It’s been a rollercoaster week for bank shares across the world as a confluence of factors stoked a panic in the sector. Exposure to energy, the impact of negative interest rates and worries about a recession all played a hand.
The key decision to make here is whether or not this is the start of a recession. I do not believe so: the US yield curve is still positively sloping, oil is a supply rather than a demand-driven issue and even within credit, the percentage of investment grade bonds with very high spreads is relatively small. Furthermore, the largest banks’ energy exposure is not particularly material – up to 4% of loans in many cases.
However, what I do see is a longer term ‘tale of two continents’ between banks in the US and in Europe. European banks appear to be stuck in a Groundhog Day scenario, despite the eurozone recovery. Forward EPS expectations have fallen by around 10% during each of the last three years and in aggregate by 8% over the period. This has happened during a time where loan loss provisions have fallen very materially for the banks – a tailwind that will end in the next couple of years. In short, the low interest rate environment has stifled earnings.
Contrast that to the US. The banks’ profitability is materially healthier than in Europe – and EPS expectations have risen by 40% over the same period. And this is despite the downgrades year-to-date, as analysts have hacked back their expectations for interest rate rises and have put in large banks’ guidance for energy loan loss provisions (which broadly assumes that the oil price stays at US$30 for the next year or so).
The key differentiator between these two continents is the negative interest rate environment, whilst US rates are low by historical standards they are at least positive. Very low interest rates are bad news for banks. Margins are compressed and revenues can shrink, particularly when loan growth is anaemic. In Europe, this is clearly happening at a time when economic growth is subdued. As interest rates turn negative, this medium-term pressure on revenues increases. Meanwhile, regulatory standards continue to crimp banks’ return on equity: ongoing higher capital requirements, the potential costs associated with bank ‘bail in’ rules, and liquidity requirements that constrain the profits on larger, institutional deposits. If central banks cut interest rates materially further from here, they risk a scenario where banks have to choose between even lower returns, trying to charge wider spreads, or tightening lending standards in an attempt to protect their lower return on equity when the next recession comes. Further policy easing is no panacea for banks’ management teams.
The European bank earnings season so far has been difficult with profitability somewhat constrained. A number of European wholesale banks are still restructuring following the financial crisis and this has added further pressure as restructuring often requires a charge on the balance sheet. Short term, these banks are trying to reconcile destroying some capital by taking these charges on the one hand, with regulation that requires them to continue to build capital ratios on the other. Coping with this, and the very low interest rate environment, makes Europe’s banks in particular vulnerable to macro concerns. Unless growth significantly surprises on the upside, this is a backdrop that can last for some time.
Yet the system is awash with liquidity and historically a banking crisis is caused by a lack of liquidity. I therefore think contagion is really quite unlikely, but with negative interest rates and tighter regulation I do see pressure on banks’ capital and profitability, principally in Europe and less so in Japan. US banks are in a much stronger position, the consumer drives growth in the US economy, energy exposure is not a material issue for the banks and the outlook likely remains healthy.
Much of the current panic is being driven by memories of the financial crisis in 2008. Although the risks remain, the extent of declines across all regions does not appear justified and banks are better capitalised and more strictly regulated today. The current sell-off could generate some attractive entry points, however it is important to remain selective.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.