So far this year equity markets have been characterised by de-ratings – falls in the price investors are willing to pay – while earnings expectations have remained elevated. With recessions now seeming inevitable, those earnings forecasts are looking susceptible to downgrades as consumers start to feel the pinch of a cost of living crisis.
However, the banking sector is being increasingly seen as an exception where earnings are set to improve dramatically.
This won’t apply to every company in the sector, but in our view, there are five reasons that make the investment case for most European banks an attractive one currently.
1. Low valuations
Typically, banks trade on a discount to the wider stock market given the cyclicality of their earnings, among other things. The US banks today are among the most expensive in the sector. Given the challenges in the UK and Europe, valuations are far cheaper.
The below chart shows the valuations of Pan European banks over the last 20 years. Today the sector is trading roughly 35% below its long-term average, and its cheapest for a decade
Andy Evans, European Value fund manager, said: “It’s important to look below the headline number of the sector valuation. Clearly, this is an average and there are a number of banks trading at further discounts. These are attractive valuations given the outlook for banks today is rosier than it has been for a long time, namely due to rising interest rates and strong balance sheets”.
2. Rising interest rates and the impact on earnings
Bank shares are, on the whole, positively correlated with higher interest rates. The chart below compares the European banks index relative to the European equity index (a proxy for bank shares’ relative performance, blue line) and the Euro three-year forward swap rate (a proxy for expected interest rates, green line).
“The last decade shows a clear relationship between falling interest rates and lacklustre relative share price performance, peppered with brief rallies on the back of rate rises.In terms of rates, over a decade of cuts has been unwound in a matter of months. However, the relationship between interest rates and banks’ share price performance relative to the market has so far not moved in its typical lock-step fashion. We believe this gap will be short-lived and offers an opportunity to investors”.
Justin Bisseker, European banks analyst
While interest rates are usually falling going into a recession, this time around central banks are desperate to suffocate rapidly-rising inflation and so are raising interest rates.
The current economic environment has little historic precedent and is one banks are likely to benefit from. Their business models are operationally geared in that small rate rises can have a dramatic uplift on earnings. This is because revenue increases run through to the bottom-line with minimal cost increases. (Operational gearing measures the percentage change in a company’s trading or operating profits that arise from a 1% change in its revenues.)
Banks are, for the first time since the Global Financial Crisis (GFC), on the cusp of a very significant improvement in profitability. The post GFC era saw significant downward pressure on bank returns given the corrosive impact of lower interest rates on net income, coupled with regulatory pressure to increase capital levels appreciably. Capital is the financial resources a bank has to hold that act as a cushion against unexpected losses.
Before 2008, when interest rates were much higher, competition among banks for deposits led to net interest margins being squeezed in order to win business. Today, banks are highly liquid with loan/deposit ratios typically well below 100%, meaning that there is little incentive to raise rates paid on deposits as market interest rates rise.
3. Interest rate sensitivity
The degree to which each bank benefits as rates rise is far from uniform across the sector. It is a function of differences in income mix, the speed of asset repricing and operating leverage. All else being equal, the bank that is more operationally geared has more to gain than those that are not.
Business models vary hugely across banks. Some have a greater focus on non-interest rate-bearing activity, such as wealth management. Others with a greater focus on retail banking are more highly geared to net interest spreads (the difference in borrowing and lending rates).
Seeking interest rate sensitivity therefore sounds a sensible play as rates rise, but caution should be exercised as a number of other considerations will impact a bank’s ability to make the most of any increase in net interest spreads.
4. Good balance sheets
One concern – which is likely keeping valuations low – is the level of provisions a bank must set aside to cover potential losses and bad debts from customers and businesses defaulting on their loans in a recession. As Europe’s economy slows down, the market’s expectation is this could erode much of the margin improvement from rate hikes.
However, for most banks, the scale of revenue benefit from higher interest rates is so large that it should more than outweigh the burden of higher credit losses. This is especially the case when one considers that most banks still carry precautionary credit loss provisions established during the Covid-19 pandemic.
The potential impact of a recession is a concern but a number of the European banks are very well-capitalised already. A typical recession sees provisioning rise to around two to three-times the average level across an economic cycle. Provisions would have to rise to more than six times this average to see all sector earnings lost. What’s more, provisioning losses only happen once. In contrast, the revenue benefits from higher rates should recur.
Looking at core equity tier 1 ratios – the key capital adequacy and balance sheet leverage metric that regulators focus on for a bank’s financial health – these are much stronger today than they were before the financial crisis. The likes of Caixa Bank and ING Groep are holding around 15% of tier 1 capital, with some of the Nordic banks holding more than 20%. 15 years ago, at the dawn of the financial crisis, many were holding capital in the mid-single digit range.
5. Dividend yields
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 far higher than they have been for well over a decade.
Justin Bisseker said: “Aggregate dividend yields for the European banks stand at around 7.5% in 2023. With healthy dividend cover, plus the strength of the balance sheets and provisioning, this offers an attractive shareholder return even in the absence of any share price movements.”
With higher inflation perhaps here to stay, and growth expectations looking more muted globally, we may see dividends playing a greater role in the total return demanded by equity investors. This could bring more shareholders to the register for the banks and drive valuations higher from today’s levels.
Windfall tax implications
Finally, there is speculation in the UK that banks and other companies may be called upon to help fill the UK’s fiscal hole. If this happened, would it break the investment case outlined above?
“From what we can see at this point, it would be the lack of removal of the banking levy (which adds around 8% to a UK bank’s tax rate) rather than a new tax on the banks. This would be broadly in line with our expectation when incorporating 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 make an estimate of normalised profits and valuations.We believe a more prudent approach such as this means that the net effect of a windfall tax on windfall profits would still leave our expectations in a superior condition compared to our conservative estimates. It is a timely reminder of the necessity of having a margin of safety on conservative assumptions, which is a core tenet of value investing”.
Andy Evans, European Value fund manager
