The rally in European banks

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