All Things Financial

 KEY TAKEAWAYS:

• Post second-quarter earnings, the banking space has stabilized; however, fundamentals remain challenged.
• Rising credit card debt – good for banks and consumers (in the short term).
• Ratings downgrade – lagging indicator, but banks will have to face high funding costs in the near term.
• Opportunities – financials that are not very credit-sensitive.

 

     

 

To learn more about the strategies mentioned in this episode, please click below:

Cambiar Large Cap Value
Cambiar SMID Value
Cambiar Small Cap Value

 

TRANSCRIPT

Ania Aldrich:

We are not index-constrained. If we don’t find opportunities in the stocks at any particular time, we will allocate capital to much more attractive investments and just be very opportunistic.

Kyle Helton:

Hello and welcome to the QPD Podcast. I’m your host, Kyle Helton, Senior Vice President and Western Regional Director at Cambiar Investors. On today’s show, we have Ania Aldrich, investment principal at Cambiar. Ania is one of the firm’s longest-tenured investment professionals and has covered the U.S. financial sector for over 20 years. Fresh off of recent earnings reports, I felt it was a good time to bring her in and discuss all things financials and get her thoughts on the space. Ania, welcome to the show.

Ania Aldrich:

Glad to be here.

Kyle Helton:

To get things started, you’ve recently traveled around the country visiting various banking institutions, and met with management. How would you describe the state of the sector?

Ania Aldrich:

I think still a lot of cross-currents in terms of the fundamental data. After the second quarter earnings, we have definitely seen some stabilizations as investors’ expectations were pretty low going into earnings. Even though the fundamentals remain very challenged, the outlooks that managements put out there were perhaps not as bad as investors anticipated. That has resulted in a mini-rally here.

I think a lot of bank stocks were heavily shorted going into earnings as concerns about ongoing funding pressures and, of course, the whole fallout from March’s mini-crisis that we had and a few bank fillers were the main catalyst for that. As those concerns evaporated and investors are able now to focus on fundamentals again, we have seen a little more stabilization.

However, the outlook remains very uncertain in terms of the macro, but also bank-specific in terms of, as we mentioned, the funding pressure, the deposit mix, slowing loan growth, and more recently, incremental regulatory standards, as well as higher capital. I would categorize it as a relatively challenged environment.

Kyle Helton:

I feel like one of the things that maybe the people who have been calling for recession have got wrong is some major negative credit impulse into the market. Maybe that was partially borne out in what we saw in regionals earlier this year. But are there any other pockets maybe of your sector or just a credit event that you feel like is looming that could maybe cause a recessionary type environment?

Ania Aldrich:

Yes, that’s definitely an interesting question and discussion for a lot of market participants. Just a little bit of background, when the Fed traditionally raises rates, at some point the yield curve inverts and a recession usually follows, recession or a slowdown. Typically, there is 12 to 18 month lag between when the Fed started to raise rates and the curve inverts and then recession follows. We are about a year into a curve inversion, so perhaps there is more time, but also what’s interesting this time versus prior cycles is that the economy going into the tightening cycle was very strong.

There was a lot of stimulus that was implemented during COVID. Interest rates obviously were reduced to zero, so both consumers and businesses refinanced. The impact from higher rates has not really been seen yet. The same applies to credit. We monitor obviously credit very closely. If you look at it on a consumer side, total debt has been increasing, but debt obligation is still relatively low. If you look at mortgage rates, currently they’re very high, but most mortgages outstanding are about 3%.

There’s really very little pressure from these high rates. Credit in general is still very stable, but we are definitely seeing normalization from really low levels during a pandemic. We continue to monitor that.

Kyle Helton:

You mentioned credit card debt climbing to over a trillion. Is this good news for banks? Is this negative news for the economy and consumers?

Ania Aldrich:

It’s good news for banks because banks earn very high interest on their debt outstanding into the teens depending on the credit spectrum of the consumer. It’s good for the consumer in the near term because it extends the spending power. If you look at overall metrics that we look at be it for credit cycle or growth cycle, they’re still very distorted because of COVID.

