Perspectives

Financials: From Market Laggard to Leader

After five straight years of badly lagging the overall U.S. stock market, the financial services sector was, by far, the leading U.S. large-cap stock sector in 2012, with a total return of 28.8% versus 16.0% for the S&P 500 Index.

Eric Veiel, manager of the T. Rowe Price Financial Services Fund, expects the sector to continue to be a market leader, though not by that degree of outperformance.

So far this year, through March 31, financials gained 11.4%, while the S&P 500 was up 10.6%.

One reason financials performed so well in 2012 is that they started the year “very distressed and valuations were very low,” Mr. Veiel says.

“As the year evolved, a lot of things that had been bad for financials stopped getting worse, and toward the end of the year things were even getting better. In particular, credit continued to improve, and we started to see some improvement on the regulatory front.”

And during the first quarter of this year, the state of financials was still on the upswing.

“Things are still improving,” Mr. Veiel says. “Financials’ balance sheets are strong, their capital reserves are improved, their liquidity is deep, and their credit positions continue to improve.”

But financials face two headwinds, he says: low interest rates and weak loan growth.

Just as depositors may be vexed by the record-low interest rates on their bank accounts, the low-rate environ­ment is keeping banks from making sufficient returns on their reinvested deposits—squeezing their margins.

Moreover, demand for loans remains down, with individuals and corporations continuing a long-term deleveraging cycle.

Investing Themes

Two investing themes that worked well in 2012—the nascent housing recovery and property and casualty insurers—remain of interest this year for Mr. Veiel, though he has scaled back on both.

Within housing, he still sees oppor­tunities for firms with large land banks, such as St. Joe, which has significant holdings in the Florida panhandle. Within insurers, he’s built some large positions in such auto insurers as Allstate, Travelers, and Progressive.

For 2013, Mr. Veiel’s other main themes are:

  • Interest rate-sensitive stocks: He believes that investors are too bearish on rates—because the Federal Reserve likely will signal a move to higher rates sooner than anticipated. That could benefit certain stocks with exposure to the long end of the interest rate curve, he says, particularly such life insurers as MetLife and trust banks like State Street.
  • Regional banks—such as PNC Bank and U.S. Bank—are more attractive relative to the large money center banks, such as Bank of America and Citigroup.
  • Mergers and acquisitions among small banks should accelerate in 2013, he says. As it is a challenging trend to play, he has focused on private-equity-backed banks that have stated the goal of consolidation.

Risks

At the same time, Mr. Veiel sees a variety of risks for the sector in 2013. They include:

  • The economy: “Financial stocks are levered plays on the underlying economy in which the stocks operate, and if Washington gets us into a posi­tion in which the United States slips into recession because of federal budget cuts, financials would underperform,” he says.
  • Interest rates: “It’s unlikely that they go much lower but, as we’ve seen in Japan, interest rates can stay low and go lower than we think for prolonged periods of time, and that would be negative for the sector.”
  • Regulation: “The regulatory environment is getting better, but you can always be caught by surprise in that area because it is inherently unpredictable.”

Financials’ prospects in 2013 and beyond very much depend on “when interest rates start to rise,” Mr. Veiel says. “As long as rates are rising because the economy is moving along nicely, they could do well.”

Because the fund’s holdings are concentrated in the financial services industry, it will be less diversified and more volatile than stock funds investing in a broader range of industries. Securi­ties mentioned by Mr. Veiel accounted for 19% of the Financial Services Fund as of March 31, 2013.

The chart in this article is for illustrative purposes only and not intended to represent the returns of any specific security. Past performance cannot guarantee future results.
 
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