So far this year, stock markets have been characterized by downgrades – declines in the price investors are willing to pay – while earnings expectations have remained elevated. With recessions now looking inevitable, these earnings forecasts look likely to be revised down as consumers begin to feel the pinch of a cost-of-living crisis.
However, the banking sector is increasingly seen as an exception where profits are expected to improve dramatically.
This won’t apply to all companies in the sector, but in our view there are five reasons why the investment case for most European banks is currently attractive.
Typically, banks trade at a discount to the broader stock market, given, among other things, the cyclical nature of their earnings. US banks are among the most expensive in the industry today. Given the challenges in the UK and Europe, valuations are much cheaper.
The chart below shows the valuations of pan-European banks over the past 20 years. Today, the sector is trading around 35% below its long-term average and is the cheapest in a decade.
Andy Evans, European Value fund manager, said: “It is important to look below the main sector valuation figure. Obviously this is an average and there are a number of banks trading at additional discounts. These are attractive valuations given that the outlook for banks is now more favorable than it has been for a long time, in particular due to rising interest rates and strong balance sheets”.
Rising interest rates and their impact on earnings
Bank stocks are, on the whole, positively correlated with higher interest rates. The chart below compares the European banks index to the European equity index (a proxy for the relative performance of bank stocks, blue line) and the three-year euro forward swap rate ( an approximation of expected interest rates, green line).
Justin Bisseker, European banking analyst, said: “The past decade shows a clear relationship between falling interest rates and lackluster relative equity price performance, interspersed with brief rallies amid rising rates.
“In terms of rates, over a decade of cuts was undone in a matter of months. However, the relationship between interest rates and changes in bank stock prices relative to the market has so far not evolved in the usual way. We believe this gap will be short-lived and provides an opportunity for investors.”
While interest rates typically fall before a recession, this time central banks are desperate to stifle rapidly rising inflation and so raise interest rates.
The current economic environment has few historical precedents and is one from which banks stand to benefit. Their business models are operationally oriented in that small rate hikes can have a dramatic increase in profits. Indeed, increases in revenue flow through to the bottom line with minimal cost increases. (Operational gearing measures the percentage change in a company’s trading or operating profits that results from a 1% change in its revenue.)
Banks are, for the first time since the global financial crisis (GFC), on the verge of a very significant improvement in their profitability. The post-GFC era has seen significant downward pressure on bank yields given the corrosive impact of lower interest rates on net income, coupled with regulatory pressure to significantly increase levels of capital. Capital is the financial resources that a bank must hold that acts as a cushion against unexpected losses.
Prior to 2008, when interest rates were much higher, competition among banks for deposits led to compression of net interest margins (NIMs) in order to win business. (The NIM is the money earned in interest on loans compared to the amount paid in interest on deposits). Banks today are highly liquid with loan-to-deposit ratios typically well below 100%, meaning there is little incentive to raise the rates paid on deposits as interest rates rise. of the market increase.
Sensitivity to interest rates
The extent to which each bank benefits from rising rates is far from uniform across the industry. It is a function of differences in the composition of income, the rate of revaluation of assets and operating leverage. All other things being equal, the most operational bank has more to gain than those that are not.
Business models vary widely from bank to bank. Some focus more on non-interest bearing activities, such as wealth management. Others, more focused on retail banking, focus more on net interest margins (the difference between borrowing rates and lending rates).
Looking for interest rate sensitivity therefore seems sensible when rates are rising, but caution is warranted as a number of other considerations will affect a bank’s ability to make the most of any increase in spreads. net interest rates.
Good balance sheets
One concern – which is likely to keep valuations low – is the level of provisions a bank needs to set aside to cover potential losses and bad debts from customers and businesses that default on loans during a recession. As the European economy slows, the market expects this could erode much of the improvement in margins from the rate hikes.
However, for most banks, the magnitude of the benefits from higher interest rates is so large that it should more than offset the burden of higher credit losses. This is especially the case considering that most banks are keeping precautionary credit loss provisions established during the Covid-19 pandemic.
The potential impact of a recession is worrying, but a number of European banks are already very well capitalised. A typical recession sees provisioning increase to about two to three times the average level over an economic cycle. Provisions would need to increase to more than six times this average to see all sector revenue lost. Also, provisioning losses only happen once. On the other hand, income from rising rates should recur.
When it comes to Tier 1 Tier 1 capital ratios – the key measure of capital adequacy and balance sheet leverage that regulators focus on for a bank’s financial health – they are much stronger today than they were before the financial crisis. Companies like Caixa Bank and ING Groep hold around 15% of Tier 1 capital, with some Nordic banks holding over 20%. Fifteen years ago, at the dawn of the financial crisis, many held capital in the mid-single digit range.
Another salient point for investors is the level of dividends banks are expected to pay out to shareholders. Consensus expectations for dividend yields in 2023 are much higher than they have been for more than a decade.
Justin Bisseker said: “Aggregate dividend yields for European banks stand at around 7.5% in 2023. With good dividend coverage, as well as strong balance sheets and provisioning, this offers an attractive return for shareholders, even in the absence of any movement in the share price. .”
With higher inflation possibly here to stay and growth expectations looking more subdued globally, we could see dividends playing a bigger role in the total return demanded by equity investors. This could bring more shareholders to the banks’ register and push valuations higher from current levels.
Exceptional tax implications
Finally, there is speculation in the UK that banks and other businesses could be called upon to help plug the UK’s fiscal hole. If this happened, would it break the investment case described above?
Not necessarily, according to Andy Evans: “From what we can see at this stage, it would be the failure to remove the bank tax (which adds around 8% to a UK bank’s tax rate) rather than a new tax on banks. . This would broadly be in line with our expectations by factoring in the rise to a 25% corporate tax rate across our UK companies.
“As value investors, while we tend not to forecast windfall taxes, we also tend not to forecast windfall profits. Instead, we estimate normalized earnings and valuations.
“We believe that a more conservative approach such as this means that the net effect of a windfall tax on windfall profits would still leave our expectations in a higher state than our conservative estimates. This is a timely reminder of the need to have a margin of safety on conservative assumptions, which is a fundamental tenet of value investing”.