European banks: with the quarterly reports now upon us and an ECB destined to act as less of an assist, what to do with the stocks in the sector? Buy or sell?
Have the shares of the European banking sector tested levels that are no longer sustainable, after those buys last year, which surged at record rates? Or, for these titles, Is the upside margin still present?
If you want updates on World News enter your email in the box below:
By filling out this form I agree to receive information relating to the services on this page in accordance with the privacy policy.
European banks, GAM: ‘valuations remain cheap’
In the note “European banks – valuations remain cheap”, answers this question Niall Gallagher, Investment Director di GAM.
The answer is all in the title: in spite of the race and despite those “impressive returns”, as Gallagher himself defined them, with which investors were rewarded, European bank stock valuations “remain cheap”.
The reason is represented by the fact that that rally, which since the beginning of the year amounted to +16.7% – started from decidedly low levels.
“First of all, let’s remember that for most of last year the European banking sector traded at some of the lowest valuations in stock market history“, explained the GAM expert, advising traders to take a look at the chart.
“Chart 1 shows that the PE multiple has gone from less than 6x to just over 7x. But this data is compared with a long-term average of over 9while on a Price Earnings Relative basis (or relative to the broader market) it went from 0.48x to 0.54x versus a long-term ‘normal’ of 0.8. These two metrics suggest there is 35 to 50 percent upside. to achieve an average valuation multiple or to establish a normal relationship with the rest of the market: on this basis, the sector remains attractive in terms of valuation”.
However, it is also true that European banks are destined to remain orphans of that strong support for their profitability which came from Christine Lagarde’s ECB:
the European Central Bank is in fact starting to cut interest rates in the euro area in June, as emerged fromlast meeting of the Eurotower Board of Directors, after the series of rate increases that brought the cost of money to rise by 200 basis points only during 2023.
In conjunction with those anti-inflation monetary tightening, during 2023 Italian banks in particular they boasted profits and dividend-buyback promises at record levels in history.
READ ALSO
Banks: profits boom in 2023 for UniCredit, Intesa, Mps & Co. But Bankitalia preaches caution
Consequently, it is natural that, as GAM points out, the question that besieges traders is the following:
“What if earnings/profits decline, as many are asking, as the interest rate cycle winds down?”
In short, what will happen now that European banks will remain ‘orphans’ of Lagarde’s ECB?
Orphan banks of the ECB. But what is the true interest-earnings correlation?
Gallagher sums it up the effect that the ECB’s monetary tightening had on the profitability of European banks, meaning European banks, in the case of the European Central Bank, the banks of the euro area:
“The rise in interest rates from -0.5% to above 2% has transformed the profitability of European banksleading to a more than doubling of the sector’s return on equity.”
That said, the warning is there.
GAM in fact believes that “Many fundamentally misunderstand the relationship between banking sector profitability and interest rates.”
The truth, however, is another, and more complex:
“In most rate environments there is little relationship between the level of interest rates, or bond yields and net interest margins, revenues and profits / ROE, of the European banking sector”.
Not only:
“the overall relationship between rates-returns and bank profits is not linear but asymmetrical”, to the point that, “in most cases, there is no relationship, but at very low levels of rates and yields (below 1.5%) the impact on bank profits is very negative indeed”.
In short:
“In other words, very low or zero interest rates and returns are very negative for bank profits and RoEbut otherwise interest rates and returns don’t matter much, while the intensity of competition is much more significant”.
Having established this point, the good news for European banks is that the prospect of seeing rates return to those levels stuck at zero is considered highly unlikelydue to the persistence of inflationary pressures,
Gallagher recalls among other things that “there is no period comparable to 2008-21 in modern history and many economists are starting to wonder whether zero rates and quantitative easing were egregious policy mistakes that created major economic distortions.”
Having said this, for banks to know that interest rates, even if cut, they won’t see those ground level levels again for a long time that they tested in the aftermath of the 2008 global financial crisis, certainly bodes well.
READ ALSO
Buch warns, “European banks are not out of the woods yet”
Banks: profits boom in 2023 for UniCredit, Intesa, Mps & Co. But Bankitalia preaches caution
Italian and European banks: everything about profits, securities, 2024 ratings with ECB turning point
Italian banks and ECB rates: Mediobanca’s acceptance of the ratings and TP of these securities
Spreads, BTP rates, ECB and banks: the S&P outlook
However, rates aside, GAM asks, “is there anything else that could cause the sector’s profitability to break down?”
European banks: still a cheap sector?
Analyst Gallagher has no particular fears or doubts about the solidity of European banks:
“We believe it is unlikely that a credit cycle (i.e., loan losses) will occur, as the sector has spent much of the last 15 years deleveraging – there is not much risk on bank balance sheets and this deleveraging is also reflected in the consumer and corporate sectors in many European economies“.
“Furthermore – concludes the investment director of GAM – the sector has gone through a phase of consolidation, thus reducing the intensity of competition, so there is not even the risk of price wars causing profitability to collapse”.
Still, “with much higher levels of capitalization, iThe sector has strongly adopted share buybacks, so much so that, even with the strong performance since the beginning of the year, most securities have a total distribution yield greater than 10%, probably sustainable for the next few years.”
In short, no fear for the future of European banks:
“In summary, while the sector has done very well year to date and there is a short-term risk of ‘consolidation’ or mild underperformance in terms of disappointments in the first quarter, in our opinion the fundamentals remain convincing and the sector remains cheap”, concludes Niall Gallagher.