The top down case for European Banks – this time it really is different
- Ultra low rates did not cause inflation, a dramatic increase in the money supply during Covid did. Equally, the forthcoming recession will not be about higher rates, but about the equally dramatic collapse in money supply growth since April.
- Instead, ultra low rates stimulated the financial markets through cheap credit and low discount rates, that bubble is already unwinding as rates rise.
- Traditionally, markets tend to overlook the benefit to Banks Net Interest Margins (NIMs) from higher short rates and instead focus on the higher provisions that inevitably result from the tightening of monetary policy and the upcoming recession.
- This time however, rates are not so much rising as normalising, as the unwise policy of Zero Interest Rates is abandoned, taking NIMs also back to a normal level, but with considerable operational gearing from the low base.
- Meanwhile, the traditional banks have not made the bad loans that will now need provisions for the simple reason that they were squeezed out of the boom that is now ending.
- The era of Zero Interest Rates that followed the Financial Crisis in 2008 did not lead to higher inflation as Central Bankers predicted, instead it created an economically damaging mis-allocation of capital and a huge Shadow Banking System in the west, which combined to fuel a series of speculative bubbles that are now unravelling as interest rates and thus discount rates finally normalise.
- These new entrants, together with regulators forcing traditional banks to strengthen their balance sheets and lending criteria, excluded traditional banks from the boom, but will equally shelter them from the bust. Meanwhile European Banks were also prevented from paying dividends or buying back shares, which, while good for their capital position, meant they fell out of favour with investors. That is now reversing.
- This leaves European Banks in particular in a similar position to Energy stocks a year ago – unloved, with institutional investors under-weight, yet full of cash and generating strong cash flow. Last year a simplistic macro bear view unwound in the face of strong earnings momentum and a recognition that it was indeed ‘different this time’. A scramble to rebalance led to 50% or more gains in the first half. This year, there is even more cash sitting on the sidelines looking for a home, preferably one allowing for diversification away from the US$. We suspect that they might just realise, all the money is in the Bank(s)
As Hong Kong finally opens up, we had the opportunity to catch up with some of our friends and colleagues from Toscafund who were marketing in Hong Kong for the first time in almost 3 years. In particular, they were talking about their flagship Financials long/short fund and how they were the most interested in European Banks that they have been for many years. While this blog is not about specific investment advice (it is, as they say, for information and hopefully entertainment purposes only) the overlap of interest is that we have added European Banks to our Model Portfolio of smart beta thematics. We are hoping to capture the beta, while they are aiming to add further alpha at both long and short side. Below, we set out the case for Beta in European Banks in 2023, something we see as the equivalent of the energy sector in 2022 – full of cash, unloved, under-owned and with a mis-reading of the macro view based on market muscle memory.
The listed financial sector of the financial markets has struggled in recent years precisely because the misguided policy of Zero Interest rates has created a ‘New’ Financial sector that usurped its role as the transmission mechanism for monetary policy. From a business point of view, if we were to use the Porter’s Five Forces approach, this policy has delivered a Perfect Storm of negatives over the last decade. As such, the end of this policy is about to not only reduce a set of headwinds, but to turn them into tailwinds.
Headwinds are not only easing, but they are turning into tailwinds.
Zero Interest Rate Policies delivered a Perfect Storm of Negative 5 Forces to Banks
1) They increased the threat of new entrants – challenger banks and fin-tech, as well as private equity, private credit, and of course the Corporate Bond markets, where for over a decade it has been not just cheaper to fund in the bond markets, but a lot cheaper. However, as the chart from BofA shows – that is no longer the case, bonds yields are now well above bank rates. Moreover, the long term institutional capital funding a lot of these challengers has also slowed dramatically, not least because both the regulators and internal controls are collapsing the ability of even long term institutions to tie up funds in the underlying illiquid structures. Not all will lose, but market share is returning to the traditional banks
2) Linked to this, Zero Interest rate policies introduced the threat of substitutes: VCs, SPACs, crowd Funding, even the world of Crypto, where small companies were able to finance themselves with ‘coins’ they issued in themselves – a modern form of penny stock financing. They all came into the SME business and crowded out the traditional Banks. These too are obviously reducing as a threat.
3) The new entrants and the substitutes collapsed the pricing power of banks against suppliers – in this case negative interest rates drove savers into alternative products, while money market funds, recovering from 2008 problems, acted as a ‘safer’ way to store cash, even at low rates of return. Now, with deposit rates rising, this is the third headwind turning into a tailwind.
Higher Rates now a single, not a double, edged sword
To summarise, investors in Banks traditionally regard higher interest rates as a double edged sword, higher rates are great for Net Interest Margins (NIMs), but bring forth the negative impacts of the recession they are intended to bring about, in the form of higher bad debts. However, there are several things that are different this time.
- The Banks did not participate in the bubble that followed an extended period of low interest rates – the modern day equivalent of the secondary banking market did. That is now collapsing rapidly and the impact is largely confined to them, leaving the traditional banks as the last man standing.
- Post the Global Financial Crisis (GFC), banks were not allowed to over-extend themselves and had to build up very high capital buffers. Meanwhile, in Europe in particular they were not allowed to pay dividend or make share- buybacks, leaving them with huge amounts of cash on the balance sheet.
- Zero Covid (an equally misguided policy) forced/encouraged/allowed banks to further bullet proof their balance sheets.
- Valuations are at multi year lows, more than pricing in the recession that is inevitably coming.
- Interest rates are rising, but from an artificially low level where Banks can’t make a margin, to a ‘Normal’ level where they actually make good margins.
Thus, the key to the value case for European Banks lies with the end of Zero Interest Rates, which, as we have noted on many occasions were a highly damaging economic policy that led to a huge misallocation of capital, poor productivity growth, zombie companies and, as with all the Zero policy triumvirate (the others being Zero Covid and Zero Carbon) the very opposite of what they were intended to achieve – in this case high street dis-inflation rather than inflation as savers spent less while borrowers spent more in financial markets and fuelled speculative bubbles. It is the rapid expansion, and equally rapid contraction of the Money Supply that is driving the current inflation and the coming recession, while moves in interest rates affect both the discount rate applied to equities and the profitability of the banking sector.
To conclude: Many investors have been ‘hiding’ in US$ cash for much of this year and are watching closely as the trade weighted index – the DXY – unwinds all of the gains it made in the wake of the bond selloff that followed the Fed’s aggressive post Jackson Hole. Thus as previously noted (November Market Thinking), cash is looking for cash-flow to invest in, particularly outside of the US$ zone, as well as solid balance sheets and return of cash to investors through buy backs and dividends. As the Soufflé of virtual wealth that was in Crypto collapses and a lot of start up ‘challengers’ in the financials area realise that actually it’s their future funding costs that are going to be the real challenge, the regulatory and competitive pressures on Banks are reversing and we believe that investors are also going to realise that all the Money is, literally, in the Bank(s) and especially those in Europe. Just as last year the ‘cosy consensus’ was to remain underweight energy stocks, despite their valuation, strong cash flows and positive earnings momentum, leading to a scramble in the first few months and a 60% rally, so the current cosy consensus is to remain underweight European Banks, which looks like an extremely similar set up for 2023 and beyond.
