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Should we be buying European bank shares?

31/01/2020

European banking is a divisive issue. Some are no longer willing to look at the sector, arguing it has no future, while others point to cheap valuations as a reason to retain some targeted investments.

True, revenue growth prospects for Europe’s banks are uninspiring. First, Europe's feeble economic growth cannot power any major expansion in lending to the economy, hence Christine Lagarde's repeated calls for a coordinated fiscal boost. Second, fierce competition between banks prevents strong growth in business volumes and any significant rise in fees, making the case for consolidation at national and European scale once the regulatory framework supports it. Third, low rates makes it impossible to expand interest margins and this is set to continue as rock bottom rates remain a key plank of economic stimulus. Finally, ever stricter capital requirements have weighed on banks’ profitability.

Pending progress on these points, banks will have to work within this environment of low revenue growth, which leaves open the option of cutting costs. The consensus expects the big European banks to grow revenue at 0.81% during the next tax year while reducing costs by 1.42%.

An industry whose short-term strategy is basically to squeeze costs is hardly inspiring. Witness the sector's weak valuations and low yields (price to book and return on tangible equity average 0.79% and 9.29% respectively for this fiscal year). That said, it seems to us that the discount has been somewhat overdone given the scope for the economy to pick up thanks to a likely economic stimulus in Europe and improving international trade following the draft deal struck between China and the US. On top of this we have the cost-cutting plans, which should bear fruit in the next few years. The ECB's recent gesture on remuneration of bank reserves is another positive sign. Mergers are possible, as the CEO of Société Générale recently mooted. As for regulatory pressure to strengthen capital, it is likely to tail off once Basel III is in place and banks have already taken steps to anticipate additional steps likely to be brought in. So, the banking sector should not be dismissed out of hand. It is likely to start looking healthier in the next few months.

Data source: Bloomberg BI Large Cap European Banks Top Competitive Peers, 8 January 2020

Article completed on 10 January 2020 by Florent Delorme, macroanalyst at M&G Investments.

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