Investors have been reluctant to buy back into the sector but it is time for them to focus on the broader positive catalysts that will drive the re-rating of the sector to a more “normal” level.
US banks are already well-capitalised but equally many European banks are reaching their Basel 3 Tier 1 capital targets much faster than expected. This is being driven by improvements in profitability, limited loan growth as well as an on-going process of restructuring (recent examples of these trends being UBS, Swedbank and PNC).
Return to high yield
However, the critical catalyst to outperformance from the sector is the expectation of dividends or share buy-backs once the bank achieves its capital targets and there has already been evidence of this in the US and the stronger European bank sectors (such as Sweden). Re-rating of stocks has taken place on the back of this as the banking sector returns to its historic role as a high yielding sector.
Top-line growth for banks in the developed world is unlikely to be strong. Economies continue to de-gear, loan demand remains weak and banks appetite to lend is cautious. Added to which, low interest rates have placed downward pressure on margins and cost-cutting has been slow to take off.
However, this misses the key point about financials in recovery, that their earnings are primarily driven by falls in loan loss provisions. The financial sector will probably see some of the strongest earnings growth of any sector in the next couple of years. Added to which, should the macro environment improve, it is highly likely that the level of provisions will undershoot rather than current expectations of it “normalising”.
Macro tailwinds
A macro recovery benefits the banking sector through increased loan demand but it helps in a variety of other ways. The level of provisioning will fall (both through companies and individuals being able to service their debts but also because collateral values start to increase and potentially increasing write-backs) but equally, an improving macro environment will arguably result in higher interest rates and so improve the margin outlook. Driven by markets and regulators, banks have become much more deposit-funded than in the past as loan/deposit ratios have fallen sharply and so more likely to benefit from rises in interest rates.
A rise in rates will not however, result in wholly positive benefits, since longer-dated bonds will price downwards and some marginal borrowers may go bankrupt. In terms of the latter, as economies recover there are usually some bankruptcies since banks are feeling more comfortable that their balance sheets can take the necessary hits of essentially unviable companies.
The sector has already outperformed markets over the past 12 months, but this has barely caused a dent in the underperformance of recent years and so there is still considerable value potential ahead.
