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European banks – economic tailwind

Overview

  • The European economy looks set to continue to grow above trend
  • This growth provides an increasingly helpful backdrop for the region’s banks
  • Regulatory and other risks remain, but PBOS Investment Services sees attractive upside potential

Brighter economy, brighter banks

The eurozone has begun to enjoy an increasingly vibrant and self-sustaining recovery. Unemployment is falling sharply, regional business confidence is at multi-year highs – and is beginning to be reflected in investment – and participation in this recovery is increasingly broad-based. Perhaps as a consequence of this more visible turn in their economic fortunes, European electorates seem to have been tamed a little.

All of this is likely to have important implications for the region’s banks. The continued acceleration in loan growth that should accompany this economic outlook may encourage investors to look beyond an interest rate profile that is unlikely to be helpful for a while yet. The weight of non-performing loans, so long a burden on profitability, capital requirements and the ability to lend, will continue to lighten, in PBOS Investment Division's opinion, with increasingly functional secondary markets helpful.

Meanwhile, banks’ capital positions have already been significantly improved in recent years, with the European sector’s core regulatory capital, as a proportion of total risk-weighted assets, having doubled in the last decade.

But not without risk

Investors will not need long memories to work out why this is not an investment for all risk appetites. The banking sector has certainly been travelling in the right direction, amidst that more helpful economic backdrop. However, certain regions remain severely over‑banked. ECB deposit rates are negative and, in our view, will likely remain so for a while yet.

And with more inconclusive Italian elections possibly on the way, the political environment is not done with being a hindrance in all regions just yet. Investors will want to keep an eye on the cost of insuring against default (Figure 1), which has tended to be a good coincident indicator of bank balance sheet quality. Alongside this, it remains hard for banks to suffer a full-blown liquidity crisis without it showing up in the interbank lending rate (Figure 1).

A risk worth taking

A continuously improving economic backdrop makes the risk of a new systemic crisis increasingly unlikely in our view. Price-to-book values for countries with significant idiosyncratic risks, like Germany and Italy, are near historical lows and seem to sufficiently discount those risks.

Overall, the sector represents a play on improving economic growth and a further unwinding of regional deflation fears. Ultimately, the sector has the scope to be re-rated and experience a significant improvement in earnings if the current economic expansion stays on track, making investment in the sector still a risk worth taking in our view.

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