Global Financial Services
STRATEGY
Risk Assets: Caveat Emptor
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Cross-Sector Recommendations: We favor the following: U.S. life
insurance over U.S. regional banks, European insurance over European
banks, U.S. multinational banks and brokers over European and Canadian
banks. Life insurance versus P&C insurance is a tougher call and highly macro
dependent. In a flat to down equity and fixed income market, P&C should
outperform, while we believe life insurers have substantially greater upside
potential in the event of a broad rally. Our call is based on a comparison of risk
assets, balance sheet adjustments to economic book values and relative
valuation differences. We favor companies that stand to benefit most from
financial markets healing and asset price recovery versus those more vulnerable
to actual economic deterioration, which is largely still forthcoming.
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Risk of insurance versus banks trade is the tail risk and limited risk
management visibility for variable annuities. A substantial further correction
in the equity markets and sustained low, long-term interest rates represent the
main macro risks, but the recent steepening of the yield curve and large
reduction in volatility are both positive developments. Another risk to our call is
that we think banks may offer better relative value than insurers when the market
moves to 2012 EPS as the primary determinant of valuation. Our call is
predicated on the view that major differences in book value growth over the next
few years will be a key driver of stock price performance during 2009.
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U.S. stress test provides guidance for balance sheet adjustments: We
would characterize 2008 as the year of the mark to market “witch hunt” for
financial stocks, but ironically, the securities portfolios that have wreaked the
most havoc on balance sheets through GAAP accumulated other comprehensive
income (AOCI) adjustments, have generally garnered the lowest assumed
cumulative losses in the stress test. The rough math is the stress test results
assume that about one-third of unrealized losses on securities portfolios will
come through as realized losses. Conversely, loans, which account for the
majority of banks’ balance sheets, are expected to produce cumulative losses of
7-8%, well in excess of current reserves of 2-3%.
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Our framework for economic book values should result in meaningful
“write-ups” of book values for companies with large securities portfolios,
and “write-downs” of those with large loan portfolios.
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Continued….
With asset leverage of roughly 10 times, this 5% positive (for securities) or negative (for
loans) adjustment to asset values would have a meaningful impact to book value. After
factoring in the offsetting adjustments (such as DAC and deferred taxes), we estimate that
these impacts would have an approximate positive 30% impact for life insurers versus an
approximate 30% negative impact for banks.
■ Our Delta One team has created two stock baskets - Bloomberg tickers: CSGLFINL
and CSGLFINS - that include the Outperform and Underperform stocks highlighted in
Exhibit 4, respectively.