European Banks – The Unloved Sector


European equity markets have so far this year performed relatively well, as most global equities did. However, investors’ optimism has not been the same across all sectors. Stellar performance has been recorded by European companies in the health care, utilities, and technology sectors. All three sectors have since the beginning of the year recorded double-digit gains, in the 20 per cent region. On the flip side, European banking equities are down by over 5 per cent since the end of last year. The latter have not underperformed only their European peers, but also their US counterparts, which are generally up by 18 per cent on a year-to-date basis.

What has led to this underperformance in European banking equities, at a time when equities have become an investors’ best friend? In our article last week, we compared the half-yearly performances of the two major local banks. Reference was made to the various factors which have impacted banking profitability in Malta, notwithstanding the abnormal economic growth the economy has enjoyed in recent years. In view of this, in this article we intend to shed light on how European banking equities have performed this year and what had contributed to this performance.

Since the Global Financial Crisis (GFC), European banks have struggled with profitability. Low interest rates had their toll on European banks given the fact that banks’ profitability is highly dependent on the interest rate differential they earn on lending and what they pay on deposits. Over the past ten years, the difference between the two rates has been in decline. To make matters worse, European banks do not receive interest on their deposits with the European Central Bank (ECB). European banks, unlike their US counterparts, pay to park excess liquidity with the ECB. This adds further pressure on banks’ profitability. Over the past decade – a period of ongoing interest rate cuts – European banking equities have declined by 45%.

The valuation of the European banking sector cannot go unnoticed by any investor looking for value in financial assets. However, various forces are pushing investors away from the sector. Economic growth has generally been sluggish in Europe, pushing inflation lower in the process. In turn, the ECB responded to weak economic figures by introducing quantitative easing, and cutting interest rates several times. Banks’ profitability came under further pressure, as rates were cut even further, and below zero. Financial markets are anticipating further interest rate cuts.

Various European banks have warned investors of future lower earnings, as lower for longer interest rates put pressure on profitability. Excess liquidity at the ECB is costly to hold, while investing in high quality European sovereign bonds is no longer generating positive returns. At the time of writing, the yield (the return on a bond if held till maturity) on the German 10-year Bund, is a negative 68 basis points. In other words, if an investor invests in 10-year German paper and holds the bond till maturity, she has a sure loss of 0.68 per cent. Malta Government Stocks (MGS) with the same maturity are trading at a yield of 0.17 per cent – a far cry from the 1.7 per cent a same maturity MGS returned five years ago.

In addition, stricter regulation has forced banks to hold higher capital buffers. Many also completed painful de-risking programs. Others are still going through such programs. Tighter regulation aims to make the banking sector more safe and resilient to economic shocks. This, at a time when countries and economies have become so dependent on the soundness of the banking sector. The final goal of tighter regulation is to avoid a repeat of the GFC.

From a bondholder’s perspective, a safer banking sector makes it more likely that bonds issued by European banks honour their interest and debt obligations. Hence, the risk of default is lower. However, this has come at the expense of lower banking profits and simultaneously lower return on equity, hurting shareholders the most.

With the sector heavily underperforming its peers, it is a fact that there are more sellers than buyers for banking equities. Yet, there are few investors who believe that there is value in European banking equities, as the sector looks attractive from a valuation point of view. Inevitably, banking equities have also gained the attention of various investors, at a time when various sectors are trading at all-time highs while the markets battered banking stocks.

Many agree that investing in this sector is not a short-term play. Investors should understand that tapping in a sector which is so unloved is only for the long-term. While some bright spots within the sector may exist, we should remain mindful of the fact that in a risk-off (higher volatility) environment, fire sales may send lower the whole sector, and disregard any banks which have so far proved to be outliers.

The Eurozone needs profitable banks for a sustainable recovery

Cracks in the banking sector can deepen recessions. This was the case during the GFC. Banks play an important role in the transmission of monetary policy in an economy. The Eurozone needs well-capitalised banks to support its recovery. However, banks also need to be profitable which will help them build capital buffers over time. A weak banking sector will break the monetary policy chain and the effectiveness of any intended policy the ECB has in place. For the European banking sector to improve, Europe needs to harmonise further any differences between countries, which have so far acted as barriers to further integration. In addition, to build confidence in the banking sector, Europe needs a more stable political environment.

Gabriel Mansueto is Head of Investment Advisors at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email [email protected]