We Become More Constructive On Financials
In the wake of the Financial Crisis of 2008-2009, the financial sector has been very criticised by investors. This is particularly true of European banks, which have lived through too many crises. Admittedly due to the laxity shown at the time by many large financial institutions, and their "emergency" rescue packages, regulators have become much more demanding. Central banks had to intervene again during the "Greek crisis" and opened the liquidity tap in a bid to save the euro in the years 2012-2015. This was the famous episode of Mr. Draghi's monetary bazooka, promising that he would do everything he could to save the European currency (and the European banking system!).
However, while the euro has been saved, there is still a feeling that something is missing, especially when comparing the European banking system with the American one. While the great crisis of 2008-2009 emanated from the American continent with the bursting of the real estate bubble - in particular the (in)famous "subprime loans" that led to the catastrophe and to the bankruptcy of Lehman Brothers-, paradoxically, US banks have restructured themselves much more quickly. While in Europe, laws and controls are increasingly restrictive (and therefore costly) for banks, there has been some deregulation in the United States for some time. For example, the Volcker rule, which limits speculative and illiquid investments by major US banks, is regularly reviewed and relaxed. For instance, since August of this year, US banks' short-term positions are less systematically considered as proprietary trading. The relatively illiquid private equity is also now more accepted and less controlled. This allows American banks to free up capital for other projects.
On the monetary side, the Federal Reserve (Fed) has also been faster than the European Central Bank (ECB) in increasing the size of its balance sheet by buying back huge amounts of bonds in order to put downward pressure on interest rates and help companies - and banks in particular - to refinance themselves.
Finally, the tax reform of the Trump administration has given to the US banks a significant competitive advantage by lowering taxes and providing favourable conditions. The major US banks are now over-capitalised and can afford:
- new investments: in particular, their digital transition is impressive and relatively advanced;
- dividend increases;
- significant share buybacks.
Thus, in this relatively favourable environment, they are gaining market share, especially in investment banking, versus their European counterparts.
In Europe, we wonder whether monetary policy has gone too far with negative interest rates expected for a long time (no respectable financial text book has ever considered such a context!). This type of policy can sometimes have perverse effects, for example the survival of "zombie" companies (unprofitable and insolvent), exacerbated competition and, ultimately, deflationary pressures.
Some ECB measures attempt to reduce the pressure of this negative-rate refinancing on banks' profitability, in particular the tiering system with, for example, a lower refinancing cost for legal reserves and a higher cost for a large excess of liquidity at the ECB. To encourage lending by less well-capitalised banks (particularly in southern Europe), a 'TLTRO' system has been put in place where banks can borrow from the ECB at favourable rates in order to provide loans to small- and medium-sized enterprises and revitalise the economy through this process.
But these measures do little to address the fundamental concern of the profitability of European banks, which are forced to restructure continuously to lower costs, to be more competitive in the new digital economy and to offset interest margins which are under pressure given the low interest rates (even negative in the case of the ECB deposit rate).
It can also be seen that European banking integration is still in its infancy. German Finance Minister Olaf Scholz gave a glimmer of hope at the beginning of November by insisting that with the expected Brexit, it is probably high time to make progress in building a more integrated banking system within the euro zone.
US banks and diversified financials
Last year, investors feared a sharp economic slowdown, exacerbated at the end of 2018 by strong trade tensions between the United States and China as well as a further rate increase (one too many?) by the Federal Reserve. Mr. Powell then changed his mind at the beginning of the year, that he justified by the global economic slowdown which was induced by trade tensions. We had become more cautious on Financials after their rebound in early 2019 in view of the publication of poor economic indicators. The bond yield curve had begun to reverse, which is often a precursor to a recession.
In August, another cut in Fed rates and a much more conciliatory speech by President Trump led to hopes that the economic deterioration would stop. And there has been recently a stabilisation or slight improvement in leading economic indicators. The yield curve has also steepened.