First year of COVID 2020, we have seen close to 20% decline in credit card outstanding debt because consumers, one, were not spending, and two, because of the various stimulus and excess savings they had that paid down that debt. Looking at current debt growing at 20% per year, it may seem very high and it is in absolute terms, but the data is still fairly distorted from COVID.

Kyle Helton:

As is a lot of the data I’m sure that you look at.

Ania Aldrich:

Definitely.

Kyle Helton:

Any given day being very distorted off of hopefully hard to replicate period of our lives. Shifting back to regional banks, at the beginning of August, Moody’s downgraded a number of them. What do you make of that?

Ania Aldrich:

You can look at Moody’s or any rating agencies actions typically that’s kind of a lagging indicator, because it reflects the data that investors have already been focused on. The specifics that Moody’s citing are the headwinds from higher deposit betas, which basically means how much banks have to pay and deposits that businesses and consumers keep at the bank, higher capital requirements, and then potential credit issues.

These are all the factors that investors have been focusing on. The potential implication near term is that banks will potentially face higher funding costs because the credit ratings are lower and it’s similar to the US debt that got downgraded. These are real challenges to be content with.

Kyle Helton:

That as the backdrop, how constructive should investors be on the banking sector right now?

Ania Aldrich:

In general, I think we are fairly cautious. Again, it’s really difficult to figure out this cycle versus price cycles, because as we mentioned, a lot of data is being distorted. On one hand, the consumer is still very healthy, partially driven by very low unemployment and obviously the wage growth that we are observing. But interest rates did increase by over 500 basis points and we have seen very little impact from that. Like we mentioned, there is a lag effect. We are starting to see normalization in credit and the question is, how bad will it get?

Some areas of particular concern are commercial real estate and office in particular. With the new trend post-COVID, working from home, there’s just less demand for office. You are definitely seeing pretty significant impact there where values have declined of office buildings between 20 to 40% depending on a location. We’re starting to see some impact, but it’s still at a relatively low level. And then the other bigger issue for all banks, with exception maybe of the really small ones is the higher capital standards that the regulators are putting forward.

Those will definitely put pressure on growth. Lots of banks have already said that they are, one – tightening lending standards because of the concern of overall recession, but two – withbecause they just want to be more careful about how they deploy capital to only the most worthy credits. There’s definitely going to be pressure, one, on revenue growth for banks. There’s going to be pressure on profitability given higher capital standards. And then of course, like we mentioned, credit is another thing that we are watching very closely.

At this point, we are looking for banks with strong balance sheets, higher capitals, higher reserves, those opportunities that we are looking at. But in general, we are more cautious than optimistic on banks’ fundamentals near term.

Kyle Helton:

Despite your hesitation in allocating capital to banks, our large cap value portfolio currently has over 17% in financials. Can you elaborate on the type of industries and businesses that you’ve gravitated towards?

Ania Aldrich:

Sure. As we discussed, we have significantly reduced our exposure to the traditional banks, but we have been able to find a lot of interesting opportunities within other sub-sectors of financials. We have put some money to work with companies such as MasterCard and American Express, which are not very credit-sensitive and have very strong profitability metrics and continue to benefit from ongoing growth in spending.

Other areas that we really like are exchanges, very unique business models with strong pricing power and strong growth characteristics, certainly benefiting from current volatility, increase in the markets, especially as interest rates continue to rise, but also longer-term product innovation, which obviously drives volume growth for them as well. Another interesting area we like is property and casualty insurance.

This is the sector that has over the last couple years started to benefit significantly from improved pricing after years of underperformance, which is driving strong top-line growth, margin improvement, as well as return improvement. If you look at the valuations, they remain undemanding relative to the profitability that these companies are producing at this point. Even though we have stayed away from banks because we don’t find the investments in those stocks very appealing right now, we are finding opportunities in other sectors that are less balance sheet sensitive.

Again, if you look at how we construct our portfolios, we are looking for companies with strong business models, strong profitability, but at the same time with diverse return drivers. And that’s what we are trying to achieve here.

Kyle Helton:

You cover financials for all three of our domestic strategies, Large Cap, SMID, and Small Cap. Do we maintain similar exposures in the financial stack up and down the cap spectrum?

