Pick-up in growth puts bank stocks back in favour

Financial stocks are firmly back on private banks’ radar, having been largely shunned since the 2008 crisis.

Having consolidated since then, amid a rising regulatory burden and uncertain economic outlook, especially in Europe, where they have been penalised by negative deposit rates, the sector is now recovering. It is being driven by stronger economic growth, rising interest rates and the prospect for financial deregulation, especially in the US.

On president Donald Trump’s promises of a fiscal boost, US bank stocks rose by roughly 23 per cent in the last two months of 2016, further fuelling the market (see chart).

Financials are currently ranked as the most favoured industry sector by private banks. Around 70 per cent of them have an overweight stance on financial stocks, according to this year’s Global Asset Tracker survey*. Two thirds of CIOs believe it “most likely” or “likely” that Mr Trump’s presidency will contribute to supporting financial stocks.

But with rising investors’ fears about Mr Trump’s ability to deliver his promises, amplified by recent failures to repeal Obamacare and implement the controversial Muslim ban, should investors focus on US stocks or look elsewhere?

“Financials, and bank stocks, in particular are a good investment, and we are overweight the sector,” says Niladri Mukherjee, director of portfolio strategy at Merrill Lynch Wealth Management in New York, seeing the consolidation of their gains this year as a positive development, after last year’s rally.

The focus is on US banks’ earnings and earnings estimates, which are improving, explains Mr Mukherjee. The improvement of corporate and consumer sentiment will ultimately translate into loan growth for the sector, even though it has flattened now.

Tax reforms, which Merrill expect will be passed, are going to be hugely beneficial. Banks in the US pay the highest effective tax rates versus other sectors, according to Merrill’s analysts, and significant upside may derive from cutting corporate tax rates to 20 or 15 per cent.

Regulation is also key, when it comes to building a bullish case for US bank stocks. “Regulatory relief too plays a big part of the positive story for banks, as it can be meaningful both on the revenue and cost side,” says Mr Mukherjee.

According to the Federal Financial Analytics Group, compliance and regulatory costs borne by the largest six US banks doubled from $35bn in 2013 to $70bn in 2017.

While regulation may have been a strong headwind for the US financial sector, investors are increasingly sceptical about Mr Trump’s ability to replace the Dodd-Frank banking law, now very engrained in the system. Mr Trump recently reiterated his vow to give Dodd-Frank a “major haircut”, but Merrill Lynch believes repealing this regulation is not really necessary for banks’ earnings to improve. The law is “broadly written” and subject to significant interpretation of whoever is running the agencies, appointed by the president. 

“Any change in supervisory leadership can be quite impactful to the regulatory relief, as repealing Dodd-Frank would be. That’s a key point the market is missing,” says Mr Mukherjee. “We still remain bullish on bank stocks as long as prospects for the regulatory environment improve or even stay the same.”

Higher interest rates, particularly on the short end – corresponding to pricing of 65 per cent of US bank loans – will have a positive impact on bank earnings, and Merrill expects the Fed will hike rates at least two more times this year. 

Higher rates on the long end will also benefit earnings, especially for banks holding longer duration loans, such as mortgages. “We favour banks with a strong, sticky deposit base, which can delay or pass on less of the increase in rate, and that way maximise interest margin,” states Mr Mukherjee.

Interest rate normalisation is going to be a huge tailwind for European banks, too. Their profits could potentially rise 25 per cent, if deposits rates were to move back to zero, according to Merrill Lynch.

But US banks are higher quality, are further ahead in having repaired their balance sheet and beefed up capital strength since the financial crisis, and have gained market share at the expenses of their European counterparts. They also operate in a more advanced economic and interest rate environment. 

“We like European banks too, but they are not completely out of the woods, and political risk is elevated,” adds Mr Mukherjee. There is higher return potential associated with European banks, but US ones represent a “safer bet”. 

Credit Suisse brings a different perspective. The Swiss bank had an overweight stance on US financials until a few weeks ago, when the position was brought back to neutral and preference shifted to European financial and bank shares. 

“Yield curves in Europe have more room to steepen compared to the US, and US banks have had a good run up already,” explains Burkhard Varnholt, deputy global CIO at Credit Suisse. He believes the current stockmarket cycle is above all driven by a “synchronised global economic upswing, and resulting impact on the yield curve, currencies and earnings,” rather than Mr Trump’s “political manoeuvres”. 

European financials have been weighed down by political uncertainty and upcoming elections, and have lagged US financials both on valuation terms as well as in the market rally. 

Perceived weakness of banks, particularly in markets at Europe’s southern periphery, extremely low interest rates and capital market yields, compared to slightly higher ones in the US, have also been a drag. “We would like to view those negatives as an opportunity, rather than an added risk,” states Mr Varnholt. 

A possible Marine Le Pen victory in the French presidential election would most probably lead to a risk-off environment, but the victory of a more moderate candidate – a scenario deemed more likely by the Swiss bank – would lift investors’ spirits, the credibility of the euro and benefit European domestic stocks. 

This picture, combined with an already accelerating economic backdrop and the valuation gap, makes European banks more attractive than their US counterparts, concludes Mr Varhnolt.

Indeed, European banks are “exceptionally cheap” in terms of price-to-book and price-earnings. “It is still a devastated industry in terms of valuation, so you are effectively buying value stocks,” says Didier Duret, CIO at ABN Amro Private Banking. 

The Dutch bank went back to a neutral position from underweight during August last year, after banking institutions in the old continent had reached their nadir in July, hammered by fines for misconduct, litigation costs, market volatility, and declines of bond trading revenues as central banks continued repressing bond market yields. After that, the economic cycle started to turn. 

Regulation itself makes European stocks less risky, believes Mr Duret. “European banks are less profitable, but probably less risky than in the US, as they are operating in a much more constrained environment, having to meet very strict capital requirements, imposed by both their national central banks and the ECB.” 

Financials, together with small cap stocks, are the ultimate domestic cyclical sector, as they are amongst the first few industry sectors to be hit when a recessionary sentiment prevails. 

Vice-versa, banks in particular, are the “perfect play for the pick-up in economic growth,” says Cesar Perez, CIO at Pictet Wealth Management. “With the current global reflation trade, and the shift from monetary to fiscal policy, banks benefit massively from the yield curve pick-up and interest rates rise on the short end, and we have an overweight position to banks globally,” he says.

US banks, especially regional ones, will benefit from tax cuts and acceleration of the domestic economy, says Mr Perez, who started buying US banks early last year. Deregulation will also support valuations, for instance if it enables them to pay higher dividends.

However, Mr Perez thinks now is also the time to start buying quality banks in Europe, those which managed their credit book more conservatively in the past, in an industry which is still deleveraging. European banks, following in the steps of their US counterparts, will also gradually be able to reverse their provisions for non-performing loans, and M&A activity is potentially going to rise in the old continent. 

He says: “We are going to start to cherry-pick good quality banks in Europe, which are going to benefit from ECB’s start of tapering, increase in deposit rate and pick-up in the economic growth.”