The investment case for European Banks

SOPHIÉ-MARIÉ VAN GARDEREN Portfolio Manager at Truffle Asset Management

A more hawkish leaning Fed has led to a rapid rise in nominal and real bond yields; 10-year fixed rate yields increased by 27 basis points, and 10-year real yields increased by 39 basis points over January. However, inflation expectations implied by the bond market remained stable, indicating that the market remains confident in the Fed’s ability to contain inflation at around 2%. The bond sell-off spilled over into global markets, with European long bonds finally offering positive yields.

Unsurprisingly, ‘growth’ underperformed ‘value’ in global stock markets as long duration shares suffer disproportionately from higher discount rates. The more speculative growth companies with limited or no profit have been in decline for most of last year, with some of the larger cap tech companies now also starting to underperform. While real rates remain negative, we believe they should ultimately reach positive territory in time. Implied real rates from years five to ten are at zero – too low for a normalised economy. Transitory elements of inflation, including commodity prices and supply-chain-induced price increases, should ease over the next year. However, more sticky elements like wages and shelter (rental), costs may remain elevated. Shelter costs are one-third of the CPI basket and the single largest contributor – so any enduring rental inflation would be significant.

A buoyant economy benefiting from accommodative monetary policy will likely prolong a tight labour market and should keep wage pressures elevated, potentially pushing inflation above expectations. This will further maintain the Fed’s hawkish stance and hence the path for bond yields to rise further. Growth estimates remain above trend, and monetary conditions are still favourable, given that real rates are negative. This should support the ‘value’ portion of the market, provided any inflation surprises and consequent Fed remedial actions are not overly aggressive.

Rising inflationary pressures and rates are impacting most regions but to varying degrees. Europe, which has struggled with below-target inflation for many years, is experiencing higher inflation. Current expectations are for the ECB to bring rate hikes forward and end their bondpurchasing program sooner. As a result, European bond yields have finally exited negative territory.

Aside from offering compelling value relative to the overall market, banks typically benefit from rising interest rates. Banks earn a spread on the rate they charge creditors less the rate at which they borrow. When rates fall close to or below zero, they cannot reduce their borrowing rates below zero. Depositors who provide funding to banks don’t take kindly to being charged interest on their deposits! As a result, bank margins get squeezed. Furthermore, banks earn interest on their equity, which also suffers when rates are low. Hence, rising rates are positive for bank earnings.

Globally, European banks, especially Spanish and Italian, are most sensitive to rising interest rates. These banks have a more significant proportion of floating-rate loan books, which they can quickly reprice as rates rise. Some of these banks have been generating low levels of profitability and are operationally geared. Hence, they will benefit significantly from rising rates.

Given our expectations of positive revisions to earnings, combined with relatively cheap valuations and attractive dividend yields, we remain positive on European banks.