European banks strategy
Reassessing the tail risk
Fundamental concerns stillpersist, which could limit amaterial re-rating of the sector
January 25, 2012
EU banks have bounced sharply in 2012 as tail risk is reassessed
The SX7P banks index is up 11% YTD (27% from its November low),outperforming the market by 6%, as investors have reassessed the tail riskof eurozone economic collapse in light of ECB liquidity provisions (whichhave assisted in a fall in peripheral bond yields and enabled a pickup inprivate financing), strengthened firewalls from the EFSF/ESM and IMF,and improved global economic data. ‘Value’ stocks have led the way dueto low absolute and relative valuations, risk-averse investor positioning andencouraging regulatory developments (EBA and Basel 3).
Yet while tail risk is reduced, it is not eliminated
However, even as tail risk is reduced, it is not eliminated, with PSI talks inGreece ongoing and the potential for this to spread to weak peripheralcountries. For larger countries, we question how much the improvement inspreads is driven by the banks given the record level of ECB deposits, andprogress towards a definitive firewall through the combined and leveragedresources of the EFSF, ESM, IMF and SMP remains slow, leavingrenewed solvency concerns a possibility, especially if growth falters.Geopolitical risk in the Middle East cannot be entirely discounted.
And fundamental concerns persist
While the ECB three-year LTRO has averted a near-term sharpdeleveraging and margin squeeze for the sector, we see significantmedium-term challenges. Under the weight of austerity plans being passedinto national constitutions, the eurozone is slipping into recession in 2012,which in some countries could be prolonged, leading to rising impairmentsand earnings risk. Banks will eventually need to wean themselves off ECBfunding (a task made more difficult the more they encumber), which willrequire ongoing capital build. Even with some regulatory forbearance, thismakes capital return more limited vs the cash-rich corporate sector.
We would be wary of chasing the sector too much higher
If investors remain primarily concerned about default/tail risk, the balanceof newsflow could see the sector trend higher near term, led by low P/TBVbanks, which are still comparatively lower in their recent trading range,such as SocGen. Yet, at some stage, fundamentals will return to dominatethe investment thesis and cap the upside, with that cap likely to be lowerfor EU17 banks where earnings/dilution risks are higher. While the sectoris still 35% below its 52-week high, when it traded at 1.3x TBV vs 0.9xtoday, we believe that the tail risk of Italian default will need to beeliminated and that the eurozone will need to exit from recession beforethe sector will trade at a material premium to tangible book. Medium term,we continue to favour non-EU17 banks where risks are lower, such asUBS, SWED, HSBC and STAN, with a select number of northern EU17national champions such as BNP and ING to hedge against better EUdevelopments.
Research analystsEuropean BanksJon Peace - NIplc
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Robert Law - NIplc
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Daragh Quinn - NIplc
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Domenico Santoro - NIplc
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Chintan Joshi - NIplc
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Tarik El Mejjad - NIplc
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Omar Keenan - NIplc
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Scott Sheridan - NIplc
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Manish Kumar Marodia
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