The share prices of European banks have been rising in recent months, and their rally has further to go. In the long term though, structural underperformance will continue, believes Jonathan Fearon (pictured), investment director European Equities at Aberdeen Standard Investments.
European banking stocks have been one of the biggest losers of the coronavirus crisis, losing around 28% last year. ‘Corona has put a lot of pressure on banks’ results’, says Fearon. ‘Demand for consumer loans fell, while lending margins were further squeezed by monetary stimulus. In addition, massive loan provisions were needed for expected future credit losses.’
According to Fearon, the earnings outlook remains subdued. ‘Credit losses have been limited for now, thanks to government support, and will decrease after the crisis ends. But interest rate rises are not to be expected in Europe for a long time, so the lending margin and thus sales and profits will remain under pressure in the medium term.’
Dramatic decade
The difficult low interest rate environment in which European banks have had to operate for some time now did not do equity prices any favours in the past decade. With a negative total return for the MSCI Europe Banks index of 2.6% a year on average, the sector performed much worse than the broad European equity market, which gained 6.3% annually on average.
Since the end of October, bank shares have found their way up again. However, Fearon does not expect the rally to continue for much longer. ‘Banks are trading at around 65% of book value after the recent rally. I don’t see prices climbing to 100% of book value that quickly, given the low returns on equity,’ he says.
‘Still, many European bank stocks could rise by around 20% during the corona virus recovery phase. But in the medium term, structural underperformance will persist. Banks remain structurally low-growth, low-yield investments,’ Fearon adds.
For a sustained reversal of the negative trend, much higher interest rates are needed. ‘If inflation unexpectedly returns in the coming years and long-term interest rates rise, European bank shares have huge upside potential. However, this is not our base case scenario,’ says Fearon.
Dividend resumption
He does point out that the solvency of European banks is much better than before the credit crisis in 2009. ‘Banks are now predominantly well-capitalised, which means that rights issues are not to be expected.’ This also allows for an early resumption of dividend payments. Banks cancelled dividends for 2019 under pressure from regulators. After September, the European Central Bank will withdraw all restrictions on paying dividends. UK banks will also be allowed to pay dividends again this year, albeit with a limited payout ratio.
According to Fearon, the resumption of dividends is an important support for banks’ share prices. He does not expect a full dividend recovery this year. ‘The pay-out ratio on 2021 profits is likely to return to pre-corona levels. But because credit losses will still be above average, the absolute dividend amounts will be even lower.’ He reckons that the dividend will not return to the pre-corona level until 2022 or 2023. Based on current share prices, that would mean a dividend yield of over 6%. After that, distributions will not grow much but remain stable, Fearon expects.
Scarce growth
The equity strategist, who also manages the ASI Europe ex UK Growth Equity Fund, sees more perspective in European insurers. In the past 10 years, they have outperformed the banks and the MSCI Europe index. With a price/earnings ratio of around 10.5, Fearon thinks the sector is still attractively valued. ‘Insurers are not as cheap as banks, but their business model is much more robust. That justifies a higher valuation. Also, compared to banks, European insurers have greater exposure to the US, where interest rates are more likely to rise.’
Although the current low interest rate environment is negative for life insurers, Fearon says this risk has been partly mitigated by a shift to unit-linked products. One insurer he finds attractive is AXA. ‘The company is well capitalised and pays a handsome dividend. The company is not well understood by investors because of its complex structure and is therefore priced at a discount compared to its peers. The valuation is very attractive.’
He is also positive about stock exchanges like Deutsche Boerse and disruptive asset managers like Italy’s Fineco Bank. ‘These are not value stocks but fast growers, with good earnings prospects.’ A scarce grower among traditional banks is Nordea Bank. ‘This bank is active in regions where the corona crisis did not hit as hard. Moreover, Nordea Bank has a very strong balance sheet, which offers room for generous distributions to the shareholders. We therefore remain enthusiastic about this stock.’