Europe banking: The 20-year trade with zero return
European banks stocks have been on a tear since their summer lows, with the Stoxx Europe 600 banks index rising by 30% from the bottom of 117 in early July, up to 153 at the end of October.
And while investors could be forgiven for being underwhelmed by this – given that the index is still down 17% year-to-date – some market participants are daring to hope that the worst may be over for European banks.
Equity strategists at Citi called European bank stocks the world’s biggest contrarian trade, back in late September. OK, they admitted, EMU banks may well be the single worst-performing sector and region combination over the past 10 years out of 285 the firm tracks around the world, but history says now is the time to buy.
What are the supporting arguments?
Mainly that they are dirt cheap, especially so on price-to-book value, slightly less so on price to gross operating profit. Hopes are emerging that, with the European economy showing signs of slow but resilient GDP growth that could hit 2.5% next year, loan demand will increase so that volume growth might offset declining sector margins.
Citi analysts estimate that the sector return on tangible equity might pick up from 4.9% last year, to 5% this year and then hit 8% in 2017. European banks have raised capital, shed assets and comply with regulatory requirements. NPL ratios and cost of risk are below their 10-year historical averages in most large European economies except Spain and Italy. Hopes are reviving that with rates now rising, banks might profit if the yield curve steepens.
No, it’s not very convincing, is it?
In September, even Citi’s strategists themselves did not sound convinced. Their key recommendation was to reduce underweights on the sector – not actually to go long – and to put on proxy trades, such as on the spread between banks and industrials and between quality banks and the overall sector – rather than load up.
Berenberg Bank analysts suggest that investors betting on a boost to European bank profitability from rising long-end rates will be disappointed. They do accept that an 8% return on equity in a zero-rate world would be cause for celebration, but warn that expectations for 20% earnings per share growth in 2017 look unrealistic. They also argue that the root cause of European banks’ problems – too much debt on balance sheets that was mispriced when it was first originated and provides too low a margin – remains, while policymakers continue to misdiagnose it.
While US banks put on credit risk correctly priced for a roughly 70bp return on assets, European banks have for decades lent at an average rate of 30bp return on assets.
The Berenberg analysts argue that European policymakers continue to avoid the truth that Europe has relied on subsidized credit and forbearance for too long, with banks using leverage to hide these profitability issues. Instead of writing down and cleaning up their stock of bad debts, European banks have tried to take small losses over a long period of years and hoped that reviving GDP growth might eventually dig them out of the hole.
But the only way for investors to regain full confidence in European bank balance sheets and earnings is for a forced and full clean-up of NPLs, with regulators insisting that assets be carried at net present value and provisions, now standing at 60bp of total system assets, eventually falling close to zero.
Such an exercise would require backstop capital of the kind which bail-in regulation now appears to prevent European states from providing to banks.
But does it?
The Berenberg view is that the resuscitation of European banks still needs the sector to go through a crisis moment, with taxpayers permitted to extend temporary bailouts for banks found to be solvent but under capitalized by properly stringent stress tests. The purpose of the taxpayer backstop would be to convince investors that bank regulators were finally being tough and realistic with their stress tests.
A taxpayer-funded backstop for precautionary recapitalization – and Berenberg suggests €372 billion inside the European Stability Mechanism is enough – might not even have to be used but rather, following the US experience with the Trouble Asset Relief Program, give confidence to private investors to go back into banks whose balance sheets have been properly cleansed.
If it plays out like this, the recent recovery in European bank stock prices will not proceed smoothly, and volatility will return with a vengeance.
Perhaps European bank stocks could be a good long-term bet. Euromoney likes to take the long-term view. Tracking back, it strikes us that value of the Stoxx Europe 600 banks index, which hit 153 on October 24, 2016, also stood at 153 in October 1996.
In 20 years, European bank stocks have paid some dividends but earned long-suffering investors a capital return of precisely nothing.