2016’s a year that has been dominated by concerns over banks, and in particular, European banks.
Financial markets were spooked in January after banks like Deutsche Bank missed 4Q 2015’s earnings targets by a wide margin, and solvency problems also rose as investors became concerned that banks and lenders around the world would be affected by a rise in non-performing loans from the commodity sector (as commodity prices cratered and crude oil prices plunged below USD 30/barrel).
While banks in Asia and the US also had to deal with similar issues, European banks thus far were more severely punished by the markets as they also had to deal with structural and regulatory issues on the continent.
Many of them had to deal with legacy issues (fines for their involvement in the 2007-2008 credit crisis) as well as ensure that they meet regulatory requirements in capital imposed by financial watchdogs and policy-makers. Not a day goes by without the news reporting that regulators have slapped fines on (yet another) European bank for either rigging/anti-competitive behaviour or for 2008 GFC issues…
Headline risks from the political sphere has also been unhelpful in alleviating banks’ woes. The pronounced volatility seen in the share prices of European banks relative to their peers on news of Brexit and the recent Italian constitutional referendum serves to highlight the weakness (or woes assigned by the market) in this sector.
However, things may be turning the corner.
First, here’s a list of concerns that are weighing on the prospects of European banks when 2016 started:
- too exposed to the commodity sector?
- low interest rates in the Eurozone weighing on earnings prospects
- regulatory concerns affecting core capital issues
- disruption prospects from a rise in fin-tech companies
- political risks affecting investment and economic sentiment
It’s easy to understand the pessimism on the sector. These factors above seem to encompass everything from the earnings prospects of banks to the viability and sustainability of the banks’ business models themselves.
However, because they’re so widely known among the global investment community over the course of 2016, there probably is a great amount of these negative factors probably factored in to prices as we now know of it. As Jamie Mai says in Hedge Fund Market Wizards:
“Markets tend to overdiscount the uncertainty related to identified risks. Conversely, markets tend to underdiscount risks that have not yet been expressly identified. Whenever the market is pointing at something and saying this is a risk to be concerned about, in my experience, most of the time, the risk ends up being not as bad as the market anticipated.“
While the banks itself could be in trouble should there be a possible halt in economic growth within the Eurozone due to a change in political winds, there is a short to mid-term opportunity among European banks for now while sentiment is still relatively poor. They may not however be great long-term investments due to the fundamental situation of shifting secular trends as well as the fact that equity financing is the sought-to measure (think Italian banks).
On traditional valuation metrics like the price-to-book ratio, major banks on the continent are trading not just below their book values but also below their historical averages. This development has attracted some audacious, contrarian value investors out there.
Commodity prices have rebounded since their 2016 lows, and if the trend of gradual price recovery continues into the next quarter, optimistic investment sentiment can return pretty quickly as commodity woes are brushed aside, which could lead to more upside to European banking stocks.
Like Japan, the Eurozone boasts low interest rates amidst an environment of muted inflationary pressures and sluggish economic growth momentum. The European Central Bank’s (ECB) policy stance of its negative deposit rate and its stimulus programme (since 2014/2015) have succeeded in lowering bond yields and financing costs in the Eurozone, which has weighed on earnings prospects of the banking sector as the yield curve there flattens (lowering interest margins).
This too, is changing. The yield curves of various Eurozone countries have steepened in recent weeks, and the recent announcement by the ECB on 8th December saw the central bank actually modifying its asset purchase programme to include issues that are shorter term in nature, which has the effect of steepening the yield curve. Going forward, the ECB could continue to influence the shape of the yield curve by adjusting its monetary policy (much like how the Bank of Japan did so in order to alleviate profitability concerns of insurers and banks). With a steeper yield curve, European banks could see their earnings improve as net interest margins rise.
With regards to capital concerns: while we do not know the exact exposure of various banks out there with whatever publicly available data, a point to note is that many European banks are not exactly in the similar situation as US financial institutions (like Lehman Brothers) in 2007/2008 during the Global Financial Crisis (GFC). They do not face a liquidity and a rapid deterioration of quality of their assets at this juncture, unlike what we saw during the GFC. Concerns over European banks facing a lack of capital are mainly external constraints, like legal or regulatory in nature. There is no doubt that they are systematically important to the global financial system, but based of what we know now, likening them to the Lehman debacle could be stretching it…
A quick technical analysis of Europe’s banks tells us that a bottom could have already been formed, with many charts showing a nice inverse head & shoulders pattern on the weekly and daily time frames. The recent rally in European equities post-Italian referendum also sent many financial stocks above their 200 day moving averages, which is a tell-tale sign of a possible short/mid-term rebound.
With proper setups, I’m considering to go long outright a couple of European banks, and the most depressed among the lot include German titan Deutsche Bank (DB) and of course, Credit Suisse (DB). These two banks had their share prices hammered by markets earlier in the year, and have plagued investors’ sentiment since then. At where we are today, current prices provide a viable entry point for a long trade and a tight risk point:
Alternatively, I could go for a diversified bet on the entire sector via the iShares MSCI European Financials ETF (EUFN). The ETF indicated that the entire sector has rallied in recent weeks, and prices are trading above its 200 day moving average as well. Here are its 10 largest constituents:
I’m also considering to hedge this trade via shorting the Euro against the US Dollar (EUR/USD), although I would have to think of how to size an EUR short due to the consensus largely bearish on the EUR (“the Euro will hit parity against the Greenback”)
Longer term, European banks could be in trouble due to the complicated situation the Eurozone members find themselves in. Changing political sentiment (a shift to the right) and a rise in populism are legitimate concerns that could derail economic growth on the continent. And they still have to deal with possible disruption from the global fintech scene… This tricky situation makes the above idea a mid-term trade – which should be how we manage money in dangerous times like this. Flexibility is key.
*image credits to The Economist & The Telegraph & BlackRock*