Banks’ Woes Tied to Earnings Pressures,
Not Balance Sheet Problems
March 18, 2016 | Monthly Market Insights
Each month State Street Global Advisor (SSGA’s)
investment teams from around the world gather to talk
about broader trends in the global economy and markets
and their implications for investors. With bank stocks
experiencing steep declines of 20% or more, along with the
prospect of persistent low or even negative interest rates,
financials stock analyst Jeremy James of SSGA’s Active
Fundamental Equity team focused on banks and discussed
why the sector’s current woes are unlikely to pose systemic
contagion risk.
Key takeaways
• Bank stock declines reflect earnings headwinds, not balance
sheet concerns
• Post-crisis regulations have strengthened
bank fundamentals
• US banks have recapitalized more quickly than European
banks, but ECB’s backstop is key for Europe
• Negative interest rates in Switzerland, Denmark and Sweden
have had a limited effect on bank profitability
• Though China’s opacity complicates NPL risk assessment, its
semi-closed system should limit global contagion
• Insurance companies and nonbanks are lending more, but
starting from a low base
• Historically low valuations in bank stocks create select
buying opportunities in the US and Europe
Financial shares have struggled dramatically to be sure,
but from our perspective, the story has mostly been about
earnings troubles rather than balance sheets. That is an
important distinction because to us, this episode does not look
like another 2007 global financial crisis or 2011 European debt
crisis. Since those periods, we think the sector’s fundamentals
have strengthened.
Regulation has improved dramatically. The European
Central Bank, for instance, is now the single regulator for
the region, in charge of conducting annual stress tests and
other supervisory reviews of the banking system. The ECB
can provide a backstop — albeit an imperfect one, with
work on regulatory issues and resolution systems still to do.
Nevertheless, the degree and coordination of sector oversight
is far better than it was.
Capital levels are much stronger. Tier 1 ratios in Europe
are up from 8% during the GFC to about 14% now. The quality
of capital is also much improved. Admittedly, banks have
deleveraged much faster in the US, yet asset-to-equity ratios in
Europe have come down from 25 times to 17 times.1 So leverage
levels are lower, while equity levels are firmer.
Liquidity shows a marked difference. In Europe, the
banks are less reliant on short-term wholesale funding and
US dollar sources. All this suggests to us that the sector’s
problems have more to do with earnings, and we observe a
number of reasons why consensus estimates for 2016 and 2017
have been revised downward.
Interest rates are not rising as fast as had been expected.
Neither in the US — where the Federal Reserve seems to be on
hold again after only one hike — nor in a number of European
countries including Switzerland, Denmark and Sweden —
where rates have already fallen into negative territory. This
raises the specter that we might move into a negative rate
environment more generally. Obviously that impacts banks’
net interest margins, because they are unable to reduce deposit
costs further while lending yields fall. Yet the evidence from
banks in countries with negative rates suggests that the damage
to overall profitability has been limited.
The global energy sector remains in a slump. With crude
oil prices still stubbornly low, higher provisions for loans to
the energy sector might be required. Overall, however, we
think that situation could be fairly manageable because the
exposure to oil companies ranges on average from only 2% to
6% of loans at most banks.2 Even if, as in the last oil crisis, 10%
of energy sector loans went nonperforming, banks ought to be
able to cope. Given loan reserves of about 3%, that amounts to
an annual hit on earnings of about 5% over the next two years,
which would be painful but not life-threatening.
Capital markets weakness
Weak trading and capital markets have spilled over from the
fourth quarter of 2015 into the first quarter, which is normally
stronger. Many investment banks have already disclosed
downward pressure on earnings in 2016.
Market Commentary | Banks’ Woes Tied to Earnings Pressures, Not Balance Sheet Problems
Contagion from emerging markets is another worry.
As China’s economy continues to decelerate along its
evolutionary path from being investment-driven to consumerled, slower loan growth would be a natural effect. Though
China’s opacity complicates our assessment of risk, we are
forecasting a pickup in nonperforming loans — but not
necessarily spillover effects to the rest of the world’s banking
system, because of relatively limited foreign exposure to
Chinese banks.
Insurance companies and nonbanks have taken on more
risk. In such a low yield environment, there is always the
concern that the banking and shadow banking industry has
been chasing yield in places they would normally avoid, such as
high yield or non-investment grade issues in the energy sector.
However, we believe exposure is manageable. The situation
reminds us of 2001–2002, when weakness in the technology
and telecommunications sector was absorbed by the banking
sector and did not spill over into the rest of the economy.
Valuations are becoming more attractive. At the same time
that prices and earnings have been under pressure, financial
stock multiples have come down. On average, banks are trading
at about 0.7 times book value3 — not yet at the trough of the
GFC, when they fell below 0.6 times,4 but still at a significant
discount to the long-term average of about 1.1 times, reflecting
a return on equity of 10% on average over the long run.5 That
could be low enough to offer an argument for value appearing in
the sector.
What we observe in the funding markets at the moment
seems to suggest that investors are still fairly sanguine about
financials. The interbank market is functioning fine and
bank cash debt spreads are not widening that much. The
only area where we have seen some stress is in the relatively
small Additional Tier 1 market — also known as contingent
convertible bonds, or CoCos — which we believe has been
driven more by uncertainty around bank resolution and the
constraints on coupon payments than by concerns about bank
solvency. Unless we are heading into a major recession in the US
and Europe, we do not see a balance sheet issue for the sector.
Instead, we view this as an opportunity to buy select financials
at some compelling valuations and price levels that tend to be
consistent with attractive, long-term returns.
Source: European Central Bank cited by Deutsche Bank, as of February 12, 2016.
Source: AB (AllianceBernstein), as of January 27, 2016.
3.
Source: FactSet, as of February 11, 2016.
4.
Source: FactSet, as of March 9, 2016.
5.
Source: SSGA estimate of long-term multiples and returns.
1. 2. ssga.com
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