First it was the PBOC, then came the ECB and now the Fed. Investors are now starting to pencil in the likely new era of “EGG ME” or Extraordinary Globally Guaranteed Monetary Easing in perpetuity. And in this “EGG ME” background it is becoming difficult to get bullish on bank equity in any part of the developed world.
I would argue that in certain parts of the world, bank equity valuations are stretched (Canadians, Aussie and even some large cap US banks) and do not reflect economic realities. In addition, non-bank players are disrupting the traditional lenders and eating away the already shrinking revenue pie. In Europe, the problem is even more acute given that the banks have multiple fundamental problems including shrinking margins, high cost base and very poor growth prospects.
Fool me on growth, fool me on inflation but GIMME (Guaranteed Indefinite Maximum Monetary Easing) QE forever seems to the only way to keep risk assets from completely falling over. Given that decent global growth levels are getting increasingly difficult to achieve and inflation not reaching targets in any sustained manner, central bank after central bank are outplaying one another on who is going to be more dovish. And the minute there is a semblance of monetary policy normalisation, investors are throwing a big tantrum and running for the hills.
This backdrop means that monetary accommodation likely to stay for extended periods of time or even indefinitely and that is certainly seems to be the case in Europe. In addition to the above issues facing the sector, investors are focussing on:
If you didn’t notice, European Bank Index (SX7E) was down almost 7.5% last week reflecting investors angst and despair about earnings momentum. We can add to it the Brexit related uncertainty and the very poor PMI numbers in Germany and France.
From an equity investor perspective, at first sight, valuations across the sector seem cheap given the low Price/TNAV (trading at a large discount to tangible net asset value), attractive dividend yield and fairly priced on a price to forward looking earnings estimates. But all of the three valuation metrics could still be questioned – is TNAV accurate? Are dividend payouts sustainable? Are the forward estimates realistic?
Valuations may be cheap and attractive but markets see to be focused on the “unknowns’ and risk/issues outlined above and they are unlikely to be resolved anytime soon. Clearly qualitative factors comfortably taking precedence over quantitative models.
With bank equity looking potentially expensive and likely to underperform, investors may be forced to look into high yielding assets such as AT1s and bank sub debt. Whilst the carry on AT1s may be attractive (given where risk free assets are trading) there are other issues to consider including risk premium, equity/rates volatility and most importantly secondary market liquidity.
The structural weakness of the European banks come to the fore when they are sliced and diced in a worst case scenario – very poor earnings profile, inadequate reserve coverage for impairments and core capital shortfall due to leverage. In such scenarios (though a low probability event), at least for some banks, capital burn is significant and whilst equity investors will take most of the hit, the AT1 instruments may yet come into play in terms of potential write-downs or conversion into equity.
This I think would be due to the issuer reaching PONV (point of non viability) and regulator stepping in well before actual triggers come into play. This PONV is the biggest unknown qualitative factor (and one that is decided by the regulator) in AT1 valuation. Thus, single name selection becomes even more important in AT1 investing.
One thing is for sure – this asset class needs specialist / expert handling – someone who understands the macro picture in addition to having a deep knowledge of the issuer and the sector and can handle the volatility that comes from the underlying cross asset structural features.
Having said that there are a number of issues that look attractive to own for long- term investors. Next comes the question of liquidity, as to who would be the marginal buyer of these AT1s in size and what is the clearing level for that. I believe that AT1s yielding 7% (and above) on a yield to call basis and 6% on a yield to perpetuity basis should find some decent interest. A number of AT1s issued by large cap high quality European banks screen well on this metric including the likes of Lloyds, HSBC, UBS, ING, Nordea.
And when it gets there, I believe specialist bank capital funds, distressed debt investors and private equity firms will want to own this but as a price taker. The asset class needs a certain type of deep pocket investor with locked in capital and one who is prepared to do the necessary deep dive work both at an issuer level and at an issue level. And be able to slice and dice the balance sheet to estimate asset recovery values and its impact on capital structure.
Sub debt is always going to trade on the back of equity performance and investor perception and hence unlikely to materially tighten in spread terms but may outperform equity/AT1. In particular, the sub debt issues from the large banks in Italy and Spain are attractive to own.
Also, it appears to me that Non-preferred senior bonds issued by the larger banks and TLAC paper issued by global banks are starting to become attractive as defensive plays to fund shorts in other parts of the capital structure and/or across names.
To summarise, bank capital investing is becoming much more interesting from a relative value perspective and to some extent this strategy takes out the directional risk element. Careful single name selection and then determining which part of the capital structure to invest becoming more and more crucial.
I had set out my Bank Capital Outlook at the beginning of the year (2nd January 2019) wherein I saw significant scope for generating substantial returns (10%+) based on single name selection and evaluation of macro factors. And as of now, this strategy has returned 6% YTD.
Now, following yesterday’s ECB meeting wherein additional accommodation was announced, subtle changes to the investing strategy are required.
ECB’s TLTRO 3 will undoubtedly help the EZ banking system with more liquidity and funding options and will help the weaker banks to roll over existing debt – and also help credit creation in the process. Overall, the probability of default should decrease further as banks fund through the ECB.
Without economic growth, most of the existing NPL stock is unlikely to go away and, in fact, may lead to further NPL creation. In any case, earnings are likely to be impacted due to margin compression and given the high cost base, little room for additional loan loss provisions. And if banks were to take additional litigation/settlement and restructuring costs, earnings are likely to come under pressure.
Return on Equity is already low for many of the banks, and may yet go lower. Given the 10%+ COE for most EZ banks, the case for investing in EZ bank equities is just not there. To me, there is plenty of downside in EZ bank equities.
Whilst the ECB may have solved the liquidity issue, it has not taken away the potential Solvency issue (in case of a deep recession and/or other tail risks) and consequent recapitalisation for some banks and this new TLTRO does not address that. I believe that there is still plenty of downside in EZ bank equities.
Most of the AT1 issued by large cap EZ banks do look attractive. However, one needs to take into account the potential extension risk and especially those AT1s with low reset spreads.
Once the right issuer has been identified, then AT1s issued by that bank would be attractive to own if:
And if rates keep rallying, the chances of non-call actually increase as banks may be incentivised to keep the existing AT1s instead of tapping the markets for replacement.
So, I think the longer call AT1s may be better to own ahead of short-dated calls. Also, it is better to own the national champion peripheral bank AT1s given the additional yield and hedge them with single name equity puts.
My personal view is that the Non-Preferred Senior / Holdco Senior issued by the large EZ banks look very attractive on a risk-adjusted basis (taking into account probability of default and loss given default). The spread differential between NPS and LT2 of the same issuer seems to be excessive. The only issue seems to be the potential large supply of NPS debt, but I think that it has been overplayed.
And in CDS land, I think Senior Fin Index is wide relative to Main and I see Senior Fin trading through Main over the course of the year. And within Single names, Senior CDS of peripheral EZ banks look wide relative to Core EZ banks and expect further compression.
2019 will continue to be a very interesting year for bank capital with loads of opportunities and significant volatility. But there is significant scope for generating substantial returns based on single name selection and dynamic portfolio risk management.