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Sector Outlook: Financial Institutions Group The Financial Institutions Group (FIG) consists of public companies involved with fabrication and sale of financial instruments and services. This cluster of organizations enjoys great variety and diversity as it includes sub-sectors like commercial banking, wealth management, financial advisory, P&C insurance, and several others. Watch-list 1. 2. 3. 4. 5. 6. 7. 8. 9. Toronto-Dominion Bank (TD) Bank of Montréal (BMO) Manulife Financial Group (MFC) Genworth MI Canada (MIC) Canaccord Genuity (CF) Visa Inc. (V) Citigroup (C) Element Financial (EFN) JP Morgan (JPM) Senior Analyst: Karn Jariwala, BBA 2017 Junior Analysts: GianPiero Gigliotti, BBA 2018; Waqar Din, BBA 2018 Research Analyst: Jonathan Chan, BBA 2019 Sector Overview Following a prolonged period of economic uncertainty and heightened regulatory pressures contrasting the increasing net profits, financial services sector has begun enjoying sustainable but slow growth. The Big Six banks have tackled the downward pressure from tumbling oil prices and low-interest rates with charisma as their consolidated earnings rose to CA$35 billion, with Royal Bank's record $10-billion profit leading a very healthy pack. In contrast to the banking sector, the Canadian Asset Management Industry entered an extremely turbulent ride with rapid changes in the commodity prices and tanking investor confidence. Although there are several determinants of growth within the industry, FIG is predominantly driven by the macroeconomic factors and socio-economic situation at its place of operations. Beyond the conventional elements, in recent years, the sector has proven to be tremendously mutable by downfall in commodities, technological innovations, and alternative investment trends. Outlook As discussed previously, since the outcome of FIG is highly dependent upon macroeconomic variables and underlying industry drivers, the 2016 outlook is essentially contingent upon the following fundamentals: Interest Rates – Canada The Bank of Canada has maintained a low interest rate environment in 2015. In July interest rates were cut by 25 basis points to 0.5% in response to a technical rescission arising from decreasing demand for oil which accounts for about 30% of Canada’s exports. Poloz held the rate constant at 0.5% in January 2016. This was an effort to maintain consumer confidence and inflation as the value of the Canadian dollar paired with plunging oil prices were putting downward pressure on Canadian purchasing power. However, despite the duplicity in Canadian economic growth story, the interest rates will likely slip another 25 bps by June. Due to its effects on NIMs, a lower interest rate may cause some disruption in the Canadian banking sector depending on the top-level strategy of the sector. Interest Rates – U.S In December of 2015, the Federal Reserve increased the Federal Funds Rate for the first time since the 2008 financial crisis. The range of the benchmark rate was set between 0.25% - 0.5%. This was done in an effort to manage economic growth as the central bank believes that the U.S economy has been performing well, and is expected to do so for the time being. The Fed also plans on maintaining a gradual increase of interest rates in order to create a “safety net” as the U.S economy continues to recover. Should there be considerable instability in the future, the Yellen would have room to lower rates to a certain threshold. Given that the U.S economy is confronting an upward trending interest rate environment, Canadian financial institutions with greater exposure to the U.S. (TD, BMO, EFN) will benefit from these circumstances. GDP – Canada After two months of negative and flat economic growth, the Canadian economy grew 0.3% in November. This was a result of an increase in goods and services producing industries. Growth in goods-producing industries was surprisingly led by greater output in the oil and gas extraction sector. Factors which originally caused the economic slowdown, such as production shutdowns have been slow to recover. Despite the silver-lining, weak conditions will prevail throughout the first half of 2016 while gradual recovery remains likely in the third and fourth quarter depending on oil markets and exports to U.S. Given the plunging prices of oil and anemic GDP growth, it is likely that, corporate lending and financing will continue to decrease as investor confidence plunges. Negative effects in the top line growth of many Canadian financial institutions (especially the ones without ample USD exposure) will be a norm in 2016. GDP – U.S There has been an escalation in the worry about the U.S economic growth, leading to increased risk aversion and a stock market sell-off. However, fourth quarter results display overall economic health, with weaknesses concentrated in areas of the economy directly exposed to the oil and gas sector. In the final quarter of 2015 the American economy grew by 0.7%, and 2.4% for the entire year. However, one alarming statistic is that investment in structures fell by 5.3%, most likely caused by reduced investment in the oil and gas sector. Although a decrease in net exports has continued due to the strength of US dollar, domestic demand growth appears to be healthy. The