Why Is The European Banking Sector Performing So Well?

The banking sector has been the best sector performer over the last few weeks. European banks have risen by 3% over the past month while the Stoxx 600 index has lost 2%. This is the most positive reaction of the European banking sector since its strong rally in late 2016. The rotation into this high beta industry is not intuitive, especially as global markets are hesitant. Several key factors, however, explain this outperformance.
 

The economic situation in the eurozone continues to improve: confidence surveys point to a very positive trend, although the latest “hard” economic data suggest that the prevailing optimism should be tempered somewhat. After a growth of 0.5% q/q in 4Q16, confidence surveys conducted since the beginning of the year suggest that growth will continue at a similar, or perhaps an even stronger rate, in the first quarter of 2017. The pickup in consumer confidence has probably been mainly driven by the improvements in the labour market, with the unemployment rate declining to 9.3% in April, the lowest level since the financial crisis. Credit growth should benefit from this improving economic environment. We have already seen improving loan growth in Germany, France and Spain. Italy still suffers from a poor dynamic. This positive momentum in Europe is good news for banks’ earnings outlooks. EPS estimates have been revised up in Europe (+1% over the past three months). Banks have been one of the major beneficiaries of this positive trend (+2.5%). After a long negative trend, EPS in the European banking sector has finally turned positive.

Interest rates have risen in Europe, encouraging a sector rotation into interest-rate-sensitive sectors. The German 10-year interest rate gained 30bps in one month. Investors perceived a shift in the European Central Bank’s (ECB) rationale in its latest communication. In an important speech, given at the ECB Forum on Central Banking, President Draghi laid out the arguments for a possible policy adjustment, while stressing that the ECB would move gradually and cautiously. He said he was very confident about monetary policy efficiency: growth is above trend and well distributed across the eurozone and most factors weighing on inflation are temporary. In this context, the ECB is prepared to support the recovery, by raising interest rates in line with the pick-up in inflation and to keep its policy stable. At the same time, Mr Draghi argued that the policy must remain accommodative to ensure that inflation returns to the given target sustainably.  The market interpreted Draghi’s comments as hawkish, as they suggest that tapering might come earlier than expected. The ECB’s communication continues to fuel ambiguity over the direction of monetary policy. With fears over the tempo of monetary policy, bond yields rose significantly and European equities declined. Nonetheless, higher bond yields and the steepening of the yield curve are positive for the banking industry. Banks are showing the most positive correlation to yields. A steepening yield curve is important for banks’ net interest margins, which have been under pressure over the past few years.

While high valuations are becoming an issue for most sectors, the banking sector is still relatively cheap. The sector has rebounded over the last 12 months, but has not fully benefited from the reflation trade (unlike pure cyclicals). Despite the recent strong run, eurozone banks still look attractively valued. Their P/E relative remains on the cheap side of fair value. Their P/B is still below one (at 0.9). Banks look cheaper than most other cyclical industries.

The encouraging news in peripheral European countries has reduced the tail-risk for the European banking sector. After the rescue of Banco Popular in Spain, Italy found a solution for some failed banks. On 25 June, Italy announced the biggest bank bail-out on record. The Italian government will provide €17 billion to clean up two failed Venetian banks, Banca Popolare di Vicenza and Veneto Banca.  The deal has avoided a pure “bail-in” which would have been painful for Italy. This solution contrasts with the earlier rescue of Banco Popular in Spain, when no state aid was provided. The decision is very pragmatic, and adapted to the specific Italian situation. After lengthy negotiations, a compromise between the European authorities and Italy has been found. More recently, the European Commission has given formal approval for the restructuring plan of Banca Monte dei Paschi, paving way for state control.

In this improving environment, European banks should continue to do well. Solid banks in core Europe (Benelux and France) are preferred. In the US, even though the latest Fed stress tests have bolstered US bank stocks, the potential appears more limited: valuations are higher and the credit cycle is more advanced in the US than in Europe.