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Europe’s shunned banking sector ‘poised to rally’

Investments in the European Union, business concept. 3D rendering

Widening credit spreads have set off alarm bells for some investors over the last few months and European banks have suffered widespread sell-offs, amid concerns about inflation spiking, global trade wars and Turkish contagion.

Widening credit spreads – the difference in yield between a US Treasury bond and another debt security with the same maturity, but a lower credit rating – suggests that investors want more compensation for the risk of lending to a company rather than to the US government.

However, Michalis Ditsas, head of investment specialists at SYZ Asset Management, argues that the beleaguered European banking sector is actually poised to rally. 

“Despite the recent market gloom over the [European] banking sector, the financial system continues its balance sheet strengthening, with higher levels of equity capital and improved asset quality,” Ditsas said.

Eurozone banking institutions added billions of fresh equity capital since the end of 2010, at the same time reducing their bad loan exposure from 2015 peaks to the current Nonperforming Loan (NPL) ratio of 4.9%.

Berlin-based rating agency Scope posted a report in June arguing that the the outlook for Sweden’s banking sector was improving as fears of a housing crash recede.

Addressing NPLs

The European Central Bank, meanwhile, recently announced further steps towards addressing the stock of NPLs by shifting its policy from an EU-wide common target to a supervisory approach consisting of bank-specific targets for NPL reductions, in order to avoid discrepancies between banks and among countries.

In addition, the ECB can now impose ‘Pillar 2’ stipulations – which designate capital adequacy requirements banks must meet to withstand stressed situations – forcing banks to address any NPL issues.

“This increase in financial regulation is a positive development for Italian and Spanish banks in particular, as it will reduce the risk of sudden recapitalisation and the forced sale of NPLs. For investors, the practical impact of these regulations will likely be an increase in issuances, providing further investment opportunities,” Ditsas said.

Monetary policy stability 

At present, there is a very low risk of unexpected ‘hawkish’ shocks, as the US Federal Reserve hiking cycle is already priced in and the ECB continues to be transparent in reaffirming its cautious and supportive stance.

The market is discounting an increase in risk-free rates, but this will have limited impact on risky asset valuations, Ditsas added.

He said that emergency monetary policy mechanisms, namely the European Stability Mechanism, Outright Monetary Transactions and the banking union, have reinforced the ECB’s toolkit to ensure price and financial stability across Europe.

All 32 European banks that SYZ Asset Management analysed have “sufficient buffer not only for 2018, but also for the more demanding regulations they will face in 2019,” Ditsas added.

ICE BofAML Subordinated Euro Financial Index spreads have rebased around the five-year average, which results in attractive valuations. In addition, CoCos are offering attractive carry relative to other asset classes, Ditsas said.

“These characteristics, combined with solid banking fundamentals, positive regulatory developments, political risks that are either priced-in or have faded out and an overall stable economic environment make the asset class one of the most attractive places to invest this year.”

 

 

David Robinson

David Robinson is the editor of Expert Investor. He has 18 years’ experience as a business journalist and editor. In the past he has written for the Guardian newspaper and The Telegraph, and worked as...

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