Market Views: Equities
Why Italian politics matters for eurozone banks
Recent political events in Italy clearly matter to eurozone banks. We are now seeing something of a rebound on the formation of a new government, but eurozone bank shares are still some 10% down in the past two weeks, with Italian banks down 15%.
What is happening in Italy matters – mostly for Italian banks but also with some broader implications for the wider banking sector. Here’s why.
Wider BTP-Bund spreads will impact on capital
At the time of writing (1 June) 10-year Italian sovereign bonds (BTPs) now yield 220 basis points (bps) over German Bunds, down from the week’s high of 280 bps but still some 100 bps wider than end-March levels. Italian banks typically hedge against interest rate movements, but not against movements in spread.
Estimates are complicated by limited disclosure, hedging strategies and the transition to a new accounting standard (IFRS 9) but Italian bank Core Tier 1 capital levels can be expected to see some downward pressure in Q2.
Of course, so long as bonds are held to maturity these capital drags will reverse but for longer-duration books this will take some time and be subject to additional mark-to-market volatility along the way. That said, sensitivity here should be reasonably limited – typically a c.3% hit to Core Tier 1 capital (40-50 bps off Core Tier 1 ratios) at most for moves to date.
Higher sovereign borrowing costs will impact margins and create a new headwind to fee income growth
Italian bank net interest margins will no doubt come under modest downward pressure as their cost of borrowing on wholesale (and, to a degree, retail) markets rises with that of the sovereign.
This will be a slow-burn drag on margins and over time could be offset by higher lending yields, although this would imply a stronger degree of price discipline than we have seen in recent years from Italy’s banks.
Fee income will also face something of a headwind as retail investors may perhaps choose to invest in higher yielding BTPs than the mutual fund offerings from the banks. These pressures should be modest and therefore should not be overstated but negative earnings revisions tend not to be conducive to positive share price performance.
…As would a potential delay in ECB tightening
The longer-lasting – and sector-wide – impact of ongoing volatility in the Italian sovereign bond market could be a delay in monetary tightening from the European Central Bank (ECB). Rate expectations for 2021 have fallen some 25 bps in the last two weeks (based on three-year Euribor forwards) and expectations are building that the end to the ECB’s Asset Purchase Programme (currently €30 billion per month) could be delayed.
Higher ECB rates would be positive for the sector (our own estimates are that 100 bps higher interest rates would improve pan Europe bank sector earnings by some 18%, with the eurozone subsector benefiting some 17%). Many sell-side analysts have built a large proportion of this benefit into their mid-term earnings forecasts so the absence of this positive would present a downside risk to consensus, especially for more rate-sensitive names.
Balance sheet clean-ups could take longer and be more costly
Despite enhanced efforts to clean up balance sheets in Italy, more needs to be done. The ECB is continuing to apply pressure here (expressed most recently in the March Addendum to the ECB Guidance to Banks on Non-Performing loans).
Government actions which stall improvements in already lengthy collection periods, together with potential increases in borrowing costs and greater uncertainty as to collateral valuation, could all serve to increase the future cost of balance sheet repair.
Fortunately the larger banks have already made significant strides in this regard but for the system as a whole much still needs to be done.
Banking union could stall
In the ECB’s own words “banking union is an important step towards a genuine Economic and Monetary Union.” The first key steps on this important project have already been taken with the move to common ECB supervision for the eurozone’s largest banks, as well as the creation of the Single Resolution Mechanism.
The next step is a common deposit guarantee scheme (European Deposit Insurance Scheme, EDIS) to backstop the system. But it seems obvious that enthusiasm for EDIS in the core of Europe is likely to wane in the face of Italian populism.
What next for investors?
Some stability has been restored to markets with the 31 May announcement of a new government in Italy. Much will now hinge on the nature of policies which are implemented and whether a higher risk premium is demanded in Italy as a result. A “snowballing” of Italian sovereign debt clearly presents the greatest medium-term downside risk, but numerous checks and balances should limit the chances of this outcome.
By way of comparison it is worth noting that domestic UK bank earnings have not fallen apart post the 2016 Brexit referendum (indeed, earnings revisions have actually been positive for both Lloyds and RBS over the past year) and yet these banks remain in a “penalty box” with investors whilst uncertainty prevails. For now, Italian banks look set to suffer a similar fate, although in one or two cases the potential rewards for investors look high enough to justify the risk of investing.
For the sector more broadly, many bank valuations look very compelling on sensible base case assumptions. Our approach is to favour banks which can deliver attractive returns whatever the rate environment. If this were to be accompanied by rising interest rates then so much the better.
Unstructured Learning Time
- Brexit: what’s next? The crunch dates ahead and what investors expect
- Our multi-asset investment views - January 2020
- The converging worlds and diverging interests of equity and bond investors
- Could the coronavirus derail the global recovery?
- Davos 2020 and climate change: How investment risks have shifted over a decade