Oliver Judd and Betty Sanchez Torres argue that despite a recovery in prices, banking sector securities continue to offer value so long as a deeper recession is avoided.
Read this article to understand:
- Why the recovery in bank securities may have further to go
- Why banks look well placed to weather shallow recessions
- Why bank bond spreads look attractive relative to non-financial corporate debt
Risk assets have enjoyed a positive start to the year with both equities and corporate bonds delivering strong returns.
The MSCI All-Country World equity index climbed 7.1 per cent in January, its second-best monthly performance in more than two years and the best start to a year since 2019.1 Corporate bonds have also rallied hard.
Sectors hit hardest during the first three quarters of 2022 have fared particularly well as investors continued to be lured back into riskier assets. However, the rally has been broad based with other sectors also joining the party, including banks and other financials.
Expectations lenders’ profits will continue to be boosted by higher interest rates, as well as optimism that recessions will prove shallower than seemed likely in the autumn, mean the recovery in banking securities looks to have further to go.
In this Q&A, Oliver Judd (OJ) and Betty Sanchez Torres (BST), respectively co-head of global credit research and global equity analyst covering financials at Aviva Investors, give their thoughts on the outlook for the sector.
How are banks placed to weather a tough macroeconomic environment?
OJ: Our corporate bond portfolios have had an overweight allocation to the banking sector for some time. While we appear to be heading for choppy economic waters, banks’ balance sheets are generally healthy. Earnings are being supported by a big improvement in net interest margins following the substantial rise in interest rates, while market volatility has been boosted investment banking revenues.
Banks are in a position of strength and should have plenty of scope to build up provisions should they deem it necessary
This means banks are in a position of strength and should have plenty of scope to build up provisions should they deem it necessary. All told, they look well placed to ride out any economic headwinds, at least for the next year or so.
BST: From an equities perspective, the sector is facing a fair degree of uncertainty, especially as to the severity of any recession. But as Oliver says, most lenders already have decent cushions with a lot of the reserves taken at the outbreak of COVID-19 still sitting on balance sheets. While provisions will rise as firms factor in a recession, we see limited risk of heavy losses forcing cuts to shareholder pay-outs. Likewise, banks should be able to avoid having to raise equity, especially when you consider the extent to which capital positions have been strengthened since the financial crisis.
Having said that, the level of uncertainty over the economic outlook means it is likely to be another volatile year for share prices. We have a slight preference for European versus US banks, mainly because in Europe you still have several rate hikes to come, while in the US the debate is more around a slowing in the rate of hikes and a pause at some point.
Why do banks securities appear to be lowly rated by the market?
OJ: Since banks are regulated institutions, they should be deemed comparatively safe from a credit perspective. Yet arguably ever since the financial crisis, the market has tended to discount this and instead chosen to focus on banks’ sensitivity to the macroeconomic environment. This makes the sector prone to underperform in times of market stress.
We believe bonds issued by banks should trade closer to the wider market
We disagree with the reasoning behind this and believe bonds issued by banks should trade closer to the wider market, which helps explain our overweight. Spreads over the relevant government bond benchmark are pretty wide, even relative to where they were at other similar moments, such as the euro crises of the previous decade. Spreads over non-financial corporate debt also look excessive.
Figure 1: European bank and insurance credit default swaps versus broader European corporates
Note: Shows cost of insuring five-year risk for a basket of European financial companies versus a broader set of European corporates. Credit default swaps act as a proxy for credit valuations.
Source: Bloomberg, Aviva Investors. Data as of January 2023
The coupons we have recently been able to get on new issues from some of our more favoured banks have been attractive compared to what we were receiving in the lower-rate environment.
BST: Some of it obviously comes down to a natural fear of what toll a recession will take on banks’ earnings. But not all of it. If you take European banks, their shares have consistently traded at a sizeable discount to the broader market in terms of the price-to-earnings ratio. They are currently trading almost as cheaply as they ever have, which is hard to rationalise and helps explain our preference for European lenders.
Figure 2: European banks PE relative to the SXXP (European market)
Source: Bloomberg, Aviva Investors. Data as of January 2023
Can you give us further insight into how your portfolios are positioned?
BST: As said, we have a relative preference for Europe versus the US at present given the narrowing interest-rate differential. But within Europe it is important to be selective as there are a lot of specific risks. For example, Nordic lenders are exposed to a high level of housing-market risk. In Italy, the sustainability of the government’s fiscal position is an ever-present concern, while investors need to be mindful of the political landscape in Eastern Europe where several governments have implemented windfall taxes on banks.
It comes down to selecting the right markets and those lenders with a sufficient cushion to weather a recession
It comes down to selecting the right markets and, within those markets, lenders with sufficient cushion to weather a recession and most scope to boost shareholder returns, via buybacks for example.
OJ: US banks, which are a big constituent of the indices we follow, look attractive from a credit perspective given their overriding concern is with banks’ capital positions and the quality of their loan books. From a systemic position, the major US lenders look reasonably secure.
But we are also attracted to several European lenders given, as Betty says, earnings are likely to be boosted by an ongoing improvement in net interest margins.
Does this include Italian banks given their exposure to Italian government debt?
OJ: On balance, we have become a little more comfortable with holding Italian bank debt in our portfolios. Historically, we have only invested in the country’s two biggest banks, Intesa and UniCredit, viewing other lenders as too risky. But we would now probably consider investing in the next tier of banks, given signs of an improvement in the Italian economic outlook and recent domestic M&A activity within the banking sector, which is improving the quality of banks’ franchises and strengthening balance sheets.
A lot of this improved outlook has been priced into the bond market
Having said this, a lot of this improved outlook has been priced into the bond market, especially considering perennial concerns over Italian government bonds. This does, however, illustrate there are a lot of potential investment opportunities in the European banking sector, allowing us to be selective.
What do you see as the main risks?
OJ: A deeper recession leading to rising unemployment is probably the main one. Historically, it has been the biggest driver of problems in bank loan books. The other potential worry is that banks will have last stress tested their loan books when interest rates were much lower. The pace at which rates have risen means mortgage books, for example, could be more stressed than everybody is assuming, especially since lending standards will have tightened recently.
BST: Less than a handful of European banks have reported full-year results so far, generally in Spain, and there have been no significant signs of deterioration. But with European interest rates still rising, investors need to remain watchful.
Investors need to keep an eye on the prospect of tighter regulation
The prospect of tighter regulation is another thing investors need to keep an eye on. Banks were prevented from paying dividends in 2020 and forced to put buybacks on hold. Banks remain an easy target for politicians and the risk of tighter regulation cannot be dismissed.