Investors snub bank stocks
Why do we remain confident in the banking sector?
The reporting season has just begun in the United States, with only 7% of S&P500 companies having published their results. But already they reveal a valuable fact: investors are losing interest in bank stocks. We know that the sector consistently underperforms in a bear (or highly-volatile) market, but it is surprising when the sector struggles when markets are timidly recovering (as in the present case). This loss of interest is particularly astonishing as several American banks have recently published quarterly results above expectations. Their sales were good in the first quarter of 2018, their profit figures were decent and their interest margins were stable or improving. And yet, investors are avoiding bank stocks. They prefer to turn to oil stocks—which are rallying on rising oil prices—or more recently, growth (e.g. technology) stocks. Is the underperformance of bank stocks purely a matter of sector rotation or have their fundamentals finally deteriorated?
The evolution of interest rates is undoubtedly one of the main reasons for the sector's current woes. On both sides of the Atlantic, the 10-year bond yield has been falling constantly for several weeks. The Bund, the German benchmark rate, rose from 0.77% (a 2-year high) in February to 0.5% at the beginning of April while the 10-year Treasury yield fell from 2.95% to 2.70% over the same period. In the context of a reappraisal of the interest rate outlook, investors have rotated out of financials into more defensive sectors (energy presently).
However, we remain confident in the banking sector. Despite tighter regulations, a transformation within the industry (changes in customer behaviour) and fiercer competition (disintermediation of the market with the emergence of fintechs), in our opinion, the performance of American and European banks will soon be driven by:
1) Rising interest rates. In the context of solid growth and the return of inflationary pressure, we expect interest rates to normalise gradually due to the intervention of central banks. The 10-year bond yield will reach 1.25% in Germany and 3.25% in the US in 12 months, in our view. A steeper yield curve will have a positive impact on banks' interest margins. The European Central Bank estimates that a 200-point steepening of the yield curve in the euro area would improve banks' net income interest by 10% over three years.
2) A still buoyant economic climate. The US tax reform passed last December provided more visibility for banks, leading to significant upgrades in analyst forecasts over the past three months. In Europe, economic conditions are favourable, and lending in the euro area is growing at a steady pace. Return on equity (RoE) of European banks has increased from 8% to 9% over the last three months and from 10% to 11% in the United States.
3) Fair valuations. The sector continues to trade at relatively attractive levels. The price-to-book value ratio is still below 1. Therefore, the increase in return on equity and dividends could encourage a renewed appetite for this inexpensive and well-capitalised sector.
4) Limited political risk. In Europe, the political risk has diminished since the French elections. The political situation in Italy remains a source of concern, but we note that Italian bond spreads have not widened. Furthermore, the country's economic fundamentals continue to improve. Doubtful loans now represent less than 9% of total loans (versus 11% a few months ago).
In conclusion, equity markets are grappling with several risk factors that go beyond a fundamental market analysis. The geopolitical situation, fears of a trade war between the US and China, and political tangles in the US may continue to disrupt stock markets in the short term. However, we believe that the economic and financial environment remains favourable for equities, and bank stocks will be the main beneficiaries of the still valid reflationary scenario.