The impact of events in Portugal on markets last week has highlighted the apparent vulnerability of European banks en masse to changes in investor perception. Coming from the perspective of an equity investor, one often has to consider the extent to which underlying stock picks are simply driven by larger macro factors. Observe for example the price behaviour of the Italian banking sector versus the 2 year Italian-German bond spread (figure 1):
Since Draghi’s well publicised speech in the summer of 2012, the Italian Financials Index has rallied some 135% while the spread of 2 year Italian BTPs versus German Bunds has contracted from just over 500 basis points to 62 basis points. Was an investment in an Italian bank not simply just a quasi-long position in Italian BTPs?
These two data series are clearly fundamentally related, but determining causality here seems to be important in understanding why Italy offered an attractive investment opportunity for macro investors yet also to fundamental stock pickers. True this rally would not have occurred had the ECB not supported the broader system, however from a bottom-up perspective the essential process of repair across European financials prompted by these events was (and is) fundamental in nature.
It is hard to argue that one could have judged Draghi’s speech as a pivotal point in the Eurozone crisis and immediately piled into anything leveraged to Europe. If you did, well done! What did become increasingly clear throughout the second half of 2012 and into 2013 was that the European financial system was undergoing repair both in terms of adequate provisioning across loan books, as well as through the build-up of bank capital. While earnings had yet to recover, this capital build began to cap downside risk for the equity holder and it was at this point that one could credibly invest on bottom-up, fundamental grounds.
One of my observations throughout this crisis is that periods of strong performance of bank equities were typically triggered by a switch from investors focusing on capital to focusing on earnings. This tended to occur as provisioning was deemed adequate and there was a clear path to a sufficiently capitalised position. In the case of the US this was in 2012, the UK and Spain in 2013, and finally Italy in 2014.
In January 2013 a research meeting on Lloyds Bank, Bankinter or Intesa would have focused on capital, by the summer it was on net interest margin and this perception crucially allowed banks to become “investable”. It was this switch that drove many of the rallies across financial sectors globally as equity risk premia shrank and the global financials space became a lot more comfortable for many investors. As typically the case in markets, this appreciation took time as participants had to adjust away from a previous anchoring in valuation. The successful analysts over the previous 5 years had, after all, been the sceptical ones!
What now for the sector?
Italian banks remain the last frontier of the European financial recovery story but approaching the European Asset Quality Review (“AQR”), do characteristics still exist that could lead to a mispricing?
Banca Monte dei Paschi has just concluded a 214-per-5 rights issue following on from others such as Banco Popolare, which clears most of the capital problems from the country’s banking sector. The AQR may prove the final trigger but it appears that the market has been somewhat quicker to price in this improved position versus the US and Spanish market rallies. Nevertheless confirmation from the AQR on capital positioning could provide further confidence around a number of equities assuming that the test is shown to be sufficiently rigorous.
The aggregate market capitalisation of major indices serves as an adequate (although somewhat imperfect) proxy as to the value attributed to a given banking sector. Figure 2 compares the US, Europe and Italy:
While the US index has successfully surpassed the total market value pre-crisis, the Italian and indeed the broader European indices remain far below. It is worth noting that the major constituents of the Italian index (Unicredit and Intesa) have a significantly greater level of customer deposits than pre-crisis and therefore could have greater fundamental earnings power in the long run.
There continues to be deafening noise around the specifics of net interest margin, front-book and back-brook pricing, impairments etc…but the past has shown that by spending too much time forecasting these, you may struggle to see the wood for the trees. Once a bank has regained trust around its capital position, funding costs should normalise, impacting both earnings and equity risk premium. It is this notion of trust in capital position that has been so important throughout this crisis, and this is something we can take away for future banking confidence crises. Trust in the position of the Chinese banking sector for example seems likely to play a crucial part on equity valuation in that region of the world.
One should also remain cognisant that Italy is not structurally an easy banking market to operate in. For example the notice period for a manager at Monte dei Paschi is some 26 months while at the same time the bank is not allowed to sack staff based on “ability”! It is a market however that is lowly valued with a free option on structural reform. There are early signs that the crisis has led to some focus on the rationalisation of inefficient cost structures as well as some renewed innovation. Consolidation could also be an important driver of improved returns.
So in summary…
There have been many ways to make money in financials throughout this crisis both for the macro investor and for the stock picker. We appear to be moving into a more stable world, at least in developed markets, but I hesitate to use the word “normal”. Return on equity will likely be lower as a result of lower leverage but at the same time banks should be considerably better capitalised. One should guard against mistaking past volatility for an indicator of future risk.
The last few years in the European banking sector have been a clear example of how the interplay between micro and macro factors as drivers of asset prices can be highly complex and changeable. The panic created by Espirito Santo in the last month has illustrated that equity investors need to approach financial investments with a clear mind-set of how to address macro volatility even as business fundamentals improve. These events periodically surface causing one to reassess a bottom-up thesis, yet by keeping a disciplined and objective assessment of any real fundamental impacts, can allow an unemotional response to price action.