We believe for the best-run banks in Europe, you’d need some fairly apocalyptic tail events to justify current pricing.
Right now, much of the conversation on the investment floor is about banks – whether it’s within our credit division, who have a long track record of participation in bank capital, or in our new financial equities team, led by Giovanni Baulino.
It’s often said that banks are a proxy for risk within a regime. Viewed in the light of this statement, the current divergence between the fortunes of the US and Europe appears more striking than ever: the US is continuing to sail in relatively calm waters, while Europe is mired in a host of problems: Brexit; trade wars; the forthcoming Italian budget; Emmanuel Macron’s travails in France; and now, most pressingly, the unravelling of emerging markets (‘EM’).
Because of the perception of banks as systemic risk-proxies, they have long been used as a means of trading macro stories. In the recent weeks, sentiment has swung firmly against the European financial sector. As Figure 1 illustrates, the relative valuations of the two regions are approaching levels last seen during the most fraught days of the European debt crisis.
Figure 1. The Widening Gap Between US and European Banks
Source: Bloomberg; as of September 5, 2018.
This divergence is certainly down in part to the perceived condition of each region’s underlying economy and, while we recognise that these two elements are far from separate, it is also a factor of interest-rate expectations. The US has embarked on a tightening path since 2015, with two rate rises already this year and the anticipation of a third in September. On the other hand, European Central Bank President Mario Draghi reiterated in his speech on September 13 that Europe was in for an extended period of dramatically low rates, with no rises before the end of next summer.
Investors have been using liquid bank stocks as a way to play interest rates. They went into 2018 firmly believing in the story of European reflation and near-term rate rises. However, a mixture of negative economic data surprises and Draghi’s dovishness has sent the market in the opposite direction. Indeed, as Figure 2 shows, there is now a greater concentration of short positions in the European banking index than at any point in its history.
Figure 2. Short Interest in European Banks at a High
Source: Bank of America Merrill Lynch; as of September 4, 2018.
This positioning is comprehensible to a certain extent. On top of the many systemic issues facing Europe, the fear of contagion from the increasingly concerning situation in EM, and particularly Turkey, has been growing apace. Donald Trump’s trade wars have merely exacerbated issues within the Turkish economy. The lira is plummeting, interest rates and inflation are soaring and we’ve seen a worrying increase in corporate loan defaults. Europe remains exposed to EM to an extent that far surpasses the US, with more than 20% of banking revenues in the region coming from EM sources.1
At one time, European banks’ exposure to Turkey was viewed as a distinct benefit, a source of earnings growth at a time when the rest of the continent was stagnating. Now, such exposures are being scrutinised, with careful analysis of the extent to which those most concentrated in the area could sustain a further deterioration of the situation.
It seems that, from the banks’ own disclosures, Turkey and EM more generally are NOT big enough to be a life-threatening event for EU banks even under the most negative scenarios. However, until we have more clarity, it’s likely that fundamental investors will stay on the side-lines.
It’s clear that at this point, equity market pricing suggests that Europe is facing – if not a total cataclysm – then certainly some fairly significant existential challenges in our view. Short-sellers must believe that Draghi’s 2019 rate rises will be indefinitely deferred. Otherwise, we believe the crowdedness of short-side positioning looks suddenly rather fragile.
Yes, European banks are currently earning returns on equity (‘ROE’) of about 6-7%, while the cost of equity is above 10%,2 and yes there are systemic issues that may need addressing. However, if one believes Draghi when he says he will be raising rates a year from now, then it’s our view that – for the best-run banks, at least – you’d need some fairly apocalyptic tail events to justify current pricing. Whilst it’s an old saying that you can never price everything in when it comes to banks, it is also true that regulatory pressure to raise capital and improve risk management since the Great Financial Crisis (‘GFC’) have made the overall balance sheet of the sector more resilient to shocks than in the past.
One thing we often hear when it comes to European banks is that there isn’t much operational leverage available to them – given the painful years they’ve endured following the GFC, a lot of fat has been cut from their business models. While we believe this is largely true, it ignores the fact that the relative efficiency of the banks is not matched by the regimes within which they operate.
