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Holly LaFon
Holly LaFon
Articles (9202)  | Author's Website |

Sarah Ketterer's Causeway Capital Commentary: Holiday Stress Tests

Bruised UK and Continental European bank shares, represented by the MSCI European Bank Index, have spent the second half of 2018 in a merciless valuation de-rating. We believe they are oversold

December 06, 2018 | About:

Bruised UK and Continental European bank shares, represented by the MSCI European Bank Index, have spent the second half of 2018 in a merciless valuation de-rating. We believe they are oversold. European bank stocks may be the positive surprise of 2019. Despite abundant levels of capital, rising dividend payout ratios, and falling non-performing loan (“NPL”) ratios, these stocks have suffered from doubts about European Union (“EU”) integration and potential ramifications of various Brexit scenarios. In local currency, the Euro STOXX Banks Index has declined 25% over the year-to-date period, while the UK FTSE All-Share Banks Index has given up 15% over the same period.

In our estimate, these bank indices did not start the year overvalued. However, in recent months, Europe’s economic outlook has dimmed, and European financial sector equities have de-rated further. Banks tend to be economy- and stock market-sensitive (high beta), and thus characteristically underperform in falling markets. However, recalling the value mantra, “There’s a price for everything,” we cannot explain why some of the most operationally improved bank stocks (generating — in some cases — record high earnings and capital) have sunk to near crisis level valuations. Are we entering a crisis? We do not see one on the horizon. Central banks have armed themselves with liquidity measures to forestall economic disruption and protect their respective financial systems.

Several of the largest European banks recently have passed stringent capital adequacy stress tests. These well-capitalized banks are trading near the lowest current and prospective price-to-book value, price-to-tangible book, and price-to-earnings multiples seen since the euro zone banking crisis of 2011. The unweighted dividend yield of the five major UK banks is over 5% for 2019, and several have declared that they will deploy excess capital in share buybacks. Major Italian banks have disposed of most of their bad debts and worked assiduously to widen the gap between revenue growth and cost growth (known to bank analysts as the “operating jaws”). Banks have two primary levers to improve shareholder returns: cost control and capital management. Well-managed banks do both. We look for adept bank management teams who focus on disciplined underwriting and cost efficiency, creating a buffer to offset any revenue headwinds.

Admittedly, further deterioration of Italy’s financial health could result in major spillovers in the euro area and in the United Kingdom. The Italian government’s lack of fiscal austerity means potentially higher levels of Italian public debt — at 131% of gross domestic product (“GDP”), already among Europe’s highest. Italian banks are among the largest holders of Italian public debt and thus have significant perceived sovereign risk. Without more relief from central bank liquidity, Italian banks could experience rising funding costs, that — if passed on to households and businesses — could depress already weak growth and lead to a proliferation of bad debts. Italian NPLs already account for over 25% of all euro zone NPLs. The current Italian government may prove more fiscally frugal — out of necessity — than markets anticipate in order to avoid punitive sanctions. Regardless of the politics, we believe that euro zone banks in our fundamental client portfolios have plenty of capital.

The European Banking Authority (“EBA”) recently published the results of the 2018 EU-wide stress test of 48 banks. Commenting on the outcome of the exercise, Mario Quagliariello, Director of Economic Analysis and Statistics at the EBA, said: “The outcome of the stress test shows that banks’ efforts to build up their capital base in the recent years have contributed to strengthening their resilience and capacity to withstand the severe shocks and material capital impacts of the 2018 exercise. The results will be used by supervisors as part of their wider assessment of banks’ vulnerabilities and input to their supervisory decisions.” In the United Kingdom, bank regulators demand a crisis proof financial system. In its November 2018 Financial Stability Report, the Bank of England (“BOE”) claims: “The UK banking system is resilient to deep simultaneous recessions in the UK and global economies that are more severe overall than the global financial crisis and that are combined with large falls in asset prices and a separate stress of misconduct costs.” The BOE’s worst case scenario assumptions include (deep breath…): world GDP falls 2.4%, UK GDP shrinks by 4.7%, UK unemployment rises to 9.5%, UK residential property prices plunge 33%, UK commercial real estate prices collapse by 40%, and the pound sterling exchange rate index declines 27%. This scenario envisions rapid imposition of trade barriers with the EU, loss of existing trade agreements with other countries, severe customs disruption, sizable rise in risk premium on UK assets, and loss of confidence and other negative spillovers to UK financial markets. Even this nightmarish outcome would leave UK major banks with capital ratios twice pre-2008 levels. Today, UK banks have 3.5 times the capital they held in 2008, while conducting considerably less risky operations. Furthermore, they are funded more by low risk deposits than volatile wholesale liquidity. Consensus sell-side 2020 estimates for the major UK banks imply an aggregate capital cushion of GBP30 billion available for distribution.

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About the author:

Holly LaFon
I'm a financial journalist with a master of science in journalism from Medill at Northwestern University.

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