With inflation running closer to target, central banks in advanced economies are poised to start cutting interest rates. The forward curve is discounting a return to a neutral rate of c. 2.5% in the Eurozone and c. 3.8% in the US. As we enter a new stage of the cycle, we discuss the opportunities we see across European banks equities. Here are our 4 main convictions:
I. The bulk of the rally in long duration is behind us.
II. European banks equities should outperform the broader European market in all macroeconomic scenarios but a deep recession.
III. If growth picks up, European banks should rally by 30%+ as their aggregate price-to-book jumps above 1.0 for the first time since 2017 according to our analysis.
IV. High quality banks with resilient interest rate margins, strong capital generation and superior communication should outperform.
I. The bulk of the rally in long duration is behind us.
Though one can be tempted to extend duration after the last rate hike has been delivered, the window to do so can be very short. When looking at the last 5 cycles, 10-year Treasury yields ended up on average one percentage point lower 3 months after the last hike by the Fed but did not rally further in the following 9 months. This time, duration appears particularly overextended. We had a record 120 bps rally in Treasury yields in just two months
II. European banks equities should outperform the broader European market in all scenarios but a deep recession.
Sir John Templeton had a useful way to characterize the stages of a market rally: “Bull markets are born on pessimism, grow on scepticism, mature on optimism, and die of euphoria”.
III. If growth picks up, European banks should rally by 30%+ as their aggregate price-to-book jumps above 1.0 for the first time since 2017.
The PE ratio of banks has historically been highly correlated with PMIs. Strong bull markets in banks have often coincided with an improvement in economic prospects and a steepening of the yield curve. In our base scenario above, we assume that macroeconomic conditions remain cloudy, with weak or slightly negative growth, somewhat inverted yield curves and poor credit demand, and that multiples stay low.
IV. High quality banks with resilient interest rate margins, strong capital generation and superior communication should outperform.
In a cloudy macroeconomic environment, we believe that quality will pay off. We would favour models that offer a combination of:
1- Earnings resilience in a 1%-2% rate environment
2- High and sustainable shareholder distributions
3- Superior visibility
4- Ability to deliver growth in a weak economy