Indeed, there are many potential catalysts for an improving regulatory backdrop: the imposition of the much-discussed Pan European Deposit Guarantee scheme; the continued cleaning-up of the books of struggling banks, particularly those in Southern Europe; and governmental encouragement of cross-border consolidation. Any of these could possibly offer a significant spur to asset pricing within the sector.
We see having portfolio managers across the various elements of banks’ capital structure as a distinct benefit, and one which has led to some interesting discussions on the investment floor. We believe it’s instructive to look just above equity in the capital structure – to the so-called Contingent Convertible bonds, or CoCos – to get an idea of how investors view the sector’s prospects. CoCos were firstly issued by European banks after the GFC as an additional buffer between equity and more senior debt-holders and depositors; a means of avoiding taxpayers having to bail out banks in the future. CoCos are convertible into equity when the issuing bank breaches certain emergency capital levels.
As such, one way of viewing the yield of these bonds is as a proxy for the cost of equity. These euro-denominated CoCo bonds are currently trading in a 5-7% range,3 whereas cost of equity implied from stock pricing is closer to low-double digits.4 This implies that either debt is trading very expensively, or bank equities are cheap.
We believe it’s the latter case. Figure 3 is a scattergram of cost of equity against CoCo yields for select European banks, with their criteria determined by us. This demonstrates how frustrating it can sometimes be as a shareholder in a bank, given the position of equity investors at the bottom of the capital structure. This is not always a bad thing per se. However, when a bank does not earn its own cost of equity (banks above the line in the chart), then stock prices reflect the risk that, over time, shareholders will be diluted because there are insufficient earnings generated to remunerate the whole capital structure. Basically for these banks, the whole institution works just to pay deposit holders and bond holders, with shareholders left to sweep up crumbs beneath the table.
Figure 3. Cost of Equity Against CoCo Yields
Source: Bloomberg; as of August 28, 2018.
Circled in green in the scattergram is a sub-section of the sector – largely Scandinavian and Northern European banks – that we believe are being priced rationally by the equity markets. These banks have a sustainable high ROE above cost of equity, and equity investors and debt holders seemingly have no concerns about getting their fair share of capital back year after year. The banks circled in red appear to be pricing in the view that poor profitability will continue indefinitely. The stock price here reflects the lingering risk that there will be equity dilution in the future (hence the high cost of equity). Whilst some of these banks may indeed face difficulties in the months and years to come, we believe that a large proportion of these institutions will cross the line down to the green circle, via restructuring, M&A or the impact of higher rates (if and when they come).
With this in mind, it’s worth thinking a little more about the way that financials are traded by the majority of the market. As we’ve already said, bank stocks in this low-interest rate environment are principally used as a proxy for macro risk and rate expectations. Because for so many banks ROE is below the cost of capital, typical investors in the sector these days are not long-term investors carrying out extensive fundamental analysis on the firms they’re investing in. Rather, they are risk-on/risk-off traders looking to capture short-term gains, often in the more risky names in the European bank universe. This has proven successful for some, but it’s also an easy way to lose money in our view. There are not many doing the kind of intensive work required to understand the complex institutions that banks have become.
We believe the real way to make gains in this sector is through old-fashioned fundamental analysis, through meeting management, through close scrutiny of both the individual business’s processes and the macroeconomic backdrop. Even if rates do not rise, (or rise slower than expected) and even if the positive tail-winds of an ameliorating political situation, M&A activity and improved profitability do not materialise, there are still, we believe, well-run banks whose pricing offers investors something close to a free option on all of these potential outcomes, whilst compensating them with an impressive running dividend yield – averaging around 6% – in the meantime.
European banks have, we think, been punished indiscriminately and excessively. We believe investors will catch up with this, and when they do, we expect to see banks’ stock prices narrow to levels implying a cost of equity much closer to the current yields of their CoCos.
1. Morgan Stanley, Global Strategy: Global Exposure Guide 2018; June 13, 2018.
2. According to Bloomberg consensus of members of the SX7E Index; as of Sept. 5, 2018.
3. Credit Suisse, Global Equity Strategy; June 13, 2018.
4. Calculations from Autonomous Research.