European Banks Navigate Difficult Waters
Despite the uncertainty, we remain positive on the sector.
Although our opinion on pro-cyclical equities (favouring Materials and Industrials) continues to be relevant in this challenging global context, Financials (positive opinion) are struggling in Europe. Indeed, the financial sector is facing strong headwinds including a complex political situation in Italy, a significant drop in the 10-year interest rate and a disappointing economic recovery in Europe. The banking sector has shed 10% year-to-date (as at 17 June) with an accelerating decline since mid-May.
Three key factors must be closely monitored: regulation, earnings and valuation.
Regulation remains crucial to the performance of the sector, whose prudential framework has been overhauled since the financial crisis. These restrictive rules with far-reaching consequences for the sector are shoring up the financial system, which is stronger today than it was ten years ago. What are the next steps in terms of regulation? Following the Basel III reforms (reinforcement of capital ratios), regulators are pursuing their mission by addressing the calculation methods of risk-weighted assets. The Basel Committee made announcements on this methodology at the end of 2017 (implementation of a tighter control of risk calculation methods) that were well received by the stock markets. The Basel IV rules must be finalised by 2022. The details of these rules, announcement schedule and timetable for implementation will be decisive for banks. In this respect, news could be more scattered in Europe in the run-up to the next European elections in May 2019.
Another key date for European banks is the publication of the results of the European Banking Authority’s stress tests before 2 November. Demands will be technically more stringent in view of the application of new accounting standards for financial instruments (IFRS9). Banks (particularly the weakest) could feel a greater squeeze on their profits.
Finally, investors will be monitoring any political announcements at the next European Council meeting (28-29 June) that would favour a reform of the eurozone and a strengthening of the European banking system.
But regulation aside, banks' earnings prospects have stabilised in Europe in recent years, especially thanks to the improvement in the macroeconomic environment. The latter should remain buoyant in 2018/2019, as the good momentum of economic activity is driving lending demand. The expected rise in interest rates will also improve profitability of banks. As such, their sensitivity to changes in the 10-year interest rate is quite striking. In particular, the steepening of the yield curve (spread between long and short rates) will enhance their net interest income.
Political uncertainty in Italy is obviously a cause for concern in the European markets. Saddled with €135 billion of Italian debt (source: Bank for International Settlements, December 2017), European banks are exposed to this risk to varying degrees. French, Spanish and German banks are the most affected, with assets of €54, €38 and €33 billion respectively. Italy’s exit from the eurozone does not seem likely, because neither the Italian government nor the European authorities wants to arrive at such an extreme scenario. However, investors eagerly await the budget which will be unveiled by the new Italian government.
Finally, the valuation of the sector looks attractive. Bank stocks are heavily discounted, while the environment suggests that interest rates will rise and economic growth will remain solid in Europe. The sector's ROE, or return on equity, now stands at 9% against a price to book ratio of 0.9. Finally, the sector's dividend rate (5%) is significant.
In conclusion, despite market scepticism, we believe that European banks—and therefore European equity markets—still offer an opportunity. While investors are massively focusing on solid and visible growth sectors (i.e. Technology), we remain convinced that diversification is necessary and banks have the potential to rebound in the context of a sustained European economic recovery.