From Our Briefings Newsletter

07 JAN 2019

The article below is from our BRIEFINGS newsletter of 07 January 2019:

Briefly . . . on the Year Ahead for Financials 

2019 started for Financial Services much like 2018 ended: with volatility and questions about potential vulnerabilities in the sector. We spoke to Goldman Sachs Research's Richard Ramsden on the heels of the firm's annual Financial Services Conference for his read on industry sentiment, the year-ahead outlook and pockets of risk.

Coming off a year of market lows largely fueled by growth and rate concerns, what sense did you get from participants at the Financials Conference about the underlying macro backdrop for 2019?

Richard Ramsden: The broad view was that the backdrop is still constructive, both from a corporate and consumer perspective. Banks reported strong consumer and small business confidence, with higher consumer spending and no notable shift toward saving in higher-yielding deposit accounts. The credit backdrop also looks relatively benign, with many participants at the conference reporting strength in both corporate and consumer loan growth. So all-in-all, the fundamentals for a solid year in the sector remain intact – and that's consistent with our economists' call for continued business and consumer confidence and spending growth in 2019.

What about the capital adequacy questions surrounding large banks  do you see rising risk there?

RR: It's minimal, in our view. Even in a "moderate" recession scenario – which isn't our base case -- our analysis suggests that all the banks in our coverage would remain profitable and maintain their dividends and buybacks, albeit at slightly lower levels. They are better positioned for credit stress this cycle given operating margins are 500 basis points higher than they were heading into prior recessions and credit creation has been slower and more cautious, with a skew toward lower-risk products.

What about the outlook for bread-and-butter financial services like IPOs and M&A?

RR: Messaging from participants at the conference was more mixed. Some noted it could take up to six months for corporate sellers to adjust to recent volatility and equity devaluation, which would dampen M&A in what's now become a stronger buyers' market. Our own view is that it's a temporary setback. We think the M&A cycle – while mature – still has room to run given the high levels of cash on corporate balance sheets, accommodative financing terms, and the continuing threat of technological disruption that's prompting some companies to buy rather than develop their tech capability sets. But it will take some time for this demand to bounce back.

As for IPOs, alternative asset managers broadly noted that recent equity volatility will likely lead to a more challenging backdrop for exits and that firms may look to increase exits via strategic or sponsor deals. Alternative managers also noted across the board that recent volatility could slow the pace of private capital deployment.

Leveraged lending has received a lot of attention lately, most notably from the Fed, as a potential bubble and vulnerability for the cycle. What's your take?

RR: That actually came up quite a bit at the conference in discussions of direct lending and growth in the private credit market, which now handles a decent share of this riskier lending once underwritten by investment banks. Generally speaking, attendees didn't see substantial risk in the private market relative to other areas of credit, and the Goldman Sachs Research view on leveraged lending is largely the same. We think the default risk on leveraged loans will remain moderate near-term, given still-healthy corporate earnings fundamentals, still-strong debt servicing capacity, and relatively low near-term recession risk. Banks also have fairly limited exposure here, given the skew I mentioned earlier toward lower-risk products – their allocations to new leveraged loan deals in the primary market have fallen to roughly 5%, and their investments in collateralized loan obligations or "CLOs" are mainly concentrated in the most senior tranches – so the risk of runs from leveraged loan-related losses looks manageable.

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