After a fairly dire 2014, it appears that the arrival of spring has brought new shoots of growth for the Eurozone. Macroeconomic data this year has been improving and, to an extent, investor concerns over a deflationary spiral have largely been alleviated. Although the ECB’s quantitative easing programme has undoubtedly boosted optimism, the Comprehensive Assessment of the European banking system has also played a pivotal role. With the ECB taking responsibility for the region’s banks, the improved regulatory environment should ensure they are more resilient. Loans to both corporates and consumers have already shown signs of improvement and the new banking union will hopefully encourage cross-border lending.
On a three-year view, European banks offer strong absolute return potential. This is driven by operating leverage from a very depressed profitability base, and by reduced cost of equity as the beta of the sector comes down gradually over time. Currently, European banks trade cheaply on price to book, a function of low profitability and sentiment that is still badly damaged by the recent years of financial market stress, as well as by regulatory and oversight issues. However, the Eurozone growth backdrop appears set to improve; recent data releases, in particular bank lending surveys and money supply, confirm this positive upswing. The combination of the collapse in the oil price, a fall in the euro versus the US dollar and quantitative easing, acts as a powerful stimulant, and the banking sector is one of the most advantaged by a recovering economy.
This is initially likely to be reflected in falling provisions for non-performing loans and some write-backs, which will lead to earnings upgrades. There are obvious similarities with the US experience, albeit that the Eurozone is several years behind in forcing banks to raise capital and recognise non-performing loans. As growth improves and provisioning falls, banks will generate improved returns on equity (RoE), which for the best-capitalised will lead to significant dividend increases. Regulatory headwinds remain a challenge for the sector and a key focus for investors but, in the context of attractive valuations and a recovering economic backdrop, need not prevent the sector from outperforming. In the medium term, regulatory pressures will fade as banks comply with changing requirements, enabling higher dividend payout ratios, following the US example.
Banks are typically a higher beta play on equity outperformance, as the economy and regulatory environment continue to gradually improve we expect a higher RoE from smaller bad loan provisions and new loan growth. Despite this, we are cognisant of headwinds such as a weaker euro, the oil price and low government bond yields.