Financial services industry outlook
INSIGHT ARTICLE |
Key takeaways from the winter 2020 financial services industry outlook
- Broad financial services: Financial conditions will again provide rollercoaster ride.
- Private equity: Middle market on edge as policy reform looms.
- Banking: Negative interest rates pose challenges.
- Insurance: Low interest rates will continue to create headwinds.
- Fintech: Retail brokerage disruption headed to banking.
Middle market business leaders in the financial services sector are coming off a year of whipsaw change in which they felt the ripple effects of volatility over trade, a slowing global economy and fluctuating monetary policy. As they look to 2020, they can expect more of the same, but this year, a presidential election will only add to the uncertainty over policy.
This volatile environment comes on top of structural changes already taking place in the financial services industry, whether it is the global trend toward negative interest rates, the continuing effect of low interest rates on insurers or the profound disruption taking place in the retail brokerage industry.
U.S. financial conditions in 2020 set to follow same bumpy ride as 2019
Financial conditions in the United States have been on a roller-coaster ride for much of 2019, and this is likely to persist into 2020.
As measured by Bloomberg's U.S. Financial Conditions Index, 2019 started with tight conditions carried over from the stock market retreat of late 2018 when trade war concerns and uncertainty over Federal Reserve rate policy roiled markets. The stress eased throughout the first quarter and peaked in early May to very accommodative levels. Another bout of market panic set in to leave the index closer to neutral levels by the beginning of June.
Conditions rebounded to be very accommodative in the middle of the year before a sharp decline in early August and fluctuated at lower levels for the remainder of the year. August and October saw the index drop below zero into restrictive territory, albeit close to neutral levels
The Bloomberg U.S. Financial Conditions Index reflects the financial stress within the U.S. money, bond and equity markets—all vital plumbing systems for the funding of U.S. economic activity. Middle market business leaders should pay attention to this indicator to gauge the availability and cost of financing in the capital markets.
MIDDLE MARKET INSIGHT After a roller-coaster ride in financial conditions over the past year, middle market business leaders can expect more of the same in 2020.
The money market component of the financial conditions index is reflected in the form of short-term money market spreads. These were largely accommodative in the middle of 2019 but have been on the rise ever since the start of the Fed’s easing cycle in July. This rise is mostly attributable to the sharp declines on the short end of the Treasury curve following the Fed’s three rate cuts and does not seem to represent mounting funding stress. Despite brief episodes of pressure such as the one that saw spikes in the repo markets in September because of technical reasons, U.S. money markets have been relatively stable, and there is currently no clear reason to suggest this should change going into 2020.
The U.S. bond market component of the financial conditions index that more closely aligns with middle market credit spreads is the U.S. high-yield/10-year Treasury spread. The search for yield has benefited companies rated below investment grade by allowing them to borrow at fairly affordable pricing relative to higher quality borrowers. Despite some intra-year volatility, the average for the year and spreads toward the end of 2019 were relatively low, given some of the economic headwinds. Unless the economy deteriorates sharply and there is a prolonged period of rotation to safety, lower-rated companies should continue to enjoy the benefits of this reach for yield in 2020.
Volatility in U.S. equity markets was the main source of swings in financial conditions in 2019. Even periods of widening credit spreads during the year were largely precipitated when equity markets were spooked and money poured into Treasurys in what was otherwise a bull market year for stocks. Expect 2020 to be more of the same as the fragile backdrop that has sustained the stock market run continues to prevail. Even if the United States and China secure a phase one trade deal, posturing over phase two, other trade war frontiers, election-year uncertainties, geopolitical tensions and global economic growth will occasionally sour stock market sentiment.
Overall, with the Fed most likely to be on hold unless a significant deterioration occurs, monetary policy will take a backseat and the focus of capital markets will be on the U.S. administration’s policy actions and economic data. This should set the tone for fluctuating financial conditions given that the twists and turns on trade policy and the mixed economic data will most likely continue to signal a sideways trend, punctuated by short-lived spells of market jitters (moderately tight to neutral conditions) and bullish sentiment (very accommodative conditions).
