- Global Industry Analyst
Switzerland, Intermediary
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The power of local perspective
At Wellington, we see on-the-ground presence in key financial centres as a prerequisite for understanding the local market and providing tailored solutions that meet local investors’ specific needs. Zurich, for example, is home to one of 19 offices where Wellington’s local investment and relationship experts draw on the insights of our global investment and research platforms to provide clients with a broad range of investment solutions across traditional and alternative asset classes.
In the first of a short series on the power of local perspective, we illustrate how deep industry research is helping to uncover hidden value among European banks — one of Switzerland’s, and Europe’s, most critical sectors.
Today’s less stable and more regionally divergent macro backdrop offers active investors an attractive environment in which to search for market outperformance. The proprietary research and unique perspectives of our global industry analysts (GIAs) are key components of our active investment process.
Of the many sectors our GIAs cover, European banking is among those facing significant change and increasing stock-level dispersion amid greater divergence in monetary policy, technological disruption and industry consolidation. Here, our European banking analyst Thibault Nardin shares his insights on the sector and outlines where he sees potentially compelling opportunities ahead.
Key points
- In my view, European banking is a compelling sector for active investors with the depth of research expertise to uncover emerging opportunities.
- A likely resurgence of M&A activity and the impact of rapid technological advance will likely have profound implications and drive dispersion in performance within the sector.
- As interest rates go down, I expect increased divergence in terms of the path of return on equity and dividends for banks from different countries, which should translate into further share price dispersion.
What’s behind the European banking sector’s outperformance?
In the last three years, European banks have outperformed the broader European equity market by 65%, and the sector is 17% ahead of the market year to date.1
The European banking sector has already undergone significant change and there’s more to come. After 15 years of deleveraging, de-risking and multiple banking crises, the sector has weathered the economic volatility of the last five years successfully overall and, in my view, is now healthier than ever. Profitability has nearly doubled since 2019, balance sheets are clean, and capital and liquidity are plentiful. I think the level of credit risk in balance sheets is much lower than market perception as high-risk loans have been transferred to the non-bank unregulated sector, which means returns should stay higher for longer and be less susceptible to the shorter, more frequent economic cycles we can expect going forward.
Eurozone banks in particular have significantly outperformed their non-eurozone peers over the past five years, driven by the normalisation of interest rates and generous capital-return policies. Earnings-per-share revisions have been among the best of any MSCI Europe sector on a one-, three- and five-year view, and recent recovery in equity markets has further supported banks’ earnings momentum via their capital-market activities.2 Despite overall strong stock performance, the valuation discount of the banking sector versus EU indices has barely narrowed, standing at a 40% discount versus the STOXX Europe 600 today.
How do you view today’s opportunities and risks?
While I think that positive earnings surprises are mostly behind us — high net-interest margins may not be sustainable amid lower interest rates and as banks face repricing pressure — a combination of higher profitability levels for longer and low balance-sheet growth means the sector should continue to generate high free-cash-flow yield, which should support low- to mid-teens shareholder returns and a resurgence of M&A in the sector. As earnings growth disappears, the pressure to consolidate or “buy” new growth drivers will intensify. I see the potential for domestic consolidation in Italy, Spain and Central and Eastern Europe, in particular. There is also the potential for banks to look to buy insurance companies given strong regulatory incentives.
Additionally, technology is having a profound impact on how consumers engage with banks and their products. Rising rates have increased the cost of capital for fintech while traditional banks’ profitability has considerably improved their ability to invest in technology. While the AI “industrial revolution” will undoubtedly improve banks’ long-term efficiency, it will also improve customer awareness and reduce banks’ ability to profit from their customers’ inertia. This will likely create winners and losers, and being able to identify which management teams will be best able to adapt will be key in seeking long-term alpha generation.
In terms of the potential areas of concern, I think the main risk to Europe’s banking sector is the political environment given Europe’s large budget deficits and high sovereign debt. This environment increases the risk of sector taxation and “crowding out” of banks’ balance sheets — by reducing the availability of funding for private investments — as governments try to plug budget holes and tap retail investors with government bond offerings. Moreover, prevailing political uncertainty may, at times, weigh on valuations despite strong fundamentals, as has recently been seen in France.
The regulatory backdrop is also something I’m monitoring closely, here in Switzerland and abroad. Looking at Switzerland specifically, I expect the powers granted to FINMA to increase and the regulatory rulebook to be tightened further given the recent challenges faced by the financial sector. However, I think the Swiss bank financial-markets regulator has a delicate task at hand to ensure any additional regulatory requirements do not put internationally active Swiss banks at a competitive disadvantage relative to their global peers, particularly in the event of a Trump US presidency as a Republican administration would likely seek to loosen the regulatory framework for US banks.
What impact will the rates environment have?
Of course, interest rates remain a key part of the debate. European financials have typically been a strong sector for alpha generation. I like to tell clients that there are 44 countries in Europe and the 44 banking sectors all work differently. While this is not great for economic efficiency in Europe, it creates compelling potential for uncovering mispricing and divergence in fundamentals. As rates go down, I expect further divergence in terms of the path of return on equity and dividends for banks from different countries, which should translate into more share price dispersion across the sector.
Asset-sensitive banks (in general, Iberian, Italian, Greek and Irish banks) — which are more vulnerable to falling rates given the shorter duration of their assets versus their liabilities — have benefited from the “higher-for-longer” scenario year to date (Figure 1) and have the highest free-cash-flow generation over the short term. However, they are at peak profitability and have re-rated the most in recent months. In contrast, liability-sensitive banks (in general, Benelux, French, German and UK banks) have weaker earnings momentum, and trough or mid-cycle levels of free-cash-flow generation but, in my view, can expect higher earnings growth and resilient profitability in a falling-rate environment. For these reasons, looking out over the next three to five years, I think the risk/reward profile of liability-sensitive banks looks better than that for their asset-sensitive peers.
Figure 1
Final thoughts
It’s an exciting time to be an analyst in the European banking sector in an environment of ongoing change and growing dispersion. In my view, the sector remains a fertile ground for active investors with the research expertise to separate the likely winners from the losers.
1STOXX Europe 600 Index versus STOXX Europe 600 Banks Index as of 26 June 2024 | 2As of 26 June 2024
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