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January 17, 2013

After lagging for five years, stocks of financial services companies strongly outperformed the largecap S&P 500 Index in 2012, helped by low valuations, an improving housing market, and easing regulatory concerns. Eric Veiel, who manages the T. Rowe Price Financial Services Fund, maintains a favorable outlook for the sector and sees interesting opportunities among certain housing-related and insurance companies as well as relatively small banks. However, he expects moderating performance in 2013 and notes that economic weakness and continued low interest rates are key risks for the sector.

Financials rallied as some factors weighing on the sector stopped worsening and others improved
  • Financial services stocks led U.S. large-caps, rising almost 29% for the year.
  • Sector valuations at the start of 2012 had been very low following five years of underperformance.
  • As the year progressed, the housing market stopped worsening, while corporate credit positions and the regulatory environment showed improvement.
Our outlook remains favorable, but valuations are higher and returns should moderate in 2013
  • Most financial services companies have very strong balance sheets, are generating capital, and benefit from deep liquidity. These support our outlook. However, slow loan growth and low interest rates are creating headwinds.
  • Due to several years of deleveraging, there is less demand for loans from corporations and individuals.
  • Low rates are squeezing banks' profit margins because the interest they pay to depositors cannot go much lower while the interest they charge on loans is somewhat capped.
Housing-related, property and casualty insurance, and regional bank stocks offer interesting opportunities
  • Homebuilders may not do as well in 2013 as they did last year—and we have scaled back our holdings—but companies with large land positions and those providing data analytics or other services to the mortgage industry could benefit from the housing recovery.
  • Similarly, we reduced our exposure to property and casualty insurers that did very well last year, but companies that sell insurance to auto finance companies may have potential.
  • We believe that mergers and acquisitions involving small banks struggling with low interest rates and greater regulation are likely to increase notably in 2013. Also, larger regional banks that have economies of scale but are not heavily regulated like the megabanks could do well.
While much of the 2008 financial crisis damage has been repaired, financials may still face economic, interest rate, and regulatory risks
  • Financial services companies depend on the underlying economy in which they operate. If the economy slips into recession, financial stocks will underperform.
  • Even though interest rates are already extremely low, history shows that rates can stay low for a long time and can go lower than we expect.
  • While the regulatory environment seems to be improving, it is inherently unpredictable.

There are inherent risks associated with investing in the stock market, including possible loss of principal, and investors must be willing to accept them. Because of its concentration in financial services stocks, the fund is subject to higher potential risk than a more diversified fund. Financial services companies may be hurt when interest rates rise sharply and may also be vulnerable to rapidly rising inflation.

The views are as of January 9, 2013 and may have changed since that time. This information is provided for informational purposes only and is not intended to reflect a current or past recommendation, or investment advice of any kind. Opinions and commentary do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Copyright 2014, T. Rowe Price Investment Services, Inc., Distributor. All rights reserved.