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● Our European banks team are underweight banks (see their
report published today, European Banks: The lost decade). We
believe an underweight is warranted, given:
● Valuation not obviously cheap. Current valuations (0.67x TB)
imply an 11% RoTE, only in line with the 1960–90 average. Yet,
we believe banks ought to be 10%+ cheap, as opposed to ‘fairvalue’
due to peripheral European exposure (both to the public
and private sector), banks’ assets are still too large relative to the
size of their economies, dis-intermediation, taxation and funding.
● One of the most sensitive sectors to the cycle. Economic lead
indicators are already pointing to a recession in the Euro-area and
are, we believe, likely to deteriorate further, given the effects of
additional fiscal tightening and impact of the difficult funding
situation for banks on the real economy.
● Some stress indicators in the banking system have already
reached 2008 levels. In addition, we believe there is a risk that the
euro weakens further—and this is typically associated with
European banks underperforming.
Small underweight European banks
We agree with our European bank team’s underweight stance on the
sector. We recommend being underweight European banks because:
1) Banks look cheap, but not cheap enough: European banks
are now trading on 0.67x tangible book (TB) on our numbers,
compared to a trough of 0.47x in March 2009 and a trough
multiple of 0.5x in past banking crises. While this does not show
much downside potential (~20%), more importantly there has
been a wide spread, with banks troughing on just 0.2x tangible
book in some of the historical episodes.
2) Banks are leveraged plays on credit spreads: European credit
spreads have recently started to widen, but still remain tighter
than the deterioration of economic momentum in the Euro-area
would have suggested (and economic momentum is likely to
weaken further, putting additional upward pressure on spreads).
3) Banks are vulnerable to weak economic momentum in the
Euro-area: Banks’ sensitivity to the cycle has increased in recent
years—and its correlation with lead indicators is among the
highest for any sector.
4) Banks tend to underperform on Euro weakness: Banks tend
to underperform when the euro falls, and the two-year note
differential is consistent with further weakening of the euro from
current levels to 1.3.
5) Some bank stress indicators are approaching: 2008 levels
Indicators of financial stress in the euro area—banks’ CDS
spreads and the cost of raising dollar funding in the forex
markets—are at or above 2008 levels.
6) Exposure to peripheral European assets: While investors
have generally worried about sovereign exposure, our concern is
that banks in core Europe have around five times the exposure to
the private sector (corporate, retail lending) in Greece, Ireland,
Portugal and Spain that they have to sovereign borrowers.
7) Our model of banks’ relative performance suggests further
downside potential: Our model based on bond yields, the euro,
banks’ CDS spreads and European lead indicators (R2 of 0.95)
suggests further downside potential from current levels.
8) The central problem—banks are leverage on leverage: The
central macro problem in our view is that there is a still $8 tn of
excess customer leverage in the developed world. Some of this
has to be written off (though most will likely be inflated away).
9) Earnings momentum continues to be weak: European banks’
earnings revisions continue to be negative both on an absolute
and a relative basis—though we note that consensus EPS
forecasts relative to the market have recently stabilised.
What are the positives?
(1) European banks clearly look oversold. European banks’ price
relative has fallen back to 2009 trough levels – and the proportion of
total European market cap accounted for by banks is now close to the
all-time low reached in the 1980s (9.7% now versus 8.4% in 1985). (2)
Valuations are quite close to historic floors. European banks’ price to
tangible book, at 0.67x, is close to average trough levels during past
banking crisis (0.5x). Similarly, banks are now trading on 2.5x price to
pre-provisioning profits, compared with average crisis trough levels of
1.4x. (3) Bank lending intentions are still much better than in 2008.
What do we like?
We like domestic plays in countries that rank well on our global macro
scorecard, cheap indirect plays on emerging markets and
underleveraged banks in underleveraged countries.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
● Our European banks team are underweight banks (see their
report published today, European Banks: The lost decade). We
believe an underweight is warranted, given:
● Valuation not obviously cheap. Current valuations (0.67x TB)
imply an 11% RoTE, only in line with the 1960–90 average. Yet,
we believe banks ought to be 10%+ cheap, as opposed to ‘fairvalue’
due to peripheral European exposure (both to the public
and private sector), banks’ assets are still too large relative to the
size of their economies, dis-intermediation, taxation and funding.
● One of the most sensitive sectors to the cycle. Economic lead
indicators are already pointing to a recession in the Euro-area and
are, we believe, likely to deteriorate further, given the effects of
additional fiscal tightening and impact of the difficult funding
situation for banks on the real economy.
● Some stress indicators in the banking system have already
reached 2008 levels. In addition, we believe there is a risk that the
euro weakens further—and this is typically associated with
European banks underperforming.
Small underweight European banks
We agree with our European bank team’s underweight stance on the
sector. We recommend being underweight European banks because:
1) Banks look cheap, but not cheap enough: European banks
are now trading on 0.67x tangible book (TB) on our numbers,
compared to a trough of 0.47x in March 2009 and a trough
multiple of 0.5x in past banking crises. While this does not show
much downside potential (~20%), more importantly there has
been a wide spread, with banks troughing on just 0.2x tangible
book in some of the historical episodes.
2) Banks are leveraged plays on credit spreads: European credit
spreads have recently started to widen, but still remain tighter
than the deterioration of economic momentum in the Euro-area
would have suggested (and economic momentum is likely to
weaken further, putting additional upward pressure on spreads).
3) Banks are vulnerable to weak economic momentum in the
Euro-area: Banks’ sensitivity to the cycle has increased in recent
years—and its correlation with lead indicators is among the
highest for any sector.
4) Banks tend to underperform on Euro weakness: Banks tend
to underperform when the euro falls, and the two-year note
differential is consistent with further weakening of the euro from
current levels to 1.3.
5) Some bank stress indicators are approaching: 2008 levels
Indicators of financial stress in the euro area—banks’ CDS
spreads and the cost of raising dollar funding in the forex
markets—are at or above 2008 levels.
6) Exposure to peripheral European assets: While investors
have generally worried about sovereign exposure, our concern is
that banks in core Europe have around five times the exposure to
the private sector (corporate, retail lending) in Greece, Ireland,
Portugal and Spain that they have to sovereign borrowers.
7) Our model of banks’ relative performance suggests further
downside potential: Our model based on bond yields, the euro,
banks’ CDS spreads and European lead indicators (R2 of 0.95)
suggests further downside potential from current levels.
8) The central problem—banks are leverage on leverage: The
central macro problem in our view is that there is a still $8 tn of
excess customer leverage in the developed world. Some of this
has to be written off (though most will likely be inflated away).
9) Earnings momentum continues to be weak: European banks’
earnings revisions continue to be negative both on an absolute
and a relative basis—though we note that consensus EPS
forecasts relative to the market have recently stabilised.
What are the positives?
(1) European banks clearly look oversold. European banks’ price
relative has fallen back to 2009 trough levels – and the proportion of
total European market cap accounted for by banks is now close to the
all-time low reached in the 1980s (9.7% now versus 8.4% in 1985). (2)
Valuations are quite close to historic floors. European banks’ price to
tangible book, at 0.67x, is close to average trough levels during past
banking crisis (0.5x). Similarly, banks are now trading on 2.5x price to
pre-provisioning profits, compared with average crisis trough levels of
1.4x. (3) Bank lending intentions are still much better than in 2008.
What do we like?
We like domestic plays in countries that rank well on our global macro
scorecard, cheap indirect plays on emerging markets and
underleveraged banks in underleveraged countries.
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