by Niall Gallagher – Investment Director
2023-to-date has been characterised by significant turbulence in the US regional banking sector. In March, we saw the collapse of Silicon Valley Bank, and in April the failure of First Republic Bank and the sale of its remains to JPMorgan Chase. Read across from these events has led to the poor performance of the European banking sector year-to-date, but we believe European banks are in a very different position to US regional banks – with the takeover of Credit Suisse by UBS in Switzerland in March an idiosyncratic case. Indeed, we have stated for some time that the market remains too pessimistic on European banks and as the Q1 results season draws to a close a number of points on the strength of European banks are clear:
- European bank Q1 earnings have come in well ahead of expectations, leading to continued upgrades in estimates for 2023 and 2024 earnings. The beats and upgrades have come from much higher net interest income, a result of the impact of rising interest rates on bank balance sheets and profits. The move from negative to positive interest rates in Europe – and a normalisation of rates to more historic levels – was at the heart of our thesis that European bank profitability would be ‘transformed’, driving a significant increase in earnings and rising return on tangible equity (ROTE). This is what we are now seeing.
- Deposit books are stable, with very limited deposit outflows (typically 0-2%). During the pandemic, we saw a sharp rise in savings balances, leading the banking sector to hold excess deposits. We would expect banks’ deposit books to slowly decline, which is what we are seeing – but slowly. Loan-to- deposit ratios remain typically at around 80-90% and the liquidity coverage ratios are typically well over 150%, far beyond regulatory minimums. Furthermore, there is a limited amount of ‘terming out’ of deposits so deposit ‘betas’ remain very low. Essentially, this means banks are retaining most of the benefit of rising interest rates; we would expect this to change over time, but it is changing more slowly than expected and this is positive for earnings.
- There are no signs of credit stress or recession. Loan loss provisions (LLPs) remain below average levels but we think they are still too high given what banks are experiencing in terms of asset quality. We expect to see LLPs come down further this year, driving further earnings upgrades as banks are over provided. The market’s focus has been on commercial real estate (CRE) and although we believe there are reasons to worry about this as an asset class, bank exposures to this sector are low (well below prior cycles) and loan-to-value ratios very low (typically 40-50%). In short, 15 years of deleveraging and balance sheet repair since the Global Financial Crisis has left European bank balance sheets in a very conservative condition.
- Positive momentum on capital returns. The overall distribution yield (dividend yield plus buybacks) for the sector is approximately 12%, with some banks guiding to return close to 50% of their market capitalisations in dividends and buybacks over the next three years and numerous banks trading on dividend yields of close to 10%. Dividend and buyback guidance has largely been raised as we have gone through Q1 reporting season, with the momentum on capital returns remaining positive.
- Valuations for the sector are almost at an all-time low. The sector currently trades on approximately six times earnings, with very strong earnings momentum representing a price earnings relative of around 50% (see Figure 1). This is just about the lowest ever recorded and compares to a long-term average of 80%. On a price-to-tangible book basis, the sector trades on 0.7x for a 12.5% return on tangible equity, while fair value for the sector is 100% above current stock prices and 60% higher on a relative basis.
Figure 1: European banks’ price earnings relative
In summary, despite a very positive backdrop, with positive earnings momentum and low valuations, the sector has performed poorly year-to-date as a result of events in the US regional banking sector. Despite this we see no read-across from the US and remain positive about the sector’s prospects. As ever, active, bottom-up stock selection remains key.
