The rally in Euro­pean banks

Financial Mirror (Cyprus) - - FRONT PAGE - By Nick An­drews

More than four months af­ter it bot­tomed out one and a half stan­dard de­vi­a­tions be­low its 200-day mov­ing av­er­age, the Euro STOXX banks in­dex has ral­lied 34% and is once again trad­ing at the levels it was at im­me­di­ately be­fore the sum­mer’s steep post-Brexit losses. Yet de­spite the re­bound the in­dex re­mains down -18% year to date, and with a clutch of the fac­tors that pre­cip­i­tated the ini­tial sell-off—no­tably neg­a­tive in­ter­est rates, shaky cap­i­tal po­si­tions, and high po­lit­i­cal risk—still in place, it is ques­tion­able how much fur­ther the rally can run.

The turn­around in the bank in­dex was ini­tially trig­gered by the se­lec­tion of Theresa May as the UK’s new prime min­is­ter on July 7 fol­low­ing the res­ig­na­tion two weeks ear­lier of David Cameron. May’s fast-track ap­point­ment helped quell short term po­lit­i­cal fears and sta­bi­lized fi­nan­cial mar­kets, with the Euro STOXX banks in­dex end­ing its los­ing streak on the same day. The sub­se­quent run-up in bank stocks was lent ex­tra mo­men­tum at the end of July by favourable stress tests re­sults from the Euro­pean Bank­ing Au­thor­ity.

Then in Septem­ber a steep­ing of the euro yield curve on ris­ing in­fla­tion expectations—as sig­nalled by the euro fiveyear five-year for­ward in­fla­tion swap, the Euro­pean Cen­tral Bank’s favourite mea­sure of mar­ket in­fla­tion views— promised to ease the pres­sure on bank earn­ings, re­in­forc­ing the up­ward move. French bank stocks in par­tic­u­lar ac­cel­er­ated in Oc­to­ber as the yield curve be­gan to steepen, re­flect­ing the in­ter­est rate sen­si­tiv­ity of French banks, which rely for a rel­a­tively large share of their fund­ing on reg­u­lated high in­ter­est de­posits with rates set by the gov­ern­ment. Fi­nally this month’s elec­tion of Don­ald Trump as US pres­i­dent ce­mented expectations of higher in­fla­tion, sup­port­ing the gains in Europe’s bank shares.

As a re­sult, al­most all the Euro STOXX banks in­dex con­stituents are presently trad­ing at higher prices than on July 7. French banks have per­formed es­pe­cially well, ris­ing al­most 50%, as has the Nether­lands’ ING Group, with some Span­ish banks also mak­ing strong gains. The only ex­cep­tions are three Ital­ian banks, re­flect­ing the weak­ness of the Ital­ian bank­ing sec­tor and height­ened po­lit­i­cal risk ahead of Italy’s De­cem­ber 4 con­sti­tu­tional ref­er­en­dum.

So how much higher can bank stocks go from here? Over the last two years, in­fla­tion expectations have been highly cor­re­lated with the steep­ness of the yield curve, which in turn has driven bank stocks. A sim­ple model based on this re­la­tion­ship sug­gests that if in­fla­tion expectations re­turn to last year’s level of 1.75% on the euro five-year five-year for­ward in­fla­tion swap—which is en­tirely fea­si­ble given the fad­ing de­fla­tion­ary ef­fect of the oil price col­lapse—and the yield curve steep­ens ac­cord­ingly, then eu­ro­zone bank stocks could rally another 20% to 30%. How­ever there are four solid rea­sons to ques­tion this sim­ple bull case:

1) Europe’s banks re­main struc­turally weak. In a re­cent re­port, the In­ter­na­tional Mone­tary Fund char­ac­terised al­most half of the eu­ro­zone’s 61 ma­jor banks as “weak”, which it de­fined as hav­ing a re­turn on eq­uity lower than their es­ti­mated 8% cost of eq­uity cap­i­tal. Another third were la­belled “chal­lenged” with RoEs of be­tween 8% and 10%. Only ten were classed as “healthy”, with RoEs greater than 10%. Even in a cycli­cal re­cov­ery sce­nario more than half of ma­jor eu­ro­zone banks were deemed ei­ther weak or chal­lenged.

The ECB also puts the sec­tor-wide cost of eq­uity at 8%, but es­ti­mates that it is higher for vul­ner­a­ble banks at around 9%. In con­trast, the weighted av­er­age RoE for Euro STOXX banks in­dex con­stituents over the last year is just 3.9%.

Dutch banks are the most healthy with an av­er­age RoE of 10.4%, fol­lowed by Aus­trian banks on 8.1%. Then come the French (6.8%), Span­ish (5.7%) and Ital­ians (1.1%). For Ger­man banks, the av­er­age RoE is -3.3%, a fig­ure at­trib­ut­able to Com­merzbank’s mea­ger 2.7% and Deutsche Bank’s abysmal -9.2%. Clearly prof­itabil­ity is a prob­lem, with the so­lu­tion noth­ing short of sig­nif­i­cant struc­tural re­form of the bank­ing sec­tor conso l ida re­cap­i­tal­i­sa­tion, sheet cleans­ing re­align­ment of models.

2) Be­fore that can hap­pen, how­ever, banks must nav­i­gate a mine­field of po­ten­tial po­lit­i­cal risks over the next 12 months which will weigh on con­fi­dence and hence on eco­nomic growth. First up is the Ital­ian ref­er­en­dum. If a widely ex­pected “No” vote leads to the res­ig­na­tion of Prime Min­is­ter Mat­teo Renzi and his re­place­ment by an in­terim ad­min­is­tra­tion, po­lit­i­cal sta­bil­ity may be pre­served in the short term. How­ever, the new gov­ern­ment will still have an up­hill task con­vinc­ing in­vestors to fund the re­cap­i­tal­i­sa­tion of Banca Monte dei Paschi di Siena. Fail­ure could lead to fresh in­sta­bil­ity in the new year. May and June are likely to see fur­ther ten­sions with the na­tion­al­ist Euroskep­tic Marine Le Pen ex­pected to make it through to the sec­ond round of France’s pres­i­den­tial elec­tion. With Dutch and Ger­man gen­eral elec­tions also sched­uled for 2017, it would be com­pla­cent in the wake of Brexit and the US elec­tion to as­sume that the eu­ro­zone es­tab­lish­ment will sur­vive th­ese tests un­scathed.

3) Next month the ECB is ex­pected to de­cide to ex­tend its pro­gramme of quan­ti­ta­tive eas­ing be­yond March 2017, with the aim of flat­ten­ing the yield curve once again. Com­bined with the eu­ro­zone’s con­tin­u­ing tough reg­u­la­tory en­vi­ron­ment, any such flat­ten­ing will keep eu­ro­zone bank prof­itabil­ity un­der pres­sure next year, with credit growth likely to be weak at best.

4) Fi­nally, eu­ro­zone gov­ern­ments will re­main ex­tremely un­will­ing to em­brace the cred­i­tor bail-ins pre­scribed by Europe’s rules on bank re­cov­ery and res­o­lu­tion. As a re­sult, in the ab­sence of a com­plete over­haul of the reg­u­la­tions, gov­ern­ments will con­tinue to seek al­ter­na­tive meth­ods of re­cap­i­tal­iza­tion, even at the risk of mag­ni­fy­ing sys­temic prob­lems and pro­long­ing bank­ing sec­tor uncer­tainty.

Un­til the po­lit­i­cal and reg­u­la­tory haze clears, in­vestors are ad­vised to stay clear of Euro­pean banks. through t ion , bal­ance and a busi­ness

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