Talking Heads – Les vents sont favorables pour les actions européennes

This is an article based on the transcript of the recording of this Talking Heads podcast

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis through the lens of sustainability on the topics that really matter to investors. In this episode, we’ll be discussing European financials. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Jeroen Knol, Portfolio Manager for European Large-cap Equities and a specialist on European financials. Welcome, Jeroen, and thanks for joining me.

Jeroen Knol: Thank you, Daniel.

DM: Over the last few years, while [eurozone] policy rates and real interest rates were negative, European financials suffered poor performance and profitability. Now, after 450 basis points of monetary tightening, the outlook is different: European banks have been reporting record profits. What’s your view on whether banks can sustain this?

JK: Yes, can European banks’ net interest income continue to grow? The scope for very large earnings upgrades in the sector has finished to some extent, but as a mid to long-term investor, I expect any pullback to be temporary. While the ECB has not yet finished tightening and it’s quite likely there will be another rate hike in October, higher interest rates are helpful for banks’ loan books, even if they cannot instantly increase the rates on these loans.

This is a gradual five-year process on average and we’re only two years into that. So banks should continue to have a revenue tailwind from higher interest rates. Many banks have interest rate hedging policies in place that will continue to pay out over the next few years, so that should give  them interest income resilience. Banks have been earning less from non-interest income over the past few years and that should come back as asset management regains favour – that is a big source of income for many banks.

The market has been concerned about credit quality – charges on bad loans – but it seems we’re avoiding a recession, so these losses may not arise to the extent that the market was expecting. European banks operate with historically strong capital positions that are four percentage points higher than their minimum required ratios.

European banks also produce attractive average dividend yields of 6.5% that are being topped up by substantial share buybacks yielding a further 4%. That makes a total of some 10% that banks could earn for shareholders over each of the next few years.

DM: Do you worry banks’ profitability over the last few quarters is too far above what’s sustainable?

JK: The level of profitability is far more sustainable than it was for European banks over past decades. Banks are now far more capital efficient; they’ve restructured their balance sheet, they’re less capital heavy – they are simply better stewards of capital. We’ve also seen more discipline because there’s a higher cost of doing business – higher liquidity rules, compliance costs. This creates a barrier to entry. They have also improved their cost efficiency. The sector lends itself well to digitalisation, so that has helped to push staff and branch costs down. 

Environmental, social and governance (ESG) requirements also create a barrier to entry. They’re advising clients to become ‘greener’ and they’re quite restrictive in their lending, to support clients in increasing their ‘green’ credentials. This too helps support banks’ returns and profitability.

DM: So good news in terms of their earnings, but it always depends on what price you pay to get access to those earnings as an investor. Some investors are concerned the valuations are too high at this point. What’s your view?

JK: Bank earnings have been growing at record levels over recent quarters, but bank share prices and market sentiment have not kept up. Ever since the [global] financial crisis (GFC), banks have traded at a discount. Current valuations have degraded further –we’re close to the troughs of the GFC and the weakest point in terms of sentiment on valuations in the past 15 years.

The sector’s 2024 price-earnings multiple of a little more than 6x is half the level of the wider European market. The tangible book value is 0.9x, so it’s at a discount to tangible book. Profitability is now at over 12% doesn’t justify such multiples. And there are dividends and buybacks. So if interest rates start to plateau or slip down, we’ll see some temporary weakness in bank share prices, but there is still a lot of valuation support.

DM: To give a balanced picture, how worried should we be about commercial real estate debt on banks’ balance sheets in Europe?

JK: The stock of empty office buildings has risen with Working From Home [during and since the pandemic]. Higher interest rates are tough for indebted developers and property balance sheets, and stricter environmental standards for buildings also have a negative effect.

Overall, in Europe, banks’ exposure to commercial real estate averages 7% to 9% of the loan book. But as I said earlier, banks’ capital positions are much better and banking system profitability is stronger and more sustainable, giving a more effective cushion.

Many real estate loans are directly issued to the market, so they do not necessarily sit on banks’ balance sheets. Also, heavily regulated European banks have been steering clear of concentrations and of the highest risks.

This time, systemic risk may not reside with the banks. They have cleaned up their balance sheets and are far more localised in their exposure, so there should not be much exposure to areas of concern such as the US or China. Of course, in overheated commercial real estate markets such as Sweden, parts of Germany and Switzerland, banks will have exposure, but there are measures in place [to deal with it].

These real estate issues have been brewing for a number of years, so banks have had plenty of time to build provisions and reserves. I’m not saying we won’t see any further issues, but it doesn’t seem likely to be acute.

I would say European bank asset quality remains benign and other drivers should support earnings. Valuations also leave a lot of room to cover any setbacks in credit quality.

DM: Thank you very much for joining me, Jeroen.

JK: It was a great pleasure, Daniel.