European banks are once again facing fears of a meltdown. While current risks require careful scrutiny, a thorough checkup suggests that relatively healthy lenders can be found in the market today.
It’s been a rough start to the year for European banks. The STOXX Europe 600 Banks Index has tumbled by 22.4% from the beginning of the year through February 16, despite rebounding in recent days. Investors fear damage to bank credit quality from a possible recession and energy-sector turmoil, pressures on margins from record-low interest rates, and unintended consequences of new regulations. The ability of European banks to generate earnings and pay dividends appears to be in jeopardy.
Share Rout Across the Board
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Yet we believe that the European banking sector is generally much better positioned to withstand pressures than a few years ago. And the rout of regional bank shares has been punitive for stronger lenders as well.
Clearly, a recession would deal a big blow to the sector. Earnings would evaporate and dividends would dry up. In a global and regional economic contraction, investors don’t want to own banks.
However, we believe investor concerns about recession should be put into context. In December, the European economic sentiment indicator reached its highest level since April 2011. Fiscal policy across the region is expansionary. Of course, there are always risks, but we believe that the euro area is much better positioned to deal with the consequences of any slowdown than in the past. For example, signals from the European Central Bank suggest that monetary policy could be eased further to combat global risks.
Distressed Multiples Imply Disaster
Investors appear to disagree. Today, European banks trade at a price/book value of only about 0.7x. Distressed multiples like these haven’t been seen since the sovereign-debt crisis in 2012, when investors feared the euro would disintegrate, leading to an economic implosion in Europe.
No wonder dividends are in the spotlight. Highly rated stocks generally trade at low dividend yields, indicating that investors are willing to pay a premium for dividend sustainability and growth potential. But for European banks, both dividend yield and dividend growth metrics are elevated—and have diverged sharply from all other sectors (Display). This means investors don’t believe that banks will be able to maintain their dividend payouts.
Given that banks have lurched from crisis to crisis in recent years, investors’ fears are understandable. But, at the same time, many banks have raised capital, materially improved liquidity positions, cut costs, deleveraged and streamlined operations. Clearly, the European financial sector is much healthier today.
Stronger Balance Sheets
Balance sheets are stronger. The ratio of tangible book value (a measure of leverage) to total assets at European banks now stands at 5.4%—double the level during the global financial crisis. Provisions for nonperforming loans have declined while return on tangible book value, a measure of profitability, has also recovered and stabilized (Display).
However, looking at the entire sector can be misleading. There are big differences in risk profiles, capital positions and dividend-paying capacity among European banks.
Risk Profiles Differ
To test this, we looked at two groups of European banks with very different fundamentals. While the forecast dividend yield was high for each group, the level of confidence about receiving these yields differed materially (Display). The less risky banks appeared to have much more resilient balance sheets and loan books; as a result, in our view, they’re more likely to deliver on dividend growth expectations.
Profitability is another trouble spot. Bears argue that banks simply can’t boost profitability when interest rates are so low. Indeed, their core business relies on interest spreads between deposits and loans, which are compressed in the current environment.
But there is a flip side, for long-term investors. While monetary policy is likely to remain relaxed this year, interest rates can’t stay this low forever, in our view. If economic growth ultimately gains momentum in the coming years, interest rates can be expected to eventually rise. And when this happens, European banks will be very well positioned, because they will be able to price deposits and loans more profitably.
Extreme volatility makes it hard for investors to keep their eyes on the longer-term future. Yet we think that’s exactly what investors should do now. When valuations are so distressed, we believe that select European banks can be a source of outsized investment returns in the coming years.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.