Policy reform would bring sweeping change to middle market private equity
Private equity managers have taken a keen interest in the 2020 election, in no small part because a victory by a Democrat could bring significant changes to their industry. Among those candidates promising widespread reform is Sen. Elizabeth Warren, the progressive senator from Massachusetts, who has joined the leading ranks of Democratic contenders. She envisions nothing less than a full-blown overhaul of the private equity industry. Three of her proposals, if enacted, would have an immediate impact: a top income tax rate of 39.6% (from 37%), a new 14.8% tax for Social Security and an added annual tax of up to 6% on accumulated wealth and capital gains.
The result, private equity managers say, would be a disincentive to take risks and invest capital. According to Bloomberg, middle market buyout funds, or those with $100 million to $5 billion in assets under management starting in 2015, earned a median internal rate of return of 11.5%. This means that a wealthy investment manager of a $500 million middle market firm would be subject to $22.8 million in federal tax on income of $57.5 million, and would owe an additional $33.5 million of new wealth tax, for a total tax of $64.7 million. This amounts to a 113% effective tax rate. Private equity managers seeking to drive profitability through efficient tax planning would not be able to strip out the same wealth they have under previous tax law.
The goal of this policy change is no mystery: It takes money from wealthy managers to pay for other policy changes like health care, child care, housing and education, and addresses a major societal issue of income inequality that has America’s richest top 5% owning two-thirds of the wealth, according to the National Bureau of Economic Research.
But it would come at a cost, managers say, by creating an economic environment that discourages wealthy managers from investing at a similar pace. Private equity attracted an abundance of capital in the past 10 years. According to data from Bloomberg, these firms held a record level of uncalled capital through the most-recent June 2019 reading, the fourth time in as many years. If middle market managers were to shy away from private equity investing, there would not be enough shops to absorb all the available capital. What might follow would be bad actors who are less qualified to drive the type of earnings that Main Street Americans have enjoyed through their pensions and retirement plans.
Likewise, those managers that remain may instead make allocations to other asset classes like tax-free bonds or certain tax-efficient exchangetraded funds.
Another possible outcome may be further reductions in portfolio company investment. With interest rates so low, private equity has taken on more debt, which would seem to spur more investment and economic growth. But according to RSM’s fourth quarter 2019 Middle Market Business Index, only 46% of executives polled say they expect to increase capital spending during the next six months, down from 50% a year ago. Private equity remains the largest of all private markets, but this may change if these wealth taxes are passed. The same private equity owners who ignited economic growth over the past 15 years may be demotivated by new possible wealth taxes.
But to Warren, this is a small price to pay for what she views as much-needed reform. She contends that private equity firms need to take more responsibility for the companies they control and have fewer downside protections in the event their investments fail. Her Stop Wall Street Looting Act bill intends to close the loopholes that allow private equity firms to capture all the rewards of their investments while insulating themselves from downside risk. If passed, her bill would require private equity firms to share in the responsibility for potential liabilities of companies under their control, including debt, legal judgments and pension-related obligations.
MIDDLE MARKET INSIGHT If passed, Sen. Elizabeth Warren’s reform bill would require private equity firms to share in the responsibility for potential liabilities of companies under their control, including debt, legal judgments and pension-related obligations.
In current practice, private equity firms are on the hook only to the extent of their dollar investment but are free of any personal financial risk if the company goes belly up. For example, if a middle market manager makes a $20 million investment, the downside risk exposure is $20 million, but if this bill were passed, the possible losses could exceed $20 million. This would require middle market firms to reformulate risk-adjusted targeted returns understanding that there would be more exposure on an already risky private equity bet.
Also, in this bill, Warren aims to prevent firms from passing on dividends to investors for the first two years after the company is acquired. According to Preqin, 47% of private equity funds launched in 2010 and later have used subscription credit facilities. By comparison, just 13% of funds launched before 2010 used the shortterm financing tool. Since an increasing number of private equity firms use leverage, present day managers have spurred superior returns to investors, which this bill would make harder to do.
