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. For instance, the recent challenges faced by the Swiss banking sector may lead to regulatory tightening in that market. The Swiss financial-markets regulator (FINMA) has been given additional powers but, in my view, 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. In the event of a Trump US presidency, I think this risk would become more acute as a Republican administration would likely seek to loosen the regulatory framework for US banks.