August 16, 2012
|Eric Veiel, manager of the Financial Services Fund, provides a sector outlook for the second half of 2012.|
At the beginning of 2012, Financial Services Fund Manager Eric Veiel believed that financials were poised to perform well amid low valuations, improving U.S. economic and housing market fundamentals, and the potential for greater clarity regarding regulatory changes. In fact, financials turned out to be one of the best-performing sectors in the S&P 500 in the first half of the year. In this Q&A, Veiel discusses the state of the sector, including the two areas where he sees fundamentals steadily improving—the U.S. housing market and property and casualty insurance pricing—and offers his thoughts on JPMorgan Chase's significant trading loss and the LIBOR rate-setting scandal that broke at the end of June.
A. During the first quarter of the year, stocks continued the rally that began in late 2011 because investors saw signs of strength in the U.S. economy and temporary relief in the ongoing European sovereign debt crisis. Financials did well in this rally, but by early April, risk aversion returned as signs of a global slowdown began to emerge. Europe's troubles also took center stage as the threat of a hasty and disorderly Greek exit from the eurozone, coupled with rising sovereign bond yields in Spain and Italy, rekindled concerns over the eurozone's precarious state. All in all, the strength in the first quarter was significantly greater than the second-quarter downturn, and financials produced solid double-digit gains in the first half.
A. Like many investors, we were caught off guard by the significant lapse in risk management in the CIO division. As of now, the company has reported that the trading loss was about $6 billion through June 30 and was approximately 70% contained. While the loss is large, the actual impact to the company's balance sheet was minimal, and the company's strong earnings capability was not affected. From the end of 2011 through June 30, 2012, JPMorgan Chase grew its tangible book value per share by 6% and generated $9.9 billion in net income.
A. In late June, UK financial services company Barclays reached a settlement with three regulatory agencies—the UK's Financial Services Authority (FSA), the U.S. Commodity Futures Trading Commission (CFTC), and the U.S. Department of Justice (DOJ)—regarding allegations that it attempted to manipulate the daily settings of the London Interbank Offered Rate. Together, these three regulators fined Barclays $455 million.
A. The Barclays traders cited in the settlement documents publicized by the CFTC and FSA displayed morally bankrupt behavior that could tarnish the entire financial services industry. Yet again, we see an example of how the actions of a few can undermine the efforts of many. I believe that this settlement is the first of many more to come as Barclays was not alone in its actions. In addition to regulatory fines and possibly criminal charges, there is the potential for significant civil monetary damages. The overhang that this type of open-ended liability can create will be a significant challenge for the banks involved in this latest financial scandal.
A. As we enter the second half of 2012, we note that valuation levels are higher, but economic fundamentals in the U.S. and most other major markets are showing signs of deteriorating, at least temporarily. The regulatory landscape remains muddled, although the fog is slowly lifting as the new rules required by the Dodd-Frank financial reform law get finalized and the implementation of Basel III—which sets more stringent global guidelines for banks' capital requirements, liquidity, and leverage—moves closer to reality. In addition, today's low interest rate environment is unlikely to change anytime soon. Without higher interest rates, companies in many financial industries, such as commercial banks, life insurers, trust banks, and online brokers, will continue to struggle to generate earnings that resemble profits from past business cycles.
A. We've been steadily decreasing its exposure to the most interest rate-sensitive stocks, and we do not anticipate reversing course unless individual stock prices become significantly more distressed. We continue to add to the two areas within financials where the underlying fundamentals appear to be steadily improving: U.S. housing and property and casualty insurance. However, most financial companies would benefit from higher interest rates, so even with our modest portfolio adjustment away from interest rate-sensitive stocks, the fund should still benefit from such a trend.
A. The fund is positioned for a recovery in capital markets activity, such as increased mergers and acquisitions, issuance of equity and debt securities, and securities trading volumes. During the first half of 2012, we modestly decreased our exposure to capital markets companies by reducing positions among securities exchanges. Likewise, we continued to add to housing-related stocks, especially indirect beneficiaries of an improving housing market, and to property and casualty insurance stocks that we believe will benefit from improvements in the industry's pricing structure.
Since 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. In general, the fund represents greater potential risk than a more diversified fund, although the dividends paid by financial services companies may moderate this risk to some extent. Financial services companies may be hurt when interest rates rise sharply, although not all companies are affected equally. The stocks also may be vulnerable to rapidly rising inflation.
The securities mentioned composed 5.2% of the fund's portfolio as of June 30, 2012. The manager's views and portfolio holdings are historical and subject to change. This material should not be deemed a recommendation to buy or sell any of the securities mentioned.