Julien Eberhardt, fund manager, Invesco Perpetual Fixed Income, gives his last views on financials.
The financial sector has been under concerted pressure year-to-date. In the first two months of 2016 Contingent Convertible bonds, the most junior form of fixed income bank capital has lost 6.6% (local currency total return). Bank equity has also been weak with the MSCI Europe Bank index falling 17% (total euro return).
Slowing global economic growth and fears about the efficacy of central banks’ attempts at stimulating the economy have contributed to a general deterioration in sentiment.
Some sector specific factors have also affected returns.
These include, negative interest rates and their effect on banks net interest margins, a European Banking Authority opinion released late last year that essentially stated Additional Tier 1 coupons could be suspended at higher capital levels than investors expected, and a clumsy attempt at recapitalising Portuguese bank Novo Banco through the bail-in of select foreign senior bond holders as well as bail-ins of four regional Italian banks.
On top of all this, earnings released during February for some high profile banks were very weak.
The question I, as a fund manager, am looking to answer is whether or not the higher yields we are now seeing in the sector represent an opportunity or if the markets fears are justified.
In my view, the market has become too negative. Banks’ capital structures and liquidity have improved significantly since the global financial crisis. Capital ratios are a long way from capital triggers that would require bail-ins.
Europe’s major banks now have capital ratios anywhere between 10 and 15% – pre 2007 they were around 6% or 7%. Stress tests conducted by regulators in the UK and Eurozone have confirmed this position.
The most recent stress test by the Bank of England found no macro -prudential actions were required by banks – the two banks that failed the test had already submitted capital improvement plans and so no further action was required.
In Europe, stress tests have highlighted some banks as having capital shortfalls, but plans have been submitted to address these shortfalls.
Meanwhile, I think concerns about negative interest rates may be overdone. Accepting there are country specific factors potentially at play, year-to-date Swedish and Danish banks, which both have to contend with negative interest rates, have been some of the best performing European banks.
Indeed, data from the Riksbank indicates that net interest margins in Sweden have actually held up reasonably well as other factors offset the effect of negative interest rates.
For Additional Tier 1 capital there is a concern in the market that coupons could be suspended or bonds not called. This was one of the factors behind the extreme volatility we saw in Deutsche Bank. We think this fear is overdone. In the case of Deutsche Bank the company has stated its ability and intention to make coupon payments on the AT1 bonds both this year and going forward.
It has also reaffirmed that it will call the bond. Elsewhere, it is worth noting that some banks actually increased their dividends – a move that requires approval from the regulator. Furthermore, although recent headlines have focused on banks with weaker earnings there were a number of banks that announced earnings above consensus estimates.
So whilst we have seen some weak earnings and there are undoubtedly challenges facing the sector I don’t think this recent weakness is symptomatic of more fundamental difficulties. I have therefore been seeking to take advantage of the recent weakness and have been selectively increasing exposure to both AT1’s and equities.