The State of the Financial World Post-Brexit
2016 has been a tough year for bank stocks globally as they continue to deal with the fallout from legacy issues whilst facing a period of introspection regarding their future business models.
A minority have fared well, trading well above pre-crisis levels (Wells Fargo for example); others are still trading well below this point (Standard Chartered amongst others). At face value, the sector appears to be relatively cheap on a valuation basis, however, is this enough to compensate for the inherent risks associated with it? Much rests on whether the assets on the balance sheet are valued correctly and their sensitivity to the prevailing economic conditions. On the former point, given that many banks are trading below book value, investors suspect not (a price-to-book-value below one indicates that the company is destroying shareholder wealth rather than creating it).
Price-to-book value is a metric often used to compare banks since most financial assets are valued frequently (stale prices can render this measure inaccurate), however, there is still some discretion in how certain assets are valued. For example, some loan repayments may have a degree of uncertainty associated with them that banks may be reluctant to recognise on the balance sheet as any write-downs would lead to a reduction in the book value of equity (leading to a loss of shareholder wealth). Moreover, due to the economic sensitivity of bank assets (which comprise mostly of loans and credit to households and companies), a reduction in the value of these assets due to an economic downturn can have swift and significant repercussions for bank shares.
An increased regulatory burden has also made life more difficult, with more stringent targets for equity capital ratios and frequent stress testing of bank balance sheets. There is no doubt that this harsher regulatory landscape will put a squeeze on profitability going forward, however, on the other hand, an adherence to these stricter rules may increase shareholder confidence that there are no further nasty surprises hidden in the reported figures. Generally speaking, the institutions that have performed the poorest in recent years have been those with significant investment banking operations. Given the volatile nature of these revenues, investors may be applying a discount due to this lack of visibility/consistency of earnings.
Impact of Negative Interest Rates
Until fairly recently, the concept of negative interest rate policy was something discussed only in academic circles; however, it is now an economic reality, with the central banks of the Eurozone, Japan, Switzerland, Sweden and Denmark having dropped their interest rates below zero over the last few years.
In theory, negative rates should reduce borrowing costs for households and companies, thereby increasing loan demand. However, there are a number of factors as to why this mechanism is not functioning properly. Demand for loans is still relatively weak, household balance sheets are still being bolstered and business confidence remains fragile, with both groups continuing to horde cash. Individuals and businesses cannot be forced to borrow so banks are having to compete aggressively to obtain new lending business. This, combined with a reluctance to pass on negative rates to customers, tends to squeeze bank profits by reducing their net interest margins (the difference between the rates at which they borrow and offer loans).
If profitability continues to fall then banks may actually scale back lending, contrary to the intended outcome of central bank policy. Moreover, if banks are effectively forced to charge depositors, cash may leave the system to reside ‘under the mattress’, depriving lenders of a crucial source of funding. For example, sales of safes in Japan have doubled from a year ago. Admittedly, this is more of an emotional response to negative interest rates than an economic one, however, it provides an insight into the fragile confidence of Japanese households and the potential failure of central bankers to communicate their intentions to the populous.
On a larger scale, banks themselves are also indicating a willingness to defy their respective central banks by exploring options that would see portions of their excess deposits stored in vaults. Given that this would entail fairly high storage costs, it indicates the pressure that banks are under to find solutions to this issue. It also points to a natural resistance level to further rate cuts, whereby money leaves the system at an accelerating rate and monetary policy becomes increasingly ineffectual (the law of diminishing returns).
The immediate aftermath of the EU referendum result saw bank share prices tumble, with the sector falling on average by around 15-20%. According to Bloomberg, the trading days immediately following the referendum saw one of the sharpest negative shifts in analyst sentiment on record. Barclays, Royal Bank of Scotland and Lloyds Banking all had the ratings on their stock cut by at least six analysts. Each will face a multitude of issues and uncertainties in the coming months and years as potentially tortuous negotiations take place.
Domestically-focussed banks such as Lloyds are exposed to the prospect of an ensuing recession in the UK, the risk of another push for a Scottish referendum and significant exposure to the domestic housing market which is showing signs of cooling. Others, such as Barclays, with large investment banking divisions, are faced with the loss of ‘passporting’, which allows them to operate across the EU without having to set up local subsidiaries.