decrease in investment and corporate lending alongside imminent downturn of the investment banking sector may result in volatile short term conditions but overall outlook remains strong. Canadian Dollar In January 2015 the Canadian dollar reached its weakest point in thirteen years. The low value of the dollar actually has positive effects on the Canadian manufacturing and exports, as this makes Canadian goods relatively cheaper to that of our competitors. However, this does have adverse impacts for firms involved in the capital markets, due to the decrease brought about in international purchasing power. As a result of the low value of the Canadian dollar, and the advantages this brings to the manufacturing sector, there will likely be an increase in foreign direct investments. U.S Dollar The recent increase in the value of the U.S dollar is resultant of both cyclical and fundamental factors. Global uncertainty has increased due to slowing Chinese growth paired with falling oil prices. Subsequently, many investors perceive U.S assets as a safehaven and have increased their positions within U.S Treasuries. The U.S has also overcome many barriers still weighing on economies across the globe. This outperformance has been attainable as a result of the States’ divergent monetary policy. A high U.S dollar is advantageous to U.S industries heavily involved in importing, such as the technology or automobile industry. Housing Market The past year has been the second strongest year on record for Canadian home resales with much of the rise occurring in Toronto and Vancouver – Canada’s “hot markets”. Due to their sensitivity to the weakness in the energy sector, market conditions in Calgary and Edmonton are expected to further deteriorate following significant downward pressure on demand and prices. Lower starts in oil-producing regions are expected to be partly offset by higher starts in regions such as Ontario and Quebec as they are set to experience economic growth in 2016. At the other end of the spectrum, Vancouver set new record highs for both home resales and prices in 2015 with annual price gains up 18.9% y/y. With a weakening loonie and historically low interest rates, increased foreign interest has been a driving force behind the strong growth in Toronto and Vancouver’s housing markets. In the near-future, these trends are expected to remain stable and largely benefit the property insurance sub-sector in the short-term. Oil and Gas Environment The oil and gas industry plunged in 2015 with over 250,000 layoffs in the past twelve months. Total industry profits for 2015 are expected to shrink by 20 to 30% y/y amidst one of the worst commodity downturns seen in the past 30 years. Due to global oversupply of oil and natural gas, commodity prices have plummeted and companies have shifted their focus to adjusting their business models to account for the lengthy slump in the markets. Traditional banks have been under pressure from federal regulators to decrease their exposure to the energy industry due to the deteriorating quality of loans. Many banks have refrained from taking direct ownership of companies or assets through foreclosures and have instead focused on negotiating loan extensions and debt restructurings. Bank portfolio managers have also been hesitant to liquidate assets due to potential loan impairments being locked in at a low point in the market. In the short term, we can expect to see declines in loan underwriting as banks try to bolster reserves against potential losses. FinTech –Transitioning Industry Over the past year, investors have funneled over $14 billion into FinTech companies (an increase from less than $3 billion in 2012) and hope to experience record amounts of growth in the sector. FinTech adoption among financial institutions is set to double in 2016 as top groupings like cryptocurrency, online lending, and personal financial management demonstrated healthy confidence. Moreover, FinTech now poses a risk for traditional banks as barriers to entry have weakened and start-ups have the opportunity to disrupt the financial services industry by undercutting larger players. Over the past few months, revolutionary wealth management platforms have been developed which utilize complex algorithms to strategically determine investment allocation strategies. Blockchain technology has been a frontrunner as bulge brackets began experimenting with the technology to provide easier payment services to consumers. The significant amount of funding being poured into FinTech start-ups and rise of millennials are indicators of the forthcoming transitionary phase. Closing Remarks In the imminent future, the financial institutions group of Canada is expected to perform poorly, below than the market average. This forecast is dependent upon persistently low oil-prices and prolonged presence of the low-interest environment, as the Canadian economic forces have essentially denominated to the perception O&G landscape. Alberta, Newfoundland and Labrador, and Saskatchewan will put downward pressure on employment-rate and GDP growth to further weaken the economic conditions while slowdown in emerging markets will negatively impact Ontario and B.C. However, continued strength of the American economy will provide a cushion by pumping up national exports.