The chances of seeing a trade agreement, even if it will probably be quite light, have increased, as has a 'smooth' exit of Britain from the European sphere.
The US economy now seems quite solid again and a cyclical rebound is expected as a result of these political and monetary reversals.
US banks are still a very cheap sector both intrinsically and in relation to the rest of the stock market, given their restored solidity and significantly improved profitability. In addition, the results published in 3Q19 were generally better than expected for the major US banks.
Any economic upturn (however small) should boost these cyclical and 'value' stocks (price/earnings ratios for 2020 are around 12.5 versus 18.3 for US equities in general) and allow them to outperform. Hence our recommendation recently raised to "Positive".
European banks and diversified financials
As mentioned above, the environment remains more complicated for European banks because they continue to suffer from a certain ‘financial repression’:
- Relatively heavy regulations and taxation;
- Negative refinancing rates;
- It is very complex to close mergers and acquisitions outside national borders.
In addition, in several countries, particularly in southern Europe, but also in Germany, restructuring has been slow and many banks are still too weak today. For many European banks, the cost of equity (COE) does not compensate for the return on equity (ROE). This raises questions as ‘Basel 4' looms on the horizon, with new constraints for banks and higher capital requirements.
Money laundering scandals have also hit several banks in northern Europe (as well as the reputation of the sector) and of course, Brexit raises questions about the supremacy of London and its financial system.
Therefore, even if the economic environment seems to be improving, it seems early to be buyers of the whole European financial sector. We are therefore maintaining our recommendation on this segment at neutral for the time being. Although there are opportunities out there, the European banking system is still going at very different speeds. Investors need to be selective. The statements made by the German Finance Minister at the beginning of November (see above) further support this view.
We have long favoured banks in the core euro zone (France, Netherlands, Belgium) because they appear to be among the most solid and profitable in a much more consolidated banking landscape in these markets than in other countries.
A more pro-cyclical European policy (e.g. a major stimulus plan in Germany), an economic acceleration and/or a steepening of the yield curve would encourage us to become positive again overall on European banks, which are also very cheap/'deep value' today.
This sector has performed well since the beginning of the year. We became more cautious at the end of May after a good performance in early 2019 and when the yield curve began to invert.
Thanks to the renewed confidence in both the economy and equity markets, relatively cheap sectors should once again attract investors' attention. This is the case for Insurance, a sector that is also solid, sufficiently capitalised and well managed. Investors always appreciate the low volatility of profits and good dividends.
In the US, there is even a certain return of pricing power in the non-life segment, offsetting interest margins under pressure. Thus, while the context appears to be much better today than it was a year or two ago for insurers, valuation levels (price/book value) are similar to those prevailing at the beginning of 2018, while profitability is better. A similar situation can be observed in Europe.
Hence our now “positive” recommendation on the global insurance sector (price/earnings ratios 2020: 12.4 versus 18.3 for US equities in general and P/E ratio 2020 = 10.4 for European insurance versus 14.4 for Europe).
This sector has performed very well since the beginning of the year on both sides of the Atlantic, supported, admittedly, by ever-lower interest rates and investors' thirst for returns.
We believe that with the return of appetite for value and cyclical equities, the more defensive REITs (listed real estate funds) sector will become less popular. We do not see any fundamental problem for this sector (the companies that are part of it are generally well managed) but we believe that after the recent strong increases, a pause in the rally is needed. Several REITs are now fully valued, or even expensive.
In the event of a correction that we would judge as too excessive for listed real estate - for example in the event of a strong sector rotation - we could become positive again on this sector. We generally believe that Real Estate should remain a cornerstone of any well-diversified investment portfolio.
In the meantime, the Real Estate sector is now globally in “neutral”. Investors need to be more selective today. Finally, as we are approaching a final solution for Brexit, investor interest is returning to the United Kingdom and we are raising British REITs from negative to neutral.