The more multinational banks such as HSBC look the most insulated at present, with their exposure to Asia now seen as a help rather than a hindrance (due to the non-sterling revenue). Another potential headache for the UK government is that it could be lumbered with its remaining holdings in Royal Bank of Scotland and Lloyds for a lot longer than planned. Given that they are both now trading well below the government’s breakeven price, they will be reluctant to sell at a significant loss, putting additional strain on government resources.
Despite the rhetoric from European leaders, Brexit risks derailing the fragile recovery in Europe and, more seriously, putting the entire European project in jeopardy. Subsequently, reaction to the leave vote was extremely strong in European markets with some of the largest casualties being bank stocks.
European banks were already going through a difficult and painful turnaround process without the additional uncertainty caused by Brexit – European banks need economic growth and confidence to improve and Brexit risks both of these. Italian banks have been especially hard hit given that they were already under significant pressure due to high levels of non-performing loans in the economy.
The Italian government has already begun making contingency plans to support its banks with capital injections and/or loan guarantees, citing exceptional circumstances (which enables them to avoid EU rule breaches on state aid) Government bond yields in the so-called peripheral economies have been on the rise. Given that most Eurozone banks hold significant quantities of their government’s debt, there is a strong link between the health of the country and that of its banks, this is also an indication of heightened risk aversion. Moreover, further monetary easing is likely to hurt the banks who are already reluctant to pass on negative interest rates in full for fear of deposit flight.
Tellingly, US banks are more highly rated than their European counterparts, reflecting their greater success at tidying up their balance sheets, the relatively stronger state of the US economy (large banks tend to exhibit a fairly high correlation to GDP growth) and the closer proximity to a normalisation in interest rates (better margins).
That said, US bank stocks have still be weak this year due to moderation in the Federal Reserve’s tone on the future path of interest rates and worsening credit quality in some areas of the economy (shale gas companies for example). Given that stocks had rallied in anticipation of improving fundamentals, these developments were seen as a setback. Also, a dearth of mergers, acquisitions and initial public offerings have a depressed the revenues of the big investment banks such as Goldman Sachs.
Other developments in the US include new accounting rules that come into force in 2020. Under these, US banks will be forced to recognise losses on loans starting from the point of origination (as previously mentioned, the current standards require write-downs only when losses become ‘probable’). This assessment of probable losses will be based on a combination of experience and forecasting. The rule change has run into opposition from banks who claim that it will deter lending and introduce further volatility in earnings.
More recently, the Federal Reserve announced the results of its latest round of stress tests for 33 institutions. All passed barring the US subsidiaries of Santander and Deutsche Bank, which were quoted as having “broad and substantial weaknesses across their capital planning processes” (a sign that some of the European banks are still playing catch-up).
The latest round of stress tests were an important milestone for banks seeking to distribute more capital to shareholders in the form of dividends and stock buybacks and demonstrates that most institutions have significantlystrengthened capital buffers and internal controls, given that the conditions of the tests were arguably more extreme than those faced during the financial crisis.
Despite falling margins caused by a gradual slowdown, most banks in the region remain highly profitable. The region should also benefit from continued loose monetary policy in the US and the liquidity that this provides. There has been some cyclical deterioration in loan books, however, this remains fairly benign and central banks have the scope for a loosening of fiscal policy if necessary (they are slightly more constrained on the monetary policy front as easing could lead to unwanted currency depreciation).
One country that is a cause for concern is China, given that a significant slowdown would be a drag on the whole of Asia, however, if the constraints of volatile capital flows and tighter liquidity constraints ease, then there will be further scope for further interest rate cuts.
Despite all the negativity surrounding the sector, there are a number of potential bright spots, especially for the better capitalised banks operating in the right areas. Sentiment is seemingly about as bad as it can get, banks will be a beneficiary of (eventual) interest rate rises, margins have stopped falling, de-leveraging has taken place, litigation risks have subsided, capital buffers have been built up and companies are increasingly in a position to return capital to shareholders in the form of buybacks and dividends. Overall, risks still dominate the investment decision, however, we see opportunity in broad exposure to funds and/or investment trusts investing in financials and well as some of the leading individual names.