Ania Aldrich:

They can differ depending on opportunities set within the different market caps, particularly in a small cap strategies. But again, across the board, we look for businesses or we gravitate towards companies with durable business models and strong profitability metrics. Similarly to what we have been able to invest in large cap, in a small cap, we have found opportunities to invest in both property and casualty space.

We discussed the fundamentals are fairly positive, so we like companies such as Arch Capital, which is well diversified in terms of primary insurance and reinsurance, which are significantly improving profitability right now. But we also find opportunity in a unique space of life reinsurance with a company called RGA, which is a top three or top two at this point, global life reinsurer and is benefiting from increased demand given evolving and more complex capital requirements for the primary companies.

In a small cap strategies, we also like exchanges. Again, very unique franchises. We like CBOE. It’s a top player in its space with strong growth characteristics and pricing. 

Kyle Helton:

We’re in the business of getting our clients in front of companies that are price setters and not price takers. In the financial stack being so commoditized, it’s interesting for me to hear you talk about these players that are able to set prices. How is it that a CBOE can set the relative price in their respective business? When I think about shopping for insurance personally, a major component is how cheaply can I gain insurance. What is it about these companies that allow them to pass through whatever costs they may incur to their end customers?

Ania Aldrich:

If we focus on the insurance space, property and casualty in particular, if you roll back the clock several years, pricing has been under pressure. Given what has been happening in terms of both inflation, but also weather related losses on the property site, the cost to insure has increased. The industry is finally realizing this and together is pushing for higher prices. Some of that pricing element is a catch up from several years of underpricing.

We are just going through this phase now where pricing continues to go up as inflation as well as court cases settlements, driven partially by social inflation, continue to go higher and there is a need for significant reset within the industry. You could say it’s a period of time where pricing is very strong.

Kyle Helton:

That would be industry-specific and not company-specific. There are other players in the property and casualty space that are benefiting from this catch up in pricing power that the businesses just in aggregate have?

Ania Aldrich:

That’s correct. It’s specific to the industry. We tend to gravitate towards names when management is a better steward of capital. When you see the cycle turn, that management tends to pull back in terms of driving exposure growth and not just go after the business to generate top line growth, but with potential risk of significantly lower profitability.

Yes, the whole sector is benefiting, but we invest in companies who are either the leaders in this space and they have proven track record of managing through the cycle and deliver shareholder value over a long-term. A good metric of performance for the property and casualty companies is a growth in book value. That’s what we tend to look at because ultimately that’s what drives share price performance.

Kyle Helton:

We kind of just talked about how, it’s important to not just be looking at banks. I don’t know if you want to talk more about regional banks specifically down cap?

Ania Aldrich:

Yeah, sure. The smaller cap banks, if you look at the performance here today between the mega caps like JPMorgan, Wells Fargo, Bank of America and then the smaller banks, performance is very different with the larger banks outperforming. One is because of this notion of too big to fail. During the mini-crisis in March when we had significant deposit outflows across smaller banks, a lot of those deposits went into the larger banks because they are perceived too big to fail.

Given also that the business models are more diversified, fee income driven and not so much commercial real estate, which is a big focus for investors right now, they have outperformed because their earnings power is in a better shape near term. If you look at the smaller account bank, there is a pretty significant exposure to commercial real estate. The concern there is even if the smaller banks don’t have exposure to downtown office towers, the high-interest rates are impacting commercial real estate across the board.

You’re going to see definitely impact on valuations. Our understanding is the banks have underwritten the loans relatively conservatively, but what we are seeing in terms of the devaluation in some of the properties of 40-50% is pretty significant. Room for error is not that large, and smaller cap banks are definitely less appealing at this point because of those perceived risks.

Kyle Helton:

If there were to be ratings downgrades for larger banks, JPMorgan for example, how would that impact the way that you think about that business on a go forward?

Ania Aldrich:

Potential rating downgrade, so obviously it would impact the cost of capital. It would just be another negative that these banks are facing in terms of ongoing pressures. We talk about that all banks above 100 billion in assets would be required to hold more capital. For the largest banks, it could be as much as 200 basis point increase. With the downgrade, so it’s just going to be an incremental pressure. The whole banking space in the near term is just facing a lot of challenges right now.

