2016 and before
Bank shares could be about to change from “dogs to darlings”
James Sym explains how the return of inflation, coupled with ultra-cheap valuations, could herald a significant change of fortune for Europe’s beleaguered banking sector.
To our minds an investment in European banks represents potentially the single most attractive opportunity in our asset class.
It is that very rare thing in the post quantitative easing (QE) investment world: a “fat pitch” or, for those unfamiliar with baseball parlance, an easy ball to hit.
This will appear an incongruous statement. Banks have been the dogs of this investment cycle and readers will no doubt be familiar with many of the well-worn threats to the industry.
Anyone doubting the wisdom of an investment in this sector is certainly not alone; our analysis suggests nearly nine out of ten professional investors in Europe are underweight the sector.
To state the obvious, in a sector so unloved, given these stocks are trading way below fair value, a subsequent increase in their share prices would be incredibly painful for the many portfolios with little to no exposure.
Why then do we take the other view? Our investment theses typically take place in three steps:
- Firstly, identify why the shares trade as they do. In other words, what’s the problem?
- Secondly, identify why the key inputs have to change.
- Thirdly, when these initial conditions change, how much money could you make?
Banks trade on ultra-cheap valuations
To start with then these stocks are somewhere between very and outrageously cheap. For example, one of the better northern European banks might typically offer a 6% dividend yield.
Venture to Italy and one can find dividend yields in the double digits. Not bad if you have spare cash for investment in a world where interest rates are 0% and over half of all European government bonds globally yield less than 1%.
But why do banks trade so cheaply?
Almost by definition it’s because the market views the current level of profitability as unsustainable.
There are the threats that make good headlines such as litigation and regulation, as well as the vague notion that new technology somehow renders the banking model obsolete.
But there is one overriding, pernicious threat that has dominated the discourse around banking boardrooms across Europe over the last couple of years: that is zero (ZIRP) and then negative interest rate (NIRP) policy from the European Central Bank (ECB).
Monetary policy has hurt banks’ profits
There is no doubt that the alphabet soup of ZIRP/NIRP/QE has damaged banking profitability, and for the duration these policies are in place it will continue to do so.
For those lucky enough never to have had the misfortune of trying to digest a bank’s financial statements, it’s perhaps enough to observe that since Mario Draghi announced QE in January 2015 forecasts for banking sector profits are down by over 20% and share prices by more than 30%.
So we’ve identified the problem – excessively loose monetary policy.
However we think these excessively loose monetary policies are currently under review – and rightly so. Why? Most obviously, they have done very little to stimulate demand and inflation as they were designed to do.
Consider that Japan has tried ZIRP for 20 years and in the West it’s approaching a decade. And economic growth has been virtually non-existent.
As an aside we respectfully suggest the neo-classical economists’ models, which tie low rates to booming economies, might need a rethink.
Unintended consequences – low rates have hampered lending
More alarmingly from our own experience we are seeing more and more often how counter-productive these policies are for generating economic growth.
For example a recent meeting with one of Europe’s largest banks confirmed that because of their low share price (which is a function of low rates and consequently low profits) they are instructing their individual business units to restrict lending to only the most profitable, lowest risk loans.
This is not great if you are a small business with a new product to launch or a domestic industrial company with a factory to build. Make no mistake: this is deflationary and it is counterproductive.
No wonder then we have the rise of political alternativists across the continent: Marine Le Pen, Podemos, Cinque Stelle, Alternative fur Deutschland, Freedom Party to rattle through the five biggest eurozone economies.
The great collective wisdom that is represented by Western democracy is flexing its muscles. Self-preservation is a very powerful force when the elites are confronted with a policy choice: witness the recently changed rhetoric on austerity and fiscal stimulus.
Policy to change as inflation returns
But what’s the catalyst? What forces the policymaker’s hand? The glib answer is it doesn’t matter because the majority of banks trade below book value, which is the stockmarket’s way of telling them to shrink.
Given that 85% of all credit in the European economy is funded by the banks, it’s obvious this policy is unsustainable and counterproductive.
However, there is another, shorter-term factor that will give central bankers cover to declare victory and move to a more balanced approach and that is the return of inflation.
In the next one to two years inflation is likely to come back as the oil price has stabilised. Most models suggest a 1.5% to 2% headline reading by 2018 which is pretty much the objective of the ECB.
While the rhetoric around fiscal policy changed at the beginning of this year, the rhetoric about changing monetary policy has just begun.
So it must happen. Bond yields should rise. In this highly distorted and manipulated market they are the wrong price.
Small change in rates = big impact on profits
So to the third and final key question: why does this matter for bank shares? What’s the upside? We can cut this a number of ways.
For a country like Spain where the profits of the banking system are fairly quick to recognise the impact of a change in rates, an increase of 2% on bond yields (so for example German 10 year Bunds moving from -0.2% to +1.8% yield; not exactly outrageous and only back to 2014 levels) would be a more than 50% profit upgrade.
Given they start very cheaply, we would expect at least this much back in share price terms plus the dividends.
Or we could look at where the bank sector traded when bonds were last at these levels: that would again give more than a 50% return for the sector overall.
Finally, we might take a more fundamental approach and conduct an analysis of what the future dividend stream would be worth today if it proves sustainable.
This would produce around 200% upside in a world of low growth with inflation near target levels. Conclusion: when our scenario of higher-but-still-low rates and normalised inflation comes to pass, these shares should fly.
Higher quality banks are likely to be the winners
A final word on stockpicking. While it is true the sector as a whole is cheap, we think there is little point deviating from investing in the very strongest banks.
In fact some companies have been able to grow revenues even in this difficult environment.
Those that have the biggest headwinds are ceding market share to the winners and there is more than sufficient upside in these winning stocks to keep us interested.
It is true also that there is elevated political uncertainty across Europe so we see little benefit in ‘bottom-fishing’ (i.e. buying the very cheapest banks).
In summary then we can see why in a world of low rates the investment community has steered clear of banking stocks.
However, rising interest rates are just a matter of time and the impact for banking share prices could be very material indeed, with returns perhaps measured in multiples not percentages.
Given our analysis you will be unsurprised that while nine out of ten funds are underweight, we have one of the highest weightings to financials generally, and banks specifically, across all European equity funds.