Euro Zone Banks. Value or Value Trap?
“I check my bank account more than you check your Instagram” Kid Ink
Is the recent rally of European banks an opportunity or a trap? A minority investor told me on Friday that “every time I buy banks, they are going up, but then I lose everything.” He did not understand the volatility and risk , especially when the press would not stop talking about banks “healthy” balance sheets and adequate results.
Let’s start with a general consideration. No, European banks are not fully cleaned up. They continue to accumulate more than 900 billion euros of non-performing loans (NPLs), and generate a return on net assets below their cost of capital. That is, they lose money.
It is true that valuations are not exaggerated, at 0.8 times price to adjusted book value, which is not expensive if you estimate a 9.9% ROTE (return on tangible assets) in 2017 and a dividend yield of 5.4%. The question is whether that ROTE and yield is achievable or sustainable.
European banks are trading at almost a 40% PE discount to US banks, but this discount is justified by the high exposure to European sovereign risk, the burden of NPLs and the very low profitability (Net Income margin is almost zero). In fact, the mistake investors make when talking about “value” with respect to US banking may lead to losses, because that discount has existed since 2001 and has moved close to an average of 20-30%, justified by lower profitability, less flexibility and the valuation of their loans with debatable criteria (instead of valuing them at market-to-market).
But there are positive elements as well as caution. The excess liquidity is at record levels since the European Central Bank Quantitative Easing started, and already reaches 1.3 trillion euros, showing the weakness of the program and its low effectiveness. Negative interest rates have sunk banking profits, with historic declines in consensus estimates. But that monetary ruin is about to end.
Rates are already rising and that means that an increase of 1% can improve EPS of banks by up to 17% , according to the average consensus sensitivities (Bloomberg).
60% of European banks now have more than twice the core capital than in 2012, which means that they are much more healthy, although the problems are not over. In addition, European banks have more than double the amount of short-term liquid assets than in 2012, which can be used for divestments and to undertake capital strengthening.
Today, deposit rates are negative and that is devastating for the financial sector. A higher deposit rate would improve the spread, and this is particularly beneficial for banks in peripheral countries. According to Morgan Stanley, a rise of 70 basis points in the deposit rate would raise the earnings per share of peripheral banks by more than + 15%. Interest rates would remain extremely low, so the impact on the economy would be non-existent, but financial repression would not jeopardize the sustainability of the banks.
Risks should not be ignored.
Today, banks are rallying due to different factors. The positioning of investors is extremely cautious and underweight in the financial sector and even more so in Europe, which can lead to significant capital flows to banks when that negative weighting is reduced in the portfolios.
The banks’ rally is based on a bet on an increase in inflation that may disappoint those who play to it now that oil remains in a lateral-bearish trend and underlying inflation expectations are not being revised upward.
In addition, this rally in banks is supported by another non-fundamental external expectation. The bet that the European Central Bank will aggressively change its monetary policy. All the indicators tell us that it should, that it is urgent and that maintaining it does more harm than good, but we must not forget the risk of maintaining financial repression and real negative rates because European governments are unable to tolerate on increase in cost of debt of 50 basis points. It is important, at least, to know that the rally in the stock market is explained by an inflationary bet and increases in rates in addition to the supposed cheap valuation (banks are always “optically cheap”). Because that “reflation trade” can reverse very quickly.
Let’s not forget another factor. With higher rates and inflation, non-performing loans rise as well, as companies continue to suffer from overcapacity and tax increases.
Banks demanded the ECB’s monetary expansion program, until they realized in horror that negative rates shattered their balance sheet and income statement. The monetary expansion that they applauded until their hands bled almost sent them to the cemetery.
It is not wrong to say that the banking system is much healthier than it was four years ago . Nor is it a lie to say that its structure of balance sheet and profitability is extremely fragile, and that its core capital ratios can evaporate with a small change of the cycle. Therefore, to assume that the era of huge provisions is over is to be very optimistic. To think that there are no additional capital needs is reckless.
The combination of valuation, improvement of the cycle in Europe, change of monetary policy and return to a certain sanity with interest rates are factors that put banks’ head above water.
As a good friend, investor in the financial sector, once told me “you do not buy banks, you rent them”. Cycles are getting shorter and the challenges of the financial sector are not over, so active trading is recommended.
Daniel Lacalle is a PhD in Economics, fund manager and author of Life In The Financial Markets, The Energy World Is Flat (Wiley) and Escape from the Central Bank Trap (BEP).
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