As lockdowns ease across the world, so equity markets have rebounded, typically with banks in the vanguard. Pan European bank share prices have risen around 30% from late April levels, some 10% ahead of the market (source: Reuters, as of 11 June). However, year to date, the sector is still some 30% down in absolute terms; 20% worse off than the broader market.
So, is it reasonable to expect shares to continue to push higher?
Hopes of mean reversion seem optimistic
It feels likely that those investors expecting mean reversion from banks will be disappointed this time around.
Consider that over the last 10 years Pan-European banks have traded at an average of 9.4 times two-year forward earnings. Consensus estimates assume that by 2022 we will be back to ‘normal’, with bad debt losses back to around average levels and revenues largely recovered. Currently the sector’s valuation of 8.9 times two-year forward earnings implies single digit upside. It also fails to take into account the damage that has been done to the capital bases, dividend paying potential and profitability of many banks.
GDP and unemployment forecasts are in a state of extreme flux, but there can be no debate that the scale of output, income and employment loss will be vast. The OECD forecasts a 6% decline in world GDP in its relatively benign ‘single hit’ scenario, with eurozone GDP down some 9% and UK GDP down 11.5%. The European Central Bank forecasts an 8.7% contraction in eurozone GDP this year whilst the Bank of England’s ‘plausible illustrative economic scenario’ (included in its May Monetary Policy Report) assumes a 14% contraction in UK GDP.
OECD forecasts for unemployment are also dire, with eurozone and UK unemployment expected to rise to 9.8% and 9.1% respectively, from 7.6% and 3.8% in 2019. The European Central Bank and Bank of England are similarly pessimistic.
How the burden of this pain is shared between the public and private sectors, and specifically the banks, remains to be seen.
Credit losses are set to rise
Even with government assistance in the form of guaranteed loans, furlough subsidies and other grants, as well as loan repayment moratoria granted by the banks, it is inevitable that credit losses will rise substantially. Current accounting standards have been designed to encourage banks to recognise losses earlier than was the case previously. However, government measures, repayment moratoria and current regulatory advice run counter to this.
In Q1, credit losses were generally well-contained, with only a handful of banks reporting anything resembling recessionary levels of credit losses. Q2 will likely see banks further top-up the provisions set aside for bad loans, but investors will not be able to breathe easy for some considerable time. Repayment moratoria and furloughing schemes will be coming to an end in Q3, while corporates have as long as six years to repay government guaranteed loans.
This raises the risk that provisioning could spike in Q4 with subsequent losses deferred over the next few years, clouding the profitability of the banks through the recovery. The chance that 2022 could be a ‘clean’ credit loss year feels limited at present.
Low interest rates will hurt profitability
There are other reasons beyond simple credit losses to believe that banks will bear the scars of the Covid-19 pandemic for some time. Hits to capital from losses represent permanent dents to valuation and, for some banks, could mean a very long path to dividend resumption.
Meanwhile, interest rates seem set to remain extremely low for many years. This equates to lower net interest margins – the difference between interest paid and interest received - and a material dent to future return on equity.
Net interest income will also likely be depressed as demand for loans is brought forward by generous government guarantees. And of course, taxes will likely go up on the basis that raised government deficits have ‘saved’ the banks. For all these reasons, a good part of the Covid-19 hit to value will likely prove enduring.
Added to the above, we may see tail risks emerge that could push bank valuations lower: second or third waves of the virus; a drive by governments and/or regulators to force capital into the system to foster greater lending; financial repression (forcing losses onto banks – e.g. via enforced debt moratoria and/or sharing of credit losses on guaranteed loans); a disorderly Brexit; and, potentially, the emergence of fiscal vulnerability (most relevant for the eurozone, but also some emerging markets).
So, all doom and gloom, right?
Not necessarily. As I have written before (see here), Europe’s banks have entered this downturn in far better financial health than was the case at the start of the 2008/9 Global Financial Crisis or the 2010-12 Euro Crisis.
Banks have strong levels of capitalisation, strong liquidity buffers and are now seeing a loosening rather than tightening of regulatory requirements. The above tail risks are just that – tail risks; not base case. Indeed, a future of lower interest rates could well equate to a future of minimal steady state credit losses once the dust settles (as has been the case in Japan over the last decade).
Conversely, inflationary pressures might build as the vast quantities of money created by central bank actions around the world begins to circulate more readily in the real economy. This could push interest rate expectations and bank net interest margins higher. A wave of mergers & acquisitions is also possible as banks capitalise on lowly valued targets, using ‘badwill’ (the discount to the accounting value of net assets purchased) to restructure cost bases and clean up balance sheets.
Some banks better placed to face uncertain future than others
Sadly we have no crystal ball. Our job as investors is to analyse and understand the potential risks and rewards on offer. The Pan European banking sector is far from uniform.
Some banks are significantly better placed than others to defend capital against higher credit losses, or to engage in generous dividend and share buyback programmes if asset quality holds up better than expected. Some are significantly better placed to defend net interest margins than others thanks to an enhanced ability to reprice the ‘back book’ of loans without the drag to revenues as higher yield assets roll off the balance sheet. Some will remain exposed to long-term structural growth dynamics thanks to their market or product focus.
Over the last two decades, the top performing quartile of banks has outperformed the bottom quartile by a mean annual average of 53%. Year-to-date (as of 11 June) the top quartile of STOXX Europe 600 Banks has outperformed the bottom quartile by 45%. What is more, top quartile performers have seen share prices rise by an annual average of 35% since January 2000. Average returns for the top quartile were negative in just three of these years (2008, 2011 and 2018).
So, while the sector as whole may lack attraction, some banks could offer rich rewards to investors, even in difficult times.