Insurers, exchanges, asset managers, emerging-market banks - even US banks - will continue to outperform as the herd deserts the European banking industry, finds Lynn Strongin Dodds
It is not surprising that European banks are the pariahs of the investment community. Despite their rock-bottom valuations, the spectre of a collapsed or radically altered euro-zone combined with a spluttering economy is prompting investors in financials to look to the US, Asia and emerging markets, as well as in sub-sectors such as insurance and speciality finance.
Long-only fund managers started their withdrawal from the European banking community during summer 2011 when Greece teetered on the brink of collapse. The retreat has continued in spite of ever-lower valuations. At the end of 2011, European banks in the Dow Jones Stoxx 600 index were trading at 0.57 times book value, the lowest since the immediate Lehman fall-out of February 2009. They sold at an average of two times book from 2005 to 2007, according to Bloomberg.
“The main point is that there has been a lack of progress in resolving the euro-zone debt crisis,” says Justin Bisseker, European financials analyst at Schroders. “We may need a few more European company bailouts or banks to collapse before politicians realise how serious the situation is.”
“What we are seeing today is an escalation of the crisis that began in the autumn of 2008,” adds Jeremy Batstone-Carr, chief economist and strategist at broker Charles Stanley. “The debt crisis that engulfed the banks and resulted in the collapse of Lehman Brothers is now consuming entire countries. Western economic authorities have run out of bazookas and it remains to be seen whether the Federal Reserve and European Central Bank embark on additional quantitative easing. Conditions may have to deteriorate further in order that their hands may be forced.”
What was once unthinkable - the unravelling of the euro-zone - is now a possibility. A draft prospectus from the European Financial Stability Facility covering the latest euro-zone bail-out instruments includes explicit warnings that the euro could break apart or even cease entirely to be a “lawful currency”. While it is uncertain whether this clause will be included in the final prospectus, markets are beginning to factor in the worst-case scenario. According to analysts the recent increase in bond yields suggests that investors are worrying that a break-up of the euro would cause banks in Germany and other creditor countries to incur losses on their bond holdings, raising the possibility of bank recapitalisations.
Irrespective of whether the euro-zone breaks up European banks face major challenges in terms of a weak macro-economic climate and more stringent regulations, says Graham Kitchen, head of equities at Henderson Global Investors. “We are generally negative about European banks,” he says. “They may have to take up to a 50% haircut on some of their debt instruments and this combined with increased capital requirements and a low-growth environment is not conducive for banking stocks.”
European banks not only face Basel III requirements but also European Banking Authority regulations requiring them to increase core tier-1 capital ratios to more than 9% of risk-weighted assets by the middle of 2012. The latest figures show that European banks need to a fill a capital shortfall of €114.7bn to achieve these levels.
Although European banks are under the most pressure, their US counterparts have not emerged unscathed. Fitch Ratings recently cut seven of the world’s biggest lenders’ long-term issuer default ratings to A from A+. The banks affected include Goldman Sachs, Bank of America and Citigroup as well as Barclays, Credit Suisse, Deutsche Bank and BNP Paribas in Europe. Similar downgrades were made by Standard & Poor’s and Moody’s.
According to Fitch, no matter how well-managed, the structural aspects of these global trading and universal banks’ funding, earnings, and leverage, make them vulnerable to market sentiment and confidence, particularly during periods of ‘exogenous financial stress’. In addition, their complex business models and exposure to fat-tail risk make it more difficult to assess the size of loss that could emerge rapidly from unexpected events.
It is not all doom and gloom. “In general we have a global investment process that identifies companies that have relatively low leverage, high capital ratios, strong management and high quality earnings,” says Ben Ritchie, senior investment manager at Aberdeen Asset Management. “A handful of banks meet this criteria, including Standard Chartered, a conservatively run institution with low leverage and a fantastic position in the Middle East, Africa and Asia. HSBC ticks many of the same boxes. Meanwhile, the Nordic banks are also operationally performing well compared with many of their European counterparts, and they are not as constrained by the challenges of euro membership.”
Many analysts also believe that US banks should not be tarred with the same brush as Europe’s, given their lower economic risk, better loan growth and an easier regulatory environment.
As for sectors outside banking, insurance companies, particularly non-life, are the favourites. According to a recent report by Credit Suisse, these firms are trading on the same price-to-book multiples as banks, but have far less regulatory and political risk and a third of the leverage, once policyholder exposure is accounted for. In addition, exposure to peripheral European sovereigns is equivalent to only 35% of tangible net asset value - versus 90% for banks.
AXA, Aviva and Allianz are seen as the best bets, although Ritchie also points to Zurich Financial Services, which has a reasonable international platform with strong positions in the US and Latin America as well as a good business in Europe. “We also like Vienna Insurance, which has over 50% of its premiums coming from Eastern Europe,” he adds. “We see long-term structural growth, as demand for general and life-insurance products increases in these hitherto under-penetrated markets.”
Looking a bit farther afield, emerging markets banks - particularly underleveraged banks in underleveraged countries, such as Russia’s Sberbank and China’s ICBC - are also on radar screens. “They have stronger balance sheets, fewer problems with non-performing loans and over the next five years will produce superior returns than the global market average,” says James Ross, head of European value equities at AllianceBernstein. “We also like exchanges, due to the increasing trend of mergers such as Deutsche Börse and NYSE Euronext.”
Peter Garnry, equity strategist at Saxo Bank, also points to asset management companies and specialty finance companies such as AMEX and Mastercard as attractive investments. “In the US, the consumer has de-leveraged, spending is slowly increasing and the barriers to entry in this field are high. As for asset management companies, we look at the sector as a defensive play. We like niche players such as Ashmore, which specialises in emerging markets, as well as Federated Investors, Franklin Templeton and BlackRock, all of whom have sustained assets under management as well as a diversified asset base.”