In November 2019, the U.S. Chamber of Commerce pushed back on Warren’s private equity plan. It asserted that if the bill were enacted there would be widespread job losses, declining tax revenues, and lower investment returns for pension funds and other investors, and that a substantial loss of jobs would follow. Even if she was to win the 2020 presidential election, there is the chance that her bill never gets through Congress; still, middle market managers must acknowledge that the way they have done business may change.
Negative interest rates
As the global economy continues to evolve in the wake of the Great Recession, monetary policymakers are asking what can be done to increase the pace of growth. Enter negative interest rates.
In periods of slow economic growth and low inflation–like today’s environment– central banks around the world have few arrows in their quiver to boost economic output. They have lowered interest rates to historically low levels and further added money to their economies through quantitative easing, all to an increasingly limited effect. Now, some central banks are pushing into new territory by lowering interest rates below zero.
In its simplest form, the concept of negative rates involves a charge to member banks in order to hold their reserves with a central bank.
The negative rate experiment, while starting in Europe, has spread to other developed countries like Japan. The hope was that by cutting a hole in the floor of interest rates, or zero lower bound, it would allow rates to fall into negative territory, which in theory would encourage banks to lend rather than leaving cash idle in reserves at a central bank. The idea is that more lending leads to economic growth, and ultimately, an increase in inflation.
But as negative rates have persisted, the impact has spilled over into what some had considered the safest place to hold money–government debt and savings accounts.
As investors pulled excess funds out of banks, the logical place to put that money was fixed income debt instruments. As demand for such instruments increases, the prices go up, causing the yields to drop. What happens in these countries with negative rates when institutions and individuals with trillions of dollars are looking for such instruments? Yields fall below zero. As of November 2019, there was $12.3 trillion of negative-yielding debt, but at the peak in August 2019, there was nearly $17 trillion.
The savings of businesses or wealthy individuals held in banks outside the United States are not immune to the impact of negative rates either. In Europe, banks are beginning to announce that they will no longer shoulder the burden of negative rates. Large banks like Deutsche Bank AG are announcing that they will pass on the cost of negative rates to their larger corporate clients or deposit accounts of wealthy individuals, sparing the pain (for now) for retail customers.
For countries that are experimenting with negative rates to spur growth and boost inflation, the interest rate outlook is pointing to a new reality. Domestically, some consider the idea of negative rates as preposterous. But when taking a longerterm view of the economy, available cash in the markets and the eventual need for more price stability for those entering retirement unless the government increases spending, the question is not when we will return to the zero bound of interest rates, but how far can they fall beyond zero.
The concept of negative rates can no longer be avoided. The global macroeconomic picture, clouded further by domestic trade uncertainty and persistently negative interest rates in some of the world’s most developed countries, are a clear indication that this reality shouldn’t be overlooked and thought of as just a possibility. Time to panic? No. Time to plan? Yes.
MIDDLE MARKET INSIGHT The concept of negative interest rates can no longer be avoided. Time to panic? No. Time to plan? Yes.
Insurance continues to bear the brunt of low interest rates
The insurance ecosystem will continue to feel the burn of low interest rates into 2020. But as corporate bond credit spreads remain relatively stable despite previous Fed rate cuts, the real impact is more likely to resemble the modest effect of the 2001 dot-com bust rather than the 2008 credit crisis.
Low interest rates will continue to drag on investment income in 2020. Companies may feel some earnings relief as the insurance markets continue to harden and premiums increase; however, the relief may be temporary if claim trends continue to increase. With some companies reporting unfavorable reserve development in liability lines in the last two quarters, emerging concerns of an about-face in the reserving cycle may be cause for further price increases into 2020.
Low-yield environment brings opportunity for insurers
In an environment of a flattening yield curve and 10-year rates below 2%, insurance companies will be affected in several ways. Property and casualty insurers, and health insurers, need to be more reactive to new yields to protect short-term profits because of their higher reinvestment frequency; however, life insurers stand to lose more in the long term. With a proactive approach to managing their risk exposure, insurers can thrive in a sustained low-yield environment.
