European Bank Sell-Off Overdone
We see investment opportunities in the highest-quality stocks.
Many European bank stocks remain at multiyear lows, and we see an opportunity for investors to increase stakes in the highest-quality names at attractive discounts to our fair value estimates. We think the recent sell-off is overdone for several reasons. First, for most European banks, exposure to the energy sector--both direct and indirect--is more than manageable. Investment-grade energy bonds are pricing in losses of roughly 15%, which would result in losses of only 4.5% of common equity value, or six months of earnings for a bank otherwise achieving a 10% return on tangible common equity, and 3.6%, or just above one quarter of earnings, excluding the two most exposed European banks. Second, while lower-for-longer interest rates will be a near-term headwind for European banks, we've long anticipated a slow improvement in the economic environment, and we think recent optimism with regards to a strong European recovery was too much.
Some of the hardest-hit banks--such as UniCredit (UCG), where the CEO is under pressure to step down--have been some of the slowest to restructure postcrisis, indicating to us a level of frustration by investors at the pace of restructuring in the Italian banking system. This is a signal to other European banks they will be penalized with low valuations until management teams undertake more aggressive changes or risk being ousted themselves, as we've seen recently with the changes at Deutsche Bank (DB), Credit Suisse (CS), Barclays (BCS), and Standard Chartered (STAN). Finally, counterparty risk and notional derivative exposures are at the top of investors' minds. Here too we believe fears are overblown. Net exposures to individual asset classes, events, or counterparties are relatively manageable, especially in the case of interest rates, which make up a bulk of reported notional exposures.
We think Europe's recovery will remain slow and interest rates will stay low in 2016 and probably 2017. An aging population and structurally high unemployment will make it difficult for the region to boost growth to precrisis levels, in our opinion, and the recently stronger euro will make it harder for the European Central Bank to hit its inflation target. The European Commission forecasts real GDP growth to remain flat in 2016 at 1.9% for the European Union, compared with World Bank forecasts that the United States could grow 2.7% in 2016. This, combined with Europe's low inflation and signals that the ECB is considering additional easing, means European banks' already thin net interest margins are likely to face additional pressure, because banks find it difficult to pass on the full costs to their customers. While low oil prices will be a tailwind for much of Europe (excluding oil-exporting countries like Norway), we see risks to the downside as turmoil in emerging markets (particularly China) cuts into exports from countries like Germany.
For long-term investors, we think weak 2016 earnings are already fully priced in, and we see recent prices as a buying opportunity. Given the general European malaise, we prefer banks in banking systems that have already undertaken substantial consolidation or reform, such as the United Kingdom and Spain, and high-quality systems such as Switzerland. We prefer stronger names like Lloyds Banking Group (LYG), BNP Paribas (BNP), and UBS (UBS). For investors willing to wait, we see an attractive opportunity in Royal Bank of Scotland (RBS), which we think will have as much as GBP 20 billion in excess capital by 2018. Banco Bilbao Vizcaya Argentaria (BBVA) is also attractive, as it has a substantial presence in the rapidly improving Spanish economy as well as the profitable Mexican banking system, which is closely tied to the generally healthy U.S. outlook.
We do see more serious risks in some names. We're particularly wary of those with questionable capital strength; banks need to renew funding daily, and questions about capital can become a self-reinforcing downward cycle. We're most concerned about Deutsche Bank, which faces particularly weak earnings and large litigation expenses; we recently incorporated a EUR 5 billion capital raise into our projections. We're also wary of banks with especially high exposure to commodities and commodity-dependent geographies, like Commerzbank (CBK), Danske Bank (DANSKE), Societe Generale (GLE), and Standard Chartered, all of which carry high or very high fair value uncertainty ratings. Below-investment-grade energy bonds are pricing in losses of 30%, and losses of this size would consume well above 10% of common equity at each of these firms. We currently project that all four have enough capital to absorb likely losses, but if they were forced to raise capital, the raises would be highly dilutive.
Negative central bank deposit rates in the European Union, Sweden, Denmark, Finland, and Switzerland are meant to spur banks to lend rather than park their cash at central banks, but we see these rates as a negative to earnings, as deposit margins have contracted sharply, particularly at Nordic banks. In response, Danske Bank and Skandinaviska Enskilda Banken (SEB A) have focused their efforts on beefing up fee-related businesses, engaging in expense-cutting efforts, including aggressively investing in digital initiatives that allow them to close more expensive branches, while de-emphasizing lending. Most European banks appear ready to lend--fully loaded common equity Tier 1 capital ratios range from 11% to 13%, compared with about 10% in the U.S.--but slow growth and risks to the economic outlook mean they see few good opportunities. Moreover, in some geographies like Germany, questions about the strength of banks' capital may be restricting willingness to lend. This can cause a self-reinforcing cycle of slow growth and weak lending, as European firms are roughly 3 times as dependent on bank lending as U.S. firms, which rely more on the bond markets. We're less worried about this prospect in Switzerland, one of the few banking systems we rate as very good, as we think that its strong regulation and good competitive environment mean negative rates are more of a near-term headwind than a harbinger of distress.
While many European banks have diversified business models where interest income is balanced by fee income, we think fee income streams are likely to be weak as well. Investment banking, asset management, and wealth management are especially important fee-generating business for European banks, and we think all are likely to report weak earnings in the near term. In investment banking, market volatility may boost trading volume, but we think debt and equity underwriting is likely to remain weak. Most firms that wanted to refinance for lower rates have already done so, and equity issuances are likely to be very low until market conditions strengthen. Asset management and wealth management both have fee income streams that are highly dependent on client asset levels, and low equity market valuations will dent fee income. We may see outflows from certain sectors continue, as European offshore assets regularize and oil-dependent sovereign wealth funds pull funds to support their obligations at home. In recent years, European wealth managers depended on strong inflows from emerging markets, Asia in particular, but we think these flows are likely to dwindle as these economies slow. While we think investments in these geographies are likely to attractive long-term investments, near-term performance is likely to disappoint.
Erin Davis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.