European banks are still trading on a 48% discount to the market on price-to-book and with potential for stronger loan growth and lower provisions, which makes the sector’s relative valuations attractive, notes Morgan Stanley. Morgan Stanley looks at the sector with a focus on valuation after most of the attention this week was on stress tests.

European Banks

Sebastian Raedler and the team at Morgan Stanley in their report dated October 27, 2014 on “European Strategy” also remain Overweight on European equities as the deflation scare abates.

Positive impact from ECB’s AQR and EBA’s stress tests

The Morgan Stanley analysts note the ECB’s Asset Quality Review should be a positive catalyst for European banking, as it would aid in softening negative investor sentiment and potentially improving loan growth. European banks will also benefit from additional ECB liquidity provisions, as this would lower bank funding cost and credit spreads as well as enhancing peripheral European sovereign financing conditions.

The analysts note banks’ profitability continues to be depressed, with the current return on equity at 3.7% on a 12-month trailing basis, close to the bottom of a 40-year range:

European Banks' depressed RoE

The analysts point out that this low profitability is partly due to structural reasons such as higher capital requirements, the loss of previously viable businesses and the ongoing disintermediation in European finance. They note the partially temporary nature of banks’ profitability is highlighted by the fact that banks’ provisions still stood at a crisis-level 1.2% of loans at the end of 2013.

European banks' provisions

They highlight that even if the provision levels only fell to 0.8% of loans, compared to a pre-crisis average of 0.5%, this would lead to near-doubling of banks’ average pre-tax profits over the past four years. They note the powerful impact on profitability of a drop in provisions has already occurred in the U.S., but is yet to occur in Europe.

European Banks

European banks’ attractive valuations

Raedler et al point out European banks are still trading on a 48% discount to the market on price-to-book:

European banks trade close to PBV

According to the MS analysts, while this is close to a three-year high, it’s nonetheless 1.1 standard deviations below the 20-year average, in line with the depressed relative profitability levels.

They also anticipate that when profitability improves in line with the factors such as potential for strong growth and lower provisions, the sector will re-rate relative to the market.

European Banks

The analysts also remain overweight on European cyclicals, as these cyclicals appear to have troughed on October 10 and have outperformed by 2% since. This outperformance is likely to continue.

European cyclicals' outperformance

In their research report, the analysts also reiterate their overweight on European equities, as the slowdown scare, liquidity scare and deflation fears appears to have abated. Exuding confidence, the analysts point out that they won’t be surprised if markets rallied some 5% to 10% into year-end.

European Banks