European banks have frequently been in the headlines of the financial media this year. We have seen bank bailouts in Italy, mergers and acquisitions in Spain, large volumes of primary bank issuance as governments sold their stakes and the sector has remained a proxy for market sentiment on future European Central Bank (ECB) rate policy.
The wider European financial sector outperformed the MSCI Europe ex-UK index by 4% in 2017 through the first week in August, but has underperformed the index over the last few weeks.
In my view, the main reason for this recent underperformance is the sluggish state of European banks’ revenue lines. The European banks second quarter reporting season, which came into full swing in mid-August, was once again nominally strong. This followed five quarters of gradual improvements delivering better than-expected bottom-line income, contributing to stronger capital positions.
Fundamental doubts about the solidity of European bank balance sheets are no longer an issue – a situation very different from that eighteen months ago.
Nevertheless, for Q2 2017, financial markets were expecting a more convincing top-line (net interest income (NII)) performance. Yet revenues continue to be held back by slow loan book growth in some countries and, more importantly, low interest rates.
Two main reasons for slow bank revenues:
When assessing the two components of bank revenue disappointment, one can start with volumes. European lending volumes have gradually been improving and should continue to do so with recently increased GDP expectations for Europe; commercial loan growth, in particular, correlates reasonably closely with GDP.
For this reason we expect European bank loan growth to be in the range of 3% to 5% year-on-year for 2017. This would be a healthy growth rate given that the aggregate European loan book has grown by around 1% on average per year since 2011.
Yet the actual pace of loan growth improvement has been slow due to differences between countries; most of the loan book growth so far has been in core eurozone countries, the Nordics and the UK.
But growth in both the UK and Germany is slowing and there has been continuing shrinkage in ‘peripheral’ eurozone countries and the Netherlands. Bank loan balance growth in Spain, Italy, Ireland and the Netherlands has been restricted by the high rate of mortgage redemptions that has so far outpaced new mortgage lending, again partly due to low interest rates. Yet in those countries, mortgage growth is expected to break even toward the end of this year.
The second, in our view more important, contributor to slow bank revenue growth is that interest-rate expectations have not turned more positive, as was previously expected. Financial markets have now accepted that European interest rates will not rise as fast as they had initially anticipated. In fact, rates and bond yields have fallen since the beginning of August (e.g. the 10-year euro swap rate is down by 8bp), which is typically unhelpful for banks’ net interest income. As a result, the prospect of higher interest rates is no longer the primary driver for European bank exposure; individual stock selection is more important.
All in all, European banks’ net interest margins (NIM) remain weak (on the average NII/loans ratio has been revised down by about 2bp to 2.64% for 2017 following the second quarter reporting season). However, most NIM expectations are fairly flat for the next two years (expected to rise by only 5bp) so there is room for upgrades when the ECB actually starts to act.
Banks’ earning progress remains sound
Aside from these quarterly setbacks, our European Large Cap. equity team continues to see European banks in a favourable light. After all, despite the most recent quarter’s lack of top-line progress, European banks’ bottom-line quarterly earnings progress remains sound, with the vast majority of banks beating second quarter earnings expectations.
Exhibit 1: MSCI bank returns and earnings estimate
Source: Factset, BNP Paribas Asset Management, as of 07/09/2017
A cynic may argue that the European banking sector’s P/E ratio of approximately 11.5x next-twelve-months earnings does not have much upside relative to its historical 20-year average:
Exhibit 2: MSCI bank valuations – price-to-earnings and price-to-book
However, i) European banks still look cheap relative to other sectors:
Exhibit 3: Europe sector multiples
And ii) more interestingly, the banking sector’s profitability has risen out of its trough, mainly because the cost of credit, i.e. provisioning for bad loans, has to a large extent normalised.
But bank profitability is still being held back by low interest rates, volumes, and increased costs related to additional compliance requirements and investment in digital technologies. Most of these items should improve over time with the cycle as banks gradually adapt their business models to the new operational conditions.
Exhibit 4: MSCI banks’ return on assets (ROA) – in our view ROA should improve over time
Risks now appear much lower
European banks’ balance sheets have largely been repaired, as indicated by
- the number of one-off charges, which have diminished noticeably year-on-year, and
- the average 50bp of Core Equity Tier I capital the sector has generated over the past year.
Italian banks remain an uncertain element within the European banking sector, but ECB involvement and the rescue of the weakest Italian and Spanish banks has supported overall investor sentiment towards the sector. As such, risks now appear much lower than in previous years.
European banks’ compliance and digital conversion costs are unlikely to fall anytime soon. However, efficiency ratios should start to receive support from better revenue trends. Moreover, such costs increasingly act as a differentiator and look set to be one of the factors that will contribute to further sector consolidation now that the drawn out regulatory uncertainty appears to have entered its final phase.
Our European Large Cap equity team, which places much emphasis on sound market structures, has noticed that most European banking markets have become more concentrated since the global financial crisis.
Our team holds positions in banks in the most concentrated of these markets, such as the Scandinavian countries, the Netherlands and Ireland as well as in markets such as Spain, where concentration is visibly increasing, suggesting better pricing discipline in the future.
Written on 11/09/2017