European Banks: A Strong Buy?

Yvan Berthoux - 29 March 2018

This year, a major theme that investors have started to consider since the recent sell-off in global equities is the potential return of volatility. After hitting a historical low of 8.84 last year, the VIX has more than doubled and is now trading above its prior 2008 crisis long-term average of 20. The sudden eruption of risk-off environment triggered a sharp reverse for the European banking sector. The European Banks index (Stoxx 600) was down roughly 14% from peak to trough, with Deutsche Bank leading the way and losing one third of its market capitalization.

One popular explanation in the recent drop in banks’ stock price is the sudden rise in funding costs, the LIBOR 3M – OIS spread. Considered to be a key measure of credit risk, the spread increased from 10bps in early November 2017 to almost 60bps this week, and many analysts have concluded that the funding costs were the main driver of the banks sell-off. Figure 1 (left frame) shows the evolution of the Euro Banks 600 index and the Libor 3M – OIS spread since 2015. Even though we detect a strong co-movement between the two times series, this chart does not match the fundamental narrative.

European banks rely on the Libor market for less than 5% of their funding requirements. For instance, Deutsche Bank Libor liabilities for all currencies total €18bn or 1.2% of the banks’ assets, therefore the rise in the USD funding costs on its own cannot explain the sharp decline in the stock price. A better fundamental proxy for European banks is the German yield curve (or term spread), which we define as the spread between the 10Y and 2Y bond yields. Over the past month, the German yield curve has flattened by 23bps on the back of a fall in the long-term yields in this current risk-off environment, which has exacerbated the sell-off in Euro banks.

Figure 1. European Banks

Data source: Eikon Reuters

Does this mean that there is a value opportunity in European banks? If we look at total return to financial stocks since 2011 (in USD terms), European equities have severely underperformed their US counterparts (figure 2, left frame) and bear interesting risk premia (relative to the US) at current levels.

Hence, in our central case that long-term yields in the developed countries are going to rise in the next 12 months, yield curves should steepen in the future and levitate financial stocks, especially in Europe. Even though nominal GDP growth in Germany has been robust over the past few years (3.5% to 4%), long-term yields have been artificially lowered due to the ECB asset purchases program (figure 2, right frame). With the ECB stepping out of the bond market, long-term yields in Germany and other core countries are more vulnerable to an upside than a downside move.

To conclude, even though value investors face heightened volatility risk in European financials in this market climate, the broader trends are moving in their favour.

Figure 2.

Data source: Eikon Reuters, Homer and Sylla

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