European banks could change from dogs to darlings

James Sym (pictured), European equities fund manager at Schroders, considers the return of inflation as a sign of a significant change of fortune for Europe’s beleaguered banking sector.

To our minds an investment in European banks represents potentially the single most attractive opportunity in our asset class. It is that very rare thing in the post quantitative easing (QE) investment world: a “fat pitch” or, for those unfamiliar with baseball parlance, an easy ball to hit.

This will appear an incongruous statement. Banks have been the dogs of this investment cycle and readers will no doubt be familiar with many of the well-worn threats to the industry.

Anyone doubting the wisdom of an investment in this sector is certainly not alone; our analysis suggests nearly nine out of ten professional investors in Europe are underweight the sector.

To state the obvious, in a sector so unloved, given these stocks are trading way below fair value, a subsequent increase in their share prices would be incredibly painful for the many portfolios with little to no exposure.

Why then do we take the other view? Our investment theses typically take place in three steps.

Firstly, identify why the shares trade as they do. In other words, what’s the problem? Secondly, identify why the key inputs have to change. And thirdly, when these initial conditions change, how much money could you make?

Banks trade on ultra-cheap valuations
To start with then these stocks are somewhere between very and outrageously cheap. For example, one of the better northern European banks might typically offer a 6% dividend yield. Venture to Italy and one can find dividend yields in the double digits.

Not bad if you have spare cash for investment in a world where interest rates are 0% and over half of all European government bonds globally yield less than 1%.

But why do banks trade so cheaply? Almost by definition it’s because the market views the current level of profitability as unsustainable.

There are the threats that make good headlines such as litigation and regulation, as well as the vague notion that new technology somehow renders the banking model obsolete. But there is one overriding, pernicious threat that has dominated the discourse around banking boardrooms across Europe over the last couple of years. And that is zero (ZIRP) and then negative interest rate (NIRP) policy from the European Central Bank (ECB).

Monetary policy has hurt banks’ profits
There is no doubt that the alphabet soup of ZIRP/NIRP/QE has damaged banking profitability, and for the duration these policies are in place it will continue to do so.

For those lucky enough never to have had the misfortune of trying to digest a bank’s financial statements, it’s perhaps enough to observe that since Mario Draghi announced QE in January 2015 forecasts for banking sector profits are down by over 20% and share prices by more than 30%. So we’ve identified the problem – excessively loose monetary policy.

However we think these excessively loose monetary policies are currently under review – and rightly so. Why? Most obviously, they have done very little to stimulate demand and inflation as they were designed to do. Consider that Japan has tried ZIRP for 20 years and in the West it’s approaching a decade.

And economic growth has been virtually non-existent. As an aside I respectfully suggest the neo-classical economists’ models, which tie low rates to booming economies, might need a rethink.

Unintended consequences – low rates have hampered lending
More alarmingly from our own experience we are seeing more and more often how counter-productive these policies are for generating economic growth.

For example a recent meeting with one of Europe’s largest banks confirmed that because of their low share price (which is a function of low rates and consequently low profits) they are instructing their individual business units to restrict lending to only the most profitable, lowest risk loans.

This is not great if you are a small business with a new product to launch or a domestic industrial company with a factory to build. Make no mistake: this is deflationary and it is counterproductive.

No wonder then we have the rise of political alternativists across the continent: Marine Le Pen, Podemos, Cinque Stelle, Alternative fur Deutschland, Freedom Party to rattle through the five biggest eurozone economies. The great collective wisdom that is represented by Western democracy is flexing its muscles.

Self-preservation is a very powerful force when the elites are confronted with a policy choice: witness the recently changed rhetoric on austerity and fiscal stimulus.

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