Should investors bet on banking stocks?

Simon Smiles chief investment officer for ultra high net worth at UBS Wealth Management

Despite headwinds from low interest rates, we see selective opportunities for investors in both US and eurozone banking stocks. In the US, we prefer banks to other financial sector equities, especially large diversified firms with strong balance sheets, leverage to the US consumer and ample capital available to be returned to shareholders. In the eurozone, we focus on institutions with above-average profitability that can weather the prevailing environment of negative rates and muted credit growth.

 In the first two months of 2016, investors were concerned about not only the slowdown in the energy sector and global growth more generally, but also knock-on effects on banks and their loan books. High yield credit markets tightened, the cost of insuring European bank debt rose, and the Fed’s senior loan officer survey indicated more stringent conditions for commercial lending.

We believe these fears were overblown. In the US, high yield credit rallied in March. Yields were 8 percentage points higher than US Treasuries towards the end of February. This gap has narrowed to around 7 percentage points. US growth fears have decreased. The Fed’s timetable for interest rate rises has also moderated. 

The ECB has also remained supportive, cutting rates further and expanding asset purchases in March. Coupled with the commodity rally, this less hawkish outlook for developed world monetary policy eases pressure on emerging market financial assets, specifically the Chinese yuan.

 In short, banks are operating in a stabilising environment. The industry is also more robust than during the financial crisis. In the US, controls have improved. Fines have probably largely been paid. Although credit conditions have worsened in the energy sector, falling oil prices have benefited consumers. On average, balance sheets also remain more than adequate. Even if US banks’ earnings per share declined this year, we anticipate capital buffers would still meet regulatory standards. Multinational institutions should have sufficient cash flow to buy back shares and pay dividends.

 In the eurozone, the outlook is more mixed. Bank stocks are also priced at just 0.8 times book value. The sector is well-capitalised, with most institutions already meeting their 2019 requirements. However, given decreasing profitability, it is possible no near-term catalysts will emerge to push that valuation higher. Digitisation and a move away from physical branch networks could boost profits, but remains a multi-year strategy. Banks will have to grow their loan books much faster to achieve the market’s profit expectations for 2016 and 2017. 

Nevertheless, pockets of value remain. Italian banks in particular should benefit from the country’s economic recovery and valuations that trade at a discount.

In conclusion, investment opportunities in banks are not as broad-based as they have been, but neither are they non-existent. 

Claudia Von Türk Global Banks Analyst, Lombard Odier 

To say banks have had a rough start to the year would be an understatement. US and European bank valuations look attractive after the gains since their February lows, but should investors start buying? 

Despite seemingly low valuations, this environment remains tough for banks. European banks are currently posting a return on tangible equity of 8-9 per cent, which means they are not earning their cost of capital and explains why they are so cheap. 

It is hard to imagine a significant improvement in profitability. Banks face a perfect storm of low growth, negative interest rates, lingering regulatory uncertainty and concerns that perhaps not every southern European country has cleaned up its banking system. While the Targeted Long-Term Refinancing Operation II (TLTRO II) might help, there are longer-term consequences of negative rates on profitability as well as some unintended potential implications. 

We have a preference for banks with strong capital levels, defensive business models, active in regions with loan growth, solid execution on costs and ability to return capital to shareholders. These are mainly found in Frenelux, Scandinavia and possibly the UK, though it may be worth waiting until after the Brexit vote. 

Though we are not expecting much in terms of earnings growth, high levels of capital and reliable earnings streams translate into high dividends, since some banks in these regions are offering yields in excess of 6 per cent. 

We would rather avoid southern European countries, more affected by negative rates and still facing non-performing asset issues coupled with low profitability. Still, a high quality name in the periphery, or one with activities in capital markets to add a bit of punch to a portfolio when markets rebound, makes sense. 

US banks look a more comfortable place to be. Not only has the banking sector been thoroughly cleaned out but there is more regulatory clarity. US growth is stronger and rates look to be rising, which should boost net interest rate margins and help banks grow revenues. Banking stocks are closely tracking year-end rate expectations as the number of rate increases will influence prospective revenue growth. The flipside is costs getting tougher to cut and loan loss provisions set to increase, in part due to higher reserves for energy exposures but also because reserves releases are coming to an end. 

At this stage in the credit cycle, investors would do well to focus on high quality banks in the US with strong risk management and solid execution and, preferably, some ‘self-help’ or restructuring to ensure earnings growth, should revenues prove to be slower than anticipated.

Christine Schmid Head of Global Equity and Credit Research, Credit Suisse

While further volatility in banking stocks is possible, and pressure on profitability will continue, the sector does not face a crisis like in 2008. In fact, highly selective investment opportunities are arising.  

Banks’ biggest income stream is net interest income (NII), driven by the net interest margin and lending growth, both of which are challenged by negative interest rates and slow economic growth. With rates becoming increasingly negative in the eurozone, banks there are under pressure to counter falling margins by introducing negative deposit rates for clients. But banks are reluctant to do this. In particular, weaker banks that depend on deposit funding would face concerns about outflows. 

Meanwhile, margins on lending are being widened as banks seek to raise profitability. Thus, lending in a negative interest rate world is not getting cheaper for the real economy, and may even become more expensive. 

To offset pressure on banks, the ECB is implementing another TLTRO and has widened its asset purchase programme. The former has reduced arbitrage opportunities for banks, as it flattened the yield curve. The latter might result in an even more illiquid market for non-financial corporates. Both are negative for banks’ profitability, and for their ability to divest assets. Furthermore, the clean-up of high non-performing loan (NPL) inventories will impact bank earnings, and limit capital generation and dividend distribution. 

Banks’ balance sheets are now highly liquid, and capital levels have improved. The ECB is on standby for providing further liquidity if needed. Valuations are back to where they were during the financial crisis. 

These factors support our view that the correction in banking stocks since the beginning of 2016 now more than fully reflects concerns about impact of negative interest rates. Investor focus should be on banks with cleaned-up NPLs, capital levels that can withstand heightened volatility, and earnings generation power based on cost-efficient delivery and digital capabilities. We have a preference for efficiently-run retail banking operations: ING remains one of our top picks, Danske another. 

We avoid banks with high cost-to-income ratios and risk losing market share while restructuring, as well as those with high past levels of NPLs and less focused business models.

European banks are valued less expensively than US counterparts. US investment banking operations are facing a difficult first quarter, but will benefit if, as we expect, the Fed hikes rates twice this year. However, this is likely to be offset by US banks’ relatively high levels of exposure to junk-rated US shale gas producers, requiring further provisions. European banks’ energy sector lending is primarily to less risky integrated oil companies. 

Earnings expectations have been lowered for US banks, and positive surprises in Q1 results topped with further cost efficiency measures cannot be ruled out. JPMorgan Chase and Bank of America remain our preferred investments.