Existing bond portfolios are likely to see significant mark-to-market gains with the decrease in yields in 2019; however, lower new money yields will cause a drag on investment income as the portfolio turns over. Management teams should increase the credit quality of their bond portfolios into shorter-term government holdings while the yield spread is low and diversify their investment strategy into higher-yielding instruments like private debt, preferred shares and common equity to compensate for declining interest rates. If a company’s investment policy does not allow for this flexibility, its management team should consult its board and make necessary revisions in the coming quarters.
MIDDLE MARKET INSIGHT Insurers should increase the credit quality of their bond portfolios into shorter-term government holdings while the yield spread is low and diversify into higher-yielding instruments like private debt, preferred shares and common equity.
In an economic downturn, insurance companies that underwrite large commercial businesses and directors and officers liability insurance may be exposed to correlated downside risks between their assets and liabilities. As the economy slows and spreads widen, corporate bond portfolios may drop in value at the same time companies experience a rise in D&O exposure. In light of the pending economic slowdown, insurers should take this opportunity to review their individual fixed-income holdings and proactively adjust their portfolios where necessary to mitigate these exposures.
Finally, investment yield assumptions underlying insurance product pricing, particularly for long-duration contracts, will be difficult to achieve in a low-yield environment. Management should review product pricing, particularly for longduration contracts (life and disability insurance), as soon as possible to ensure lower long-term investment yields and maintain underwriting profitability.
FINTECH: Race to zero heading to banking
The last quarter of 2019 saw major retail brokerages eliminating commission fees for online trading and other brokerage activities. After Charles Schwab in October announced zero-fee commissions, other firms such as Fidelity, TD Ameritrade, Interactive Brokers and E-Trade followed Schwab’s lead. The fintech sector was the primary reason these traditional firms adjusted their fee structure. The speed of technology, changing global demographics and geopolitics are some factors that are disrupting this sector.
As fintech companies move into banking, it appears likely that the disruption occurring within retail brokerage will spread into this sector. A number of small banking fintech companies are offering zero fees and better rates on savings accounts. As long as the U.S. economy keeps doing well and interest rates do not fall further, the difference in savings rates and banking products will be vast between fintech and traditional banks.
A study by the Consumer Financial Protection Bureau found that college students paid $27.6 million in account fees in 2016 thru 2017. As we are about to undertake the largest intergenerational transfer of wealth in history, these college students are expected not to rely on their parents’ advisers but look toward technology to find a packaged solution provider that can be accessed by their mobile phone. Examples of fintech (wealthtech) companies that offer products that are free and user friendly are Betterment, Wealthfront and SoFi.
In addition, there is a significant difference between the rates offered on savings products by fintech companies and existing banks. This disparity in rates will create some pressure on existing banks to raise interest rates or risk the chance of losing customers.
A majority of revenues generated by middle market banks consists of shrinking interest income, lending and other customer-generated fees. With the potential change in the banking platform, many middle market banks will have to either collaborate with a fintech, merge with a competitor or make the appropriate capital investments. The last of the three is a concern based on the fourth quarter RSM Middle Market Business Index, which showed capex spending slowed with only 46% of companies noting an increase in spending.
MIDDLE MARKET INSIGHT As fintech and banking continue to evolve, many middle market banks will have to either collaborate with a fintech, merge with a competitor or make the appropriate capital investments.
One fintech company that garnered a large customer base for its zero-fee stock trading was Robinhood, which attracted the attention of existing market participants. As Robinhood shook up the retail brokerage sector, there were a number of fintech companies looking to do the same in the banking sector. According to the Fed, 22% of the population in 2018 was unbanked, which provided an opportunity for new entrants to compete for their business. Time will tell if these digital banks can force the incumbents to revert to a new strategy that leverages technology, maintains low costs and increases their depositor base with higher savings rates. The battle for the banking customer will be exciting to watch as we head into 2020.
See the full industry outlook report
Get data-driven economic insights and sector outlooks provided by RSM senior analysts on a variety of middle market industries.