Dec 13, 2022, 10:06 AM ETInterview, Podcast

The Outlook for Financial Services

Banks are viewed as the "most macro of the micro sectors," where income statement drivers (interest rates, loan demand, unemployment, corporate defaults) serve as leading indicators for the economy over a 6–12 month horizon.
The banking sector reported a strong year with top-line growth in the high single digits, driven by interest rate margin expansion and robust loan demand.
Current sentiment indicates a strong economy today but significant uncertainty regarding the impact of Federal Reserve tightening on consumer spending and corporate confidence.
Loan losses are at their lowest level in 30 years, approximately half of 2019 levels, though an expectation exists that they will normalize as rates rise and growth slows.
The primary driver for future credit losses is anticipated to be a pickup in unemployment, which has not yet materialized; currently, normalization is limited to credit card portfolios with lower FICO scores.
Banks are marginally tightening underwriting standards due to capital constraints and concerns over potential asset price declines, specifically a projected 5–10% drop in U.S. house prices and uncertainty in commercial office real estate.
Lending appetite remains broadly stable as banks focus on adjusting credit pricing to compensate for perceived risk rather than withdrawing credit availability.

Inflation has increased the size of loans required for consumers (e.g., used cars up 20–30% in cost) and corporations (inventory builds ahead of rising raw material costs).
Asset managers note that the traditional 60-40 portfolio has dropped in the mid-teens, with fixed income segments (particularly long-duration) declining as much as 20%.
There is a growing investor focus on portfolio construction, downside protection, and uncorrelated assets as the Fed shifts from an accommodating to less accommodative policy stance.
Fixed income funds experienced a record amount of outflows in 2022, though analysts anticipate massive inflows returning in 2023 due to yields on cash and liquid investment rates exceeding 5%.

M&A activity declined by 35% and equity capital markets (IPO) activity dropped over 70% in 2022 compared to 2021, driven by weak equity performance, volatility, and a reset to a higher interest rate valuation paradigm.
Capital market activity is not expected to pick up significantly until the second half of 2023, contingent on reduced volatility and narrowing bid-ask spreads.
Private equity and financial sponsors are showing increased appetite for public-to-private transactions for the first time in a long period, which is expected to stabilize the M&A backdrop.
Alternative managers and private credit firms, representing 20–25% of capital market revenue, are sidelined but are expected to redeploy capital as valuation gaps narrow.

Capital allocation is shifting toward energy transition, with trillions of dollars in required investment needed to accelerate the move to alternative energy sources.
Asset managers are prioritizing product development in alternative assets and seeking operational efficiencies through outsourcing to combat margin compression from structural outflows.
Inflation is forcing a shift in investment strategies, with a greater emphasis on floating-rate loans in private markets to capture higher yields.

Bank stocks have fallen 24% this year despite earnings upgrades, reflecting a market-implied 50–60% probability of a recession over the next 12–18 months.
Systemic risk is currently not present in funding markets (no rapid spread widening); primary concerns are external to the banking system.
Banks are concerned about deteriorating market liquidity across equities, corporate credit, and treasuries, fearing an inability to sell positions efficiently during a stress event.
Non-bank lenders are viewed as a potential source of risk in a deep downturn, though private markets possess long-term structural funding (5–10 years) that mitigates forced selling pressure.
The banking sector is highly confident in its capital and liquidity positions, projecting the ability to continue originating loans through a downturn rather than contracting the balance sheet as seen in prior cycles.
Strategic investments are pivoting heavily toward digitalization to compete with technology companies expanding into payment and banking services, with the expectation that non-bank tech competitors will define the competitive landscape over the next decade.