1. Margins … defaults. The biggest risk factor for SMEs (large businesses too) in 2019 is margin pressure. We are in the tightest labor market in 20 years. Tariffs are putting pressure on raw material costs (which could ratchet up further in March). Short-term borrowing costs have exploded (LIBOR has risen more than 10x from nearly zero to about 2.5% since late-2015). Healthcare costs (now close to 20% of GDP) continue to compound at a double-digit rate. Commercial real estate and shipping costs have firmed or even shot up (energy, too, with volatility in both directions).

Cost pressure is relentless as slack has been taken out of the system. Paired with the dramatic rise in leverage on corporate balance sheets, we expect loan defaults to rise materially in 2019. What happens if these cost pressures cannot be passed on to customers (or, if they are, does risk shift to consumer)? Which industries have margin capacity to absorb the impact? Pricing power should be front of mind for commercial lenders as we move into 2019.

2. Regional banks path forward should include partnerships. Multiple headwinds are making it difficult for smaller (regional) banks to differentiate themselves and compete with larger banks. The past decade has seen technology rapidly commoditize many traditional banking services, squeezing the margin out of important revenue streams. The combination of a flat yield curve and the rising cost of funds is putting pressure on spreads. The “new” (post-2008) compliance burden has not gone away. The costs of maintaining branch infrastructure and acquiring customers require a large revenue base. It’s tough sledding. We see this pushing regional banks down two paths: consolidate or slide further out on the risk curve. While larger banks have been reluctant to turn up the risk dials, the community and regional banking world have had little choice in competing with alternative lenders for assets. Commercial real estate and ABL lending, in particular, are two areas where risk-taking has become notably aggressive.

Is this sustainable? No. Risk-taking is a function of the cycle: As economic growth slows and defaults rise, banks will retrench. An alternative long-term approach is for regional banks to partner with independent platforms. This can help expand their product footprint and accelerate customer acquisition without expensive investments in infrastructure, especially technology. A more measured way to introduce more risk and higher yields without building the muscle to manage such exposure. Beyond interim steps of dialing up and down risk, further consolidation is inevitable.

3. Expect a wave of bank consolidation. There are 6000ish banks in the US, too much capacity chasing too few opportunities. The industry is maturing. Technology is playing a more central role and fundamentally changing the customer experience. Maintaining a physical presence in markets is costly. Financial technology platforms are trying to disintermediate banks from customers. We believe these trends underpin another wave of bank consolidation. The positive market response in recent weeks to MOE’s (Suntrust / BB&T most recently) will only fuel this dynamic. Look for regional bank MOEs and for larger banks to continue gobbling up smaller players in 2019.

4. Growth will be harder to find. We expect economic growth to become more concentrated and thematic in 2019 as the cycle matures and tax cut benefits wear off. Consumer debt is near a cycle high (well above 2007 levels). The retail and automotive sectors are slowing, with upward pressure on input costs potentially exacerbating the slowdown. Wireless infrastructure is a pocket of strength as 5G network investments ramp. Aerospace and defense should be steady. Counter-cyclical businesses (discount retailers, auto repair, accounting) should outgrow more traditional cyclical industries (residential and commercial construction). Government spending on infrastructure and alternative energy are other pockets of solid growth. Transportation (freight) has benefited from tight supply and firm pricing which we expect to continue but potentially leveling off this year. It is time to be more selective and think about secular opportunities versus a rising tide floats all boats.

5. Big data and the intersection of platforms and lending. Another important trend is the convergence of the physical (platforms) and funding worlds. Intuit, Square, Amazon, Shopify, Paypal now lend to customers/vendors on their platforms. (Stripe just joined the party.) This dynamic is broad — pharmaceuticals, logistics, agriculture, transportation, retail, etc. Develop a platform to facilitate transaction flow (e-invoicing / payments), sit at the intersection of buyers and sellers, and underwrite the rich data to extend credit. Big data meets risk. Platform meets credit. It’s sticky and scalable. It also solves perhaps the biggest pain point in commercial lending — customer acquisition. Identifying and underwriting borrowers is expensive and hard to scale. Platform models have a much lower cost of customer acquisition which allows them to pass some of those economics on to borrowers. They can leverage historical data and platform usage to manage fraud and credit risk. It is a powerful model that has the potential to fundamentally alter the lending world and potentially disintermediate traditional financial service platforms.

Important Takeaways:

1. Be discerning. We do not know the shape of economic growth, but suspect it will be less even. Combined with downward pressure on margins, a more measured approach to originations and portfolio is merited.

2. Think outside the box for growth opportunities. Simply taking more risk is not the only option for growth. Partnerships, untapped markets or industries, new products should all be on the table.

3. Stay Nimble. The world of financial services is evolving very rapidly. It will cause disruption and create opportunity. This dynamic environment demands a flexible mindset. What worked today may not work tomorrow.