After the global financial crisis of 2008/09, most investors elected to ignore the banking sector.
A notable exception, however, were credit investors, who bought the junior debt of investment grade bank issuers and, as these slowly increased their capital ratios and restructured, have accumulated more than 6% compounded annual returns over the past eight years.
Equity investors have travelled a longer, lonelier, more gruelling path. Natwest, for example, has repeatedly cut its balance sheet, contracting 66% since the beginning of the global financial crisis.
This process has involved pain, in the form of charges, losses and reduced revenue. Across European banks, this experience has been common – with equity investors bearing the brunt of restructuring. On top of this, revenues were cut as rates and yields fell to all-time lows.
Begging the questions
Investors have long been asking ‘Do banks have enough capital?’ and ‘Can they make a decent return?’
One consequence of the 2020 Covid-19 recession is that those questions can finally be answered: European banks survived the recession, with higher capital ratios at the end of 2020 than at the beginning.
Early in the pandemic, French bank BNP Paribas shocked the market by forecasting 2020 net income would likely be down by between 15% and 20% on the previous year – despite a severe recession.
Observers thought management were ‘in the clouds’ with their optimism yet the result turned out to be down 13.5% – an impressive result considering the recession’s depth.
Having spent a decade reducing their risks and balance sheets, and then managing their way through the Covid recession, European banks are finally fit-for-purpose.
Regulators have called time on ever-increasing capital buffers and equity shareholders can finally benefit from recovered profitability.
In the first quarter of 2022, a range of European banks, including Barclays, BNP, NatWest and Santander, all made returns on equity of more than 10%.
The European banking sector has a dividend yield of more than 7% while regulators are signing off on the highest number of share buybacks in the sector’s history.
Ready for rate rises
Investors have enjoyed a decade of falling yields and interest rates – by investing in long-duration assets – whether in the bond, equity or real estate markets.
With monetary policy now tightening and yields and rates going up, we are seeing a reversal in some of these trends.
As investors fret over inflation, however, there is one sector where income should substantially benefit from monetary tightening: banking. US, Canadian, UK, European banks … the list goes on.
There is a chance, therefore, that long-suffering European bank investors might be in danger of ‘missing the wood for the trees’, considering the eight years that banks have operated under negative interest rates.
With money markets pricing in a 100% probability of an interest rate hike in July – and more to come – this looks to be a seminal moment for bank investors.
Of course, not all banks are the same yet a range of them, across Europe and the US, should see their net income increase by between 20% and 50%, simply from expected interest rate increases over the coming months.
So where does all this leave investors? Credit investors are now at their maximum bearishness, according to a recent Bank of America survey.
Equity investors hardly lag, as they worry about the current slowdown slipping into recession, despite low levels of global unemployment and nominal GDP currently growing in double digits. From these heights, a slowdown is inevitable.
Yet with banks in a strengthened position, it is hard to feel pessimistic about the sector and there do look to be significant opportunities across the capital structure of banks.
In summary, we like bank equity globally and bank credit in Europe – recent junior debt in European, and even US banks, has been issued with 6% to 7% coupons.
In bank equity in Europe and the US, we see stocks with all-in yields – that is, dividends and buybacks – north of 10%. Somewhat bizarrely, we see banks that are just about to see significant earnings growth sitting on price-to-earnings ratios of between five and six times.
Now that the monetary cycle has decisively turned, it is time to look again at what has served investors well over the last decade and how the environment has changed.
It is also time to reconsider where to invest for the future. In such a challenging context for other sectors, banks look set to be the winners.
Simon Peters is an investment strategist and portfolio manager at Algebris Investments