Kyle Helton:

How does that create opportunity for us from an investment perspective?

Ania Aldrich:

Sure. I think once we have more visibility in terms of where exactly the capital standards are going and how the banks will be able to build the capital either through external or internal capital generation capability and we have more clarity on the various topics that we discuss, including credit and obviously when the Fed will be done, that’s a pretty significant data point as well. I think that will create some opportunities to properly evaluate if these are good investments or if there’s potential downward pressure or what happens to earnings growth.

This year earnings growth is obviously pretty significantly impacted by higher funding costs. Next year, similarly, funding costs will continue to be high, assuming the Fed stays put. And then we’ll also have to evaluate where the macro environment is and how that translates into potential revenue growth. Definitely need more clarity on a lot of these things.

Kyle Helton:

Inflation has been and will continue to be very topical as it relates to equity pricing. Where do you think we’re going from here and how does that impact your day-to-day?

Ania Aldrich:

The most recent data suggests that inflation has peaked and has been declining, specifically if you look at the goods inflation. But the concern remains that the service part of the inflation, which is about 60% of a total measure, continues to increase. Case in point, recently, UAW is requesting a 40% wage increase over the next three years, and this is following what pilots recently received, also a pretty significant wage increase.

This is likely happening because the labor markets continue to be very tight. Again, we talk about COVID, how it distorted a lot of data points, but also how it changed trends. With the labor market being so tight, which itself is a good thing because it provides jobs to those who want them, it makes it difficult for some industries to find employees like tech, manufacturing. This is obviously putting ongoing pressure on wages.

If you look at the yield curve, it’s interestingly today the 10-year is as high as 420 versus 380 in mid-July because the market participants, I think are expecting that maybe inflation may continue to be an issue and the Fed may have to keep hiking rates, which obviously would be bad for banks. It would be bad for the overall equity market as the cost of capital would continue to increase and valuations will be impacted as well.

Kyle Helton:

The Fed seems determined to increase unemployment and decrease inflation, those two dynamics kind of working hand in hand. Is that a realistic expectation with some of the other things that you’ve discussed coming out of this very un-normal period, people transitioning from one industry to another, maybe a reindustrialization of our economy happening all at the same time? Is full employment here to stay and is sticky wage growth here to stay?

Ania Aldrich:

It’s interesting because that was how the Fed’s thinking went historically. When interest rates went up, usually unemployment would go up as well because companies would be pressured in terms of financing and margins would be under pressure, less demand, so there would be more layoffs. But as we discussed, the labor market remains extremely tight and it appears that the Fed even is now considering that we may be in for a soft landing without having to impact labor market too significantly.

There is still a big mismatch in terms of how many job posting there are. There are basically twice as many job offerings as people looking for a job. We are still not at this point. If inflation were to continue to go down to levels that are acceptable to the Fed, it is possible that the employment will not be impacted as much as we had originally feared, which would be a good thing.

Kyle Helton:

I mean, is it worth asking you if you think 2% inflation is achievable, because it doesn’t feel that way? It doesn’t feel like 2% is a reasonable target.

Ania Aldrich:

It certainly does not feel at this point. I think the Fed recently has said that they would settle for something close to 2%. Fed is looking for 2% on longer term basis. Given the inflation has been below 2% in the past, if we are a little over 2%, if you want to say 3%, would that be good enough for the Fed? Perhaps it will be if the direction of inflation continues to be lower. We are clearly in a very restrictive territory right now and the Fed recognizes it. As long as inflation keeps going down, I think the Fed will be willing to pause.

Kyle Helton:

A lot to consider.

Ania Aldrich:

Definitely.

Kyle Helton:

Well, Ania, I appreciate you taking the time out of your busy schedule and between earnings calls to chat with me. Look forward to having you again soon.

Ania Aldrich:

Pleasure to be here. Thank you.

Kyle Helton:

And thank you to all of our listeners for tuning in. Make sure to subscribe to the show on your preferred podcast platform and stay updated on our latest episodes. I’m your host, Kyle Helton. Thank you and take care.

 

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