Banks to Come Back into Fashion
For more than a decade now, financials in general have performed poorly relative to global equities (see Exhibit 1). This has been more pronounced in the banking sector, where a large portion has not yet fully recovered from the aftermath of the Global Financial Crisis (GFC). This is predominantly due to interest rates at near zero levels since the crisis, which has meant a significant hit on profit margins across banks in general.
With respect to the larger and more well-known banks, this has been more of an issue in Europe, for two key reasons. Firstly, European bank revenues are largely lending-based. This differs to US banks, where the majority of revenues are from investment banking activities. As such, European banks’ revenues are more sensitive to interest rates, which were negative for longer in Europe.
Interest rate sensitive earnings and negative rates (and lower rates for longer) in Europe have meant that European bank earnings have struggled relative to their US counterparties, translating into underperforming share prices for European banks. Meanwhile, US banks’ share prices have largely moved in line with broader financial stocks (see Exhibit 1 below).
However, we are now in a different interest rate environment to that we have become accustomed to since 2008. Interest rates are no longer at historical lows. Rates are rising higher and faster than most investors anticipated. It is very likely that, in the near to medium-term at the very least, they will remain at elevated levels relative to the last decade.
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While rising rates is typically a negative for most companies due to higher borrowing costs, it is beneficial for the banking sector as a whole. Banks make money on the interest margin between deposits and loans, and are typically able to pass a greater amount of rate hikes to borrowers than they share with savers. As such, rate hikes provide a direct uplift to banks’ profits, and this is likely to remain the case for some time with rates expected to stay elevated.
When assessing the banking sector, it is also important to remember that the market in general is in a much stronger position now than it was before the GFC. As we enter this recession, banks’ balance sheets are much stronger and, for European banks in particular, they are well-capitalised. To give some context, many European banks are holding 15-20% of tier 1 capital, if not more, compared to mid-single digits just before the GFC.
Another factor to consider is that banks will likely pay dividends to shareholders in 2023 and 2024. Dividend yields are also expected to be far greater than they have been over the last decade. Even if share prices stay relatively flat, dividend yields should offer attractive returns. Moreover, we believe that inflation is here to stay for a while yet. This means investors will demand greater income / dividend yields from their equity portfolios, which is likely to draw them towards bank and support valuations.
US vs European banks
European banks have struggled more than US banks over the last decade due to long periods of negative interest rates and the fact that the majority of their revenues are lending-based. While we still believe that US banks in general should benefit from higher rates, it is a bit more nuanced. US banks typically have larger investment banking activities, which are set to be negatively impacted by market volatility and rising rates. It is likely that debt/equity issuance, initial public offerings (IPOs) and mergers & acquisitions (M&A) activity will all be weak over the next few years. This will affect investment banking revenues and profits, which will eat into the upside from rate rises. This is why we favour European banks relative to US banks at this point in time.
While the general outlook for banks looks appealing, there are some risks to consider. Among them are an upcoming recession, which represents the greatest risk by far to the banking sector, but other headwinds in the form of a potential windfall tax and geopolitics can also impact returns from banking stocks.
Most importantly, a recession is coming. We all know this, but the severity of this downturn is anyone’s guess. With the expectation that more consumers and corporates will struggle to pay back loans, banks’ loan growth will suffer. Further, they will need to increase their provisions to cover potential defaults, which can impact profit margins. What reassures us, though, is that bank collateral quality is a lot better now and so are their balance sheets.
Banks will also be protected by the amount of government support that has been provided to corporates and consumers, which will help them in meeting loan repayments and avoiding default. This is in addition to some European banks that were able to obtain state-backed loans granted during the pandemic.
There have been rumours surrounding windfall taxes (i.e. increased taxes for a particular sector due to increasing profits for reasons out of their control) in the UK and this could easily spread across Europe. It is definitely likely to come at some point given the huge fiscal deficits that governments face. However, this is not an issue we are deeply concerned with.
For a start, we do not believe there will be an explicit windfall tax. It would be far harder to justify in the banking sector than in, say energy companies. What we can expect, though, is additional bank levies across Europe or not revoking the banking levy in the UK. Even with these levies, we still expect the effect on bank profit margins to be minimal, with increased revenues from higher rates far exceeding any levies imposed and/or not removed.
We are favourable on the banking sector. This is because we expect interest rates to rise more and faster than expected by most, and that will have a significant, and positive, impact on the bottom line over the next year or two. Moreover, much of the sector has not yet recovered from the GFC, so valuations are very attractive, being well below long-term historical averages. This is truer for the European banking sector, which we are more favourable on, because their revenues are largely lending-based. Despite the potential risks, we still favour the sector because banks are in a better position now in terms of their collateral quality and balance sheets than they were pre-GFC.
In terms of what to invest in, we would ideally create a basket of bank stocks. This is because a concentrated basket of 5-10 names will provide greater upside potential than an over-diversified bank ETF. We would recommend focusing on the larger, more well-known banks where the majority of their activities are lending-based rather than investment banking-based. This is because these banks will have the most to gain from a prolonged period of rising and higher rates. It is worth noting that this trade will be fairly volatile. In order to reduce the volatility, investors could choose to create a relative value (RV) trade. RV trades that we currently favour would include long banks vs short other financials, long European banks vs short US banks and long lending-focused banks vs short investment banking-focused banks.
15 November 2022