the short term. The trouble with property and casualty firms, says New Star’s de Blonay, is that the softening of the market “has made them too dull going forward. With rising premiums, firms can selectively underwrite and benefit from good profit opportunities. However, when capital follows volume business, as is the case now, it suggests the best has passed.” Life assurers also receive a shrug of the shoulders from de Blonay because of “scepticism over new products”. Life assurers are trying hard to diversify away from older products. They are certainly on the right path, says de Blonay, and making good progress, but are not yet convincing enough with their business propositions. Other fund managers concur, also citing the complexities of business risk associated with life assurers. Swip’s Dunbar acknowledges the current difficulties, but expects to see an increase of life assurers in his portfolio, perhaps “up to 15-20% in the future, up from 10% at present”. Yet when it comes to investment options, one argument about financial services is that particular weaknesses in sub-sectors – or market uncertainties about them – may not matter as much as first thought. The argument goes that the financial sector provides opportunities in both positive and negative market conditions – a view endorsed by de Blonay: “The financial sector is not like many other sectors, such as mining, technology or autos. If there is a slowdown in car sales, the entire auto sector suffers. If commodity prices take a tumble, the whole mining sector suffers. With the financial sector, whatever happens with interest rates or any other variable, a big chunk of companies always does well. This is a major attraction of financial services.” In other words, there are options to choose from. JPMF Global Financials fund manager Ian Henderson is currently keen on Canadian banking. “Banks there at the moment are enjoying the conditions of oligopoly,” he says. “The banks are not keen on competing on price. They are very good at customer service and capital management, choosing to prioritise share buybacks and dividends.” David Astor, who manages several financial funds at Hiscox Investment Partnership, has been closely following the performance of Asian banks. “It comes back to the issue of economic growth, which is higher in Asia at the moment,” he says. “Demand for loan growth will pick up in fast-growth markets, and the banks will be the beneficiaries. Also, the banking system in parts of Asia is currently very liquid, and regulation has improved compared with recent years since governments are keen to avoid past problems.” However, within the sector, some stocks are always likely to be approached with caution. Investment banks fall into this category. The JPMF Global Financials fund holds only about 3-5% in investment banks, according to manager Henderson: “The problem with investment banks is that their earnings are volatile, and are difficult to forecast. Their earnings are dependent largely on fees, which are dependent on deals, and deals in turn are dependent on market conditions, which are outside the control of the banks themselves.” Henderson says he tends to increase or decrease the fund’s exposure according to market conditions. Swip’s Dunbar concurs: “Because of the volatility of investment banks, there are times to own them, and times not to.” For other financial fund managers, investment banks are intriguing because they seem to be evolving into new institutions. It was hinted at last month when investment banks reported their quarterly earnings. US investment bank Goldman Sachs surprised analysts by reporting a 30% increase in third-quarter profits, reaching $880m, compared with the same period the previous year. The increase was underpinned by strong growth in bond trading, investment banking, asset management and securities services, although the firm also reported a decline in profits from equity-related business. Analysts were even more surprised given that bond markets were fairly flat during the period in question, with apparently fewer opportunities for profits. New Star’s de Blonay says that he has been asking some hard questions about the attraction of investment banks of late, but on the whole is intrigued by the changes taking place. “In the recent spate of reporting, we see a very interesting theme,” he says. “Investment banks now seem to operate in such a way that whatever the environment, they can still make money. Because of the increasing diversification of their activities, if there is a weakness in their core business, they can offset it. We seem to be seeing a new type of beast when it comes to these firms – a sort of giant hedge fund. These firms are operating with the same flexibility that a hedge fund can offer.” De Blonay notes that Barclays, although not an investment bank, is a company that can be characterised in a similar way because of the way it has built up Barclays Capital, its equity trading and capital markets operation. “Whether the market is going up or down, it seems to be delivering profits,” he says. The ability to benefit from diversity could be one factor behind the relatively strong performance of financial funds compared with other sector- specific funds. Data from Standard & Poor’s indicates that during the period from September 1994 to September 2004, financial funds with global exposures on average posted annualised returns of 10.17%. As a point of comparison, funds investing in the UK equity market posted average annualised returns of 6.96% over the same period. Out of 31 sector-specific funds identified by S&P, financials posted the sixth-highest average returns after biotechnology, global energy, US and global healthcare and UK property. Of course, past performance is no guide to future returns. But whatever the current uncertainty over groups in financial services, what is clearer perhaps is that the longer-term picture does look brighter. At a fundamental level, financial services are likely to continue to prosper because of the elevated role that finance now plays in the economy. The shift from government social security systems to private savings and funds, for instance, continues to be a driver of change and a catalyst for growth. The longer-term tendency for the corporate sector to use financial services on various levels (from pension funds to derivatives and risk management products) is also an added bonus for wholesale service providers. And, when corporations are reluctant to pursue organic investment in the real economy, perhaps buying back their equity instead, this provides a further stimulus to financial markets. Many large corporations on both sides of the Atlantic are still sitting on big cash hoards. In total, these macro trends form the bedrock for the growth of financial services. Recent events in Germany provide an illustration of what can happen when some of these trends do not turn out as planned. In the first half of 2004, retail investors withdrew a record E1.5bn (£1bn) from equity funds in order to get their hands on cash. Worries about job security and the health of financial markets were partly to blame. But an equally important factor was new plans by the German government to reduce unemployment benefit for those with savings, prompting fears among German citizens that a sudden loss of employment would leave them in a vulnerable financial position. In this sense, it is widely acknowledged that the German government’s plan to wean people off social security and into private savings has backfired, at least in the short term. A second, microeconomic trend typically not considered is the way that many financial services pursue growth. Compared with other sectors, such as high technology, it could be argued that financials are not obliged to pursue growth that is high-risk in nature. They do not, on the whole, engage in risky R&D, for example. Mergers and acquisitions have provided firms with the opportunity to acquire market share without building up new assets from scratch. Firms can also effectively buy the customer base of their previous competitors without a competitive struggle. In 2003, after a relatively subdued period, M&A was back on the agenda in financial services, with a third of all global M&A taking place in the sector. At the same time, endless cost-cutting exercises have been central to bolstering profitability, either with the assistance of mergers or simply on their own. Over 2003, for instance, it was estimated that Wall Street firms shed 100,000 staff globally in order to help restore profitability. An added advantage of being in services is that firms are not necessarily subject to the same problems that manufacturers can suffer, where products can easily become commodities subject to price competition, declining margins and slow-growth saturated markets. For entities in the wholesale financial arena, “products” can more easily be adaptable to the changing needs of business clients. This enables better chances of survival in different market conditions. Of course, there are question marks over whether this type of growth can continue – and the next decade will provide further clues. Investors, however, may want to consider these more fundamental issues in addition to weighing up